Exploring the Emissions Trading System: Perspectives on Mexico

Nowadays, the planetary ecological change that we face as humanity has led us to propose different alternatives to establish new relationships with our environment. From the field of science, diagnoses and recommendations have emerged regarding our productive activities, as well as on the processes of conservation and restoration of ecosystems. As already mentioned in this space, the climate, environmental and social crisis is global and latent, so several international summits have been held at which different protocols are debated and proposed to mitigate and prevent human actions that degrade our Earth. An example of this is the famous Kyoto Protocol, which places special emphasis on the greenhouse gases that we expel into the atmosphere, which was signed by several countries in 1997, but in force since 2005, and which inspired the creation of a very relevant market instrument to address the climate crisis: the Emissions Trading System.

The central objective of the Kyoto Protocol (KP) was to reduce the emission of greenhouse gases (GHGs), one of the main causes of climate change. In addition, it recognized the principle of differentiated responsibilities. This means that Countries with higher levels of industrialization must take actions commensurate with their emissions, compared to less industrialized countries. In these terms, the Paris Agreement signed in 2015 represented a new effort to give continuity to the Kyoto Protocol on the reduction of GHG emissions, in which Mexico voluntarily presented its plan of action to collaborate in this global task. One of the already mentioned proposals in the Kyoto Protocol was the model of Emissions Trading System; what does this mean? And how does it work? These are some questions that we will answer in this text, with the help of members of the Toroto team, Juan Carlos Gallardo and Luis Ortega, because it is worth mentioning that Mexico ended the trial period of this market instrument to start trading properly in January 2023. Let's get to know him.

Emissions Trading Systems (SCE), also called Cap and Trade (“limit and trade” in English), are market-based instruments for reducing GHG emissions. The idea is that a regulatory agent, generally governmental, sets a limit on the total emissions allowed for companies in different productive sectors, which must be reduced every year. The first and largest SCE was the one established by the European Union as a result of the Kyoto Protocol. In this system, 40% of the region's GHG emissions are considered, with more than 10,000 facilities (factories, power plants, etc.) including power generation, aviation and industry in general, registered under this tool. In Mexico, as a result of a reform in 2018 to the General Law on Climate Change, the need to properly establish an SCE was accentuated. Nowadays, there is one whose pilot phase ended last December 2022, so we started this year with its formal operation; therefore, there are some of the key points that we must pay attention to in order to fully understand this tool in the present, as well as its scope in the future. Let's place ourselves in our country and name just a few.

Let's start by explaining the idea of “limit” and “trade”: the limit translates to a specific amount of Broadcast rights, which are “permits” to release a certain amount of greenhouse gases into the atmosphere. These are negotiable and the total of them is divided between companies or industries that have commitments to apply to an SCE. For example, if only 100 emission rights are generated for Mexico, and there are 5 companies participating in this market, each one will have a specific amount of rights totaling those 100 originals. Once this “cap” has been established, companies must pay emission rights if they want to emit more GHGs than established by the regulations. That is to say, that continuing with the emission of GHG represents an additional cost for the company. In this way, the gradual reduction of emissions is encouraged, because as time goes by this “limit” becomes smaller and smaller. Let's give another example only illustrative of the operation of this Cap and Trade, because the reduction presented is only a hypothetical case: let's imagine that a textile industry that emits 200,000 tons of CO2 per year enters the Emissions Trading System, so it must reduce its emissions to 160,000 tons for the first year. For the next one to this one, it will be a reduction of 140 thousand tons; the next to this one, a reduction of 120 thousand tons and so on until reaching the Decarbonization of the operation of that company. The objective is also to give a time limit that allows migrating to less polluting forms in an achievable range.

At the end of the periods defined by the SCE, participants must submit a number of emission rights equal to the number of their emissions during that period, that is, if you were granted 5 emission rights, you must submit those 5 or less. This is how the incentive to reduce emissions and the “commercial” part operate, since if the participant issues more than the rights he obtains for free (and in some cases he does not obtain any), he must buy rights in the market, which will entail an additional cost. Since emission rights are not only granted (either free of charge or through auctions) by the government, but companies can sell and buy them, this also implies that activities and companies that emit the least gases are also rewarded in terms Economical If they sell the rights they have (which means they generated less GHG) to another company that needs them (GIZ and SEMARNAT, 2018b). This transaction occurs between a company/industry that issued more than it could and a company/industry that issued below the established limit. An important issue to recognize is how a price will be assigned to these emission rights, since the possibility that this price is not an incentive to reduce because it is very low, or in the same way, they prefer to look for alternative ways because it is very high, therefore, Juan Carlos and Luis, executives from Toronto, are of the opinion:

“It is extremely important that regulation contemplates two priorities associated with the price of emission rights: on the one hand, the mechanisms through which emission rights are allocated to regulated institutions (for example, you should avoid doing so through Grandparenting [based on historical issues] and methods based on results or auctions should be promoted); and on the other hand, the minimum and maximum prices at which emission rights will be sold. In any case, the price must send the right signals to regulated entities, encouraging them to seek more cost-effective emission mitigation solutions compared to the acquisition of emissions rights. At the same time, it must be sought that this price does not harm technologies that will generate compensation credits applicable to regulation (such as forestry projects) and must function as an incentive to finance them.”

What happens when a company issues more than it can by obligation? In addition to buying emission rights from other companies that managed to go below their limit, there is an additional option to achieve the objectives: compensation credits. These credits are called Offsets or carbon credits in voluntary markets, however, can also serve as an additional source in regulated markets, since they become analogous to emission rights. Compensation credits, like a carbon bond, must demonstrate additionality, permanence, applicability and verifiability (GIZ and SEMARNAT, 2018a). However, today there is still some uncertainty regarding the type of carbon credit that will be accepted to reduce emissions, so:

“The climate hierarchy always indicates that the reduction of GHG emissions must come before compensation. However, in an SCE there are flexible compliance mechanisms; likewise, for the Mexican context, the compensation scheme does not define which protocols, national or international, can be used by interested parties. This brings uncertainty At a time when The transition to net zero emissions must be considered for action over the next few years, where the project funding of carbon sequestration it could happen in a safer way for regulated sectors to know with certainty which protocols are eligible and in turn, to be ready for the remaining emissions to be offset”.

While broadcast credits are a great idea of linking the public and private sectors to achieve common objectives and encouraging climate finance, is an area with several challenges, and in the same way, great opportunities.

On the other hand, regarding the activities that can be included in the Mexican SCE, we can say that they are multiple. The energy field includes the generation of electricity, as well as the extraction and production of hydrocarbons. Also included in the field of industry are automotive, metallurgy, steel, cement, food, etc. However:

“Currently, the Emissions Trading System in Mexico covers only fixed sources, which includes combustion in equipment installed on site, as well as emissions generated from processes (such as cement production). This regulation you should take into account in the future the need to incorporate other sources of emissions such as mobile ones (mainly land, air and sea transport fleets) to have a a more comprehensive view of the origin of emissions and how to reduce them.”

Broadly speaking, SCE participants comply with a principle that could be summarized as follows: “those who pollute, pay”. According to the promoters of this model, allowing participants to determine where and when to reduce their emissions makes the SCE a flexible and effective instrument. In a world where free markets and competition are prioritized, SCEs do not tend to undermine the competitiveness of participating sectors vis-a-vis international markets. In addition to the economic advantages of SCEs, technological innovation is also promoted for the reduction of emissions, since companies can choose different, less polluting methods to carry out their productive activities and adapt to the 2030 goals.

With regard to emissions, we can say that companies that generate more than 100,000 tons of CO2 annually - and that fall under the designated sectors - must participate in this trade on an obligatory basis, since the ultimate objective is for us to reach the goal established in the Paris Agreement, that is, a 22% reduction in emissions that occurred in 2020 by 2030. However, the only GHG contemplated in Mexico's SCE is carbon dioxide (CO2), while other systems, such as California, include other gases (besides CO2) such as methane (CH4), nitrous oxide (N2O), sulfur hexafluoride (SF6), and others, which are mentioned in the General Law on Climate Change. Therefore, in this regard, Juan Carlos and Luis They think:

“Although it is common for CO2 to be the only regulated GHG in a test program, as it matures and is implemented it is It is important to include other relevant GHGs, because it is necessary to account for emissions as accurate as possible; other GHGs (such as methane and nitrous oxide, for example) could play an important role because of their global warming potential.”

There are many areas of opportunity presented by the recently adopted Mexican SCE; we could still talk about mechanisms to avoid legal loopholes (specifically within Type 3 scopes) or the reduction adjustment in subsequent years, among other situations, however, it is a great step in favor of our planet to have this reduction instrument due to the scope and cooperation between sectors that it implies. Let us remember that these systems are directly focused on macro actors, that is, on productive and service companies, whose responsibility is greater because their environmental impact is great. Therefore, it is necessary to always think about the scales and levels at which human activities occur and their respective negative externalities. Thus, these macro actions, which involve actors such as the State, companies and industry, must coexist and exchange learning and achievements with other mitigation actions in the face of climate change, which often form the voluntary part of these market tools, led by the private sector.

Finally, let's remember that informing ourselves, both as individuals, citizens, companies and industries, is our responsibility and our primary capacity to manage a world that is more eloquent with current needs, so to learn more data and access technical documents for Mexico about the SCE, you can consult it hither.

About the authors:

Ayamel is a contributor to the Toroto blog and a graduate student in Philosophy of Science at the National Autonomous University of Mexico.

Juan Carlos and Luis are Key Account Managers in Toroto. Juan Carlos is a renewable energy engineer, enjoys the sea, sports and discovering new museums; while Luis studied Engineering in Sustainable Development and specialized in climate strategy for companies. He is passionate about nature for its beauty and its perpetuity.

References:

• SEMARNAT and GIZ (2018a). Consideration of the use of offsets in an SCE. Available in: https://www.gob.mx/cms/uploads/attachment/file/505775/Ficha_informativa_SCE__5_.pdf
• SEMARNAT and GIZ (2018b). About an Emissions Trading System in Mexico. Available at: https://www.gob.mx/cms/uploads/attachment/file/505777/Ficha_informativa_SCE__1_.pdf