Editing IPCC:AR6/SRCCL/Chapter-7 (section)

==== 7.4.4.3 Market-based instruments ====

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Although carbon pricing is recognised to be an important cost- effective instrument in a portfolio of climate policies ( ''high evidence, high agreement'' ) (Aldy et al. 2010 <sup>[[#fn:r549|549]]</sup> ), as yet, no country is exposing their agricultural sector emissions to carbon pricing in any comprehensive way. A carbon tax, fuel tax, and carbon markets (cap and trade system or Emissions Trading System (ETS), or baseline and credit schemes, and voluntary markets) are predominant policy instruments that implement carbon pricing. The advantage of carbon pricing is environmental effectiveness at relatively low cost ( ''high evidence, high agreement'' ) (Baranzini et al. 2017 <sup>[[#fn:r550|550]]</sup> ; Fawcett et al. 2014 <sup>[[#fn:r551|551]]</sup> ). Furthermore, carbon pricing could be used to raise revenue to reinvest in public spending, either to help certain sectors transition to lower carbon systems, or to invest in public spending unrelated to climate change. Both of these options may make climate policies more attractive and enhance overall welfare (Siegmeier et al. 2018 <sup>[[#fn:r552|552]]</sup> ), but there is, as yet, no evidence of the effectiveness of emissions pricing in agriculture (Grosjean et al. 2018 <sup>[[#fn:r553|553]]</sup> ). There is, however, a clear need for progress in this area as, without effective carbon pricing, the mitigation potential identified in chapters 5 and 6 of this report will not be realised ( ''high evidence, high agreement'' ) (Boyce 2018 <sup>[[#fn:r554|554]]</sup> ).

The price may be set at the social cost of carbon (the incremental impact of emitting an additional tonne of CO <sub>2</sub> , or the benefit of slightly reducing emissions), but estimates of the SCC vary widely and are contested ( ''high evidence, high agreement'' ) (Pezzey 2019 <sup>[[#fn:r555|555]]</sup> ). An alternative to the SCC includes a pathways approach that sets an emissions target and estimates the carbon prices required to achieve this at the lowest possible cost (Pezzey 2019 <sup>[[#fn:r556|556]]</sup> ). Theoretically, higher costs throughout the entire economy result in reduction of carbon intensity, as consumers and producers adjust their decisions in relation to prices corrected to reflect the climate externality (Baranzini et al. 2017 <sup>[[#fn:r557|557]]</sup> ).

Both carbon taxes and cap and trade systems can reduce emissions, but cap and trade systems are generally more cost effective ( ''medium evidence, high agreement'' ) (Haites 2018a <sup>[[#fn:r558|558]]</sup> ). In both cases, the design of the system is critical to its effectiveness at reducing emissions ( ''high evidence, high agreement'' ) (Bruvoll and Larsen 2004 <sup>[[#fn:r559|559]]</sup> ; (Lin and Li 2011 <sup>[[#fn:r560|560]]</sup> ). The trading system allows the achievement of emission reductions in the most cost-effective manner possible and results in a market and price on emissions that create incentives for the reduction of carbon pollution. The way allowances are allocated in a cap and trade system is critical to its effectiveness and equity. Free allocations can be provided to trade-exposed sectors, such as agriculture, either through historic or output-based allocations, the choice of which has important implications (Quirion 2009 <sup>[[#fn:r561|561]]</sup> ). Output-based allocations may be most suitable for agriculture, also minimising leakage risk (see below in this section) (Grosjean et al. 2018 <sup>[[#fn:r562|562]]</sup> ; Quirion 2009 <sup>[[#fn:r563|563]]</sup> ). There is ''medium evidence'' and ''high agreement'' that properly designed, a cap and trade system can be a powerful policy instrument (Wagner 2013 <sup>[[#fn:r564|564]]</sup> ) and may collect more rents than a variable carbon tax (Siegmeier et al. 2018 <sup>[[#fn:r565|565]]</sup> ; Schmalensee and Stavins 2017 <sup>[[#fn:r566|566]]</sup> ).

In the land sector, carbon markets are challenging to implement. Although several countries and regions have an ETS in place (for example, the EU, Switzerland, the Republic of Korea, Quebec in Canada, California in the USA (Narassimhan et al. 2018 <sup>[[#fn:r567|567]]</sup> )), none have included non-CO <sub>2</sub> (methane and nitrous oxide) emissions from agriculture. New Zealand is the only country currently considering ways to incorporate agriculture into its ETS (see Case study: Including agriculture in the New Zealand Emissions Trading Scheme).

Three main reasons explain the lack of implementation to date:

# The large number of heterogeneous buyers and sellers, combined with the difficulties of monitoring, reporting and verification (MRV) of emissions from biological systems introduce potentially high levels of complexity (and transaction costs). Effective policies therefore depend on advanced MRV systems which are lacking in many (particularly developing) countries (Wilkes et al. 2017) <sup>[[#fn:r568|568]]</sup> . This is discussed in more detail in the case study on the New Zealand Emissions Trading Scheme.
# Adverse distributional consequences (Grosjean et al. 2018 <sup>[[#fn:r569|569]]</sup> ) ( ''medium evidence, high agreement'' ). Distributional issues depend, in part, on the extent that policy costs can be passed on to consumers, and there is ''medium evidence'' and ''medium agreement'' that social equity can be increased through a combination of non-market and market-based instruments (Haites 2018b <sup>[[#fn:r570|570]]</sup> ).
# Regulation, market-based or otherwise, adopted in only one jurisdiction and not elsewhere may result in ‘leakage’ or reduced effectiveness – where production relocates to weaker regulated regions, potentially reducing the overall environmental benefit. Although modelling studies indicate the possibility of leakage following unilateral agricultural mitigation policy implementation (e.g., Fellmann et al. 2018), there is no empirical evidence from the agricultural sector yet available. Analysis from other sectors shows an overestimation of the extent of carbon leakage in modelling studies conducted before policy implementation compared to evidence after the policy was implemented (Branger and Quirion 2014 <sup>[[#fn:r571|571]]</sup> ). Options to avoid leakage include: border adjustments (emissions in non-regulated imports are taxed at the border, and payments made on products exported to non-regulated countries are rebated); differential pricing for trade-exposed products; and output-based allocation (which effectively works as a subsidy for trade-exposed products). Modelling shows that border adjustments are the most effective at reducing leakage, but may exacerbate regional inequality (Böhringer et al. 2012 <sup>[[#fn:r572|572]]</sup> ) and through their trade-distorting nature may contravene World Trade Organization rules. The opportunity for leakage would be significantly reduced, ideally through multi- lateral commitments (Fellmann et al. 2018 <sup>[[#fn:r573|573]]</sup> ) ( ''medium evidence, high agreement'' ) but could also be reduced through regional or bi-lateral commitments within trade agreements.

'''Case study | Including agriculture in the New Zealand Emissions Trading Scheme (ETS)'''

New Zealand has a high proportion of agricultural emissions at 49% (Ministry of the Environment 2018) – the next-highest developed country agricultural emitter is Ireland at around 32% (EPA 2018 <sup>[[#fn:r1656|1656]]</sup> ) – and is considering incorporating agricultural non-CO <sub>2</sub> gases into the existing national ETS. In the original design of the ETS in 2008, agriculture was intended to be included from 2013, but successive governments deferred the inclusion (Kerr and Sweet 2008 <sup>[[#fn:r1657|1657]]</sup> ) due to concerns about competitiveness, lack of mitigation options and the level of opposition from those potentially affected (Cooper and Rosin 2014 <sup>[[#fn:r1658|1658]]</sup> ). Now though, as the country’s agricultural emissions are 12% above 1990 levels, and the country’s total gross emissions have increased 19.6% above 1990 levels (New Zealand Ministry for the Environment 2018 <sup>[[#fn:r1659|1659]]</sup> ), there is a recognition that, without any targeted policy for agriculture, only 52% of the country’s emissions face any substantive incentive to mitigate (Narassimhan et al. 2018 <sup>[[#fn:r1660|1660]]</sup> ). Including agriculture in the ETS is one option to provide incentives for emissions reductions in that sector. Other options are discussed in Section 7.4.4. Although some producer groups raise concern that including agriculture will place New Zealand producers at a disadvantage compared with their international competitors who do not face similar mechanisms (New Zealand Productivity Commission 2018 <sup>[[#fn:r1661|1661]]</sup> ), there is generally greater acceptance of the need for climate policies for agriculture.

The inclusion of non-CO <sub>2</sub> emissions from agriculture within an ETS is potentially complex, however, due to the large number of buyers and sellers if obligations are placed at farm level, and different choices of how to estimate emissions from biological systems in cost- effective ways. New Zealand is currently investigating practical and equitable approaches to include agriculture through advice being provided by the Interim Climate Change Committee (ICCC 2018 <sup>[[#fn:r1662|1662]]</sup> ). Main questions centre around the point of obligation for buying and selling credits, where trade-offs have to be made between providing incentives for behaviour change at farm level and the cost and complexity of administering the scheme (Agriculture Technical Advisory Group 2009 <sup>[[#fn:r1663|1663]]</sup> ; Kerr and Sweet 2008 <sup>[[#fn:r1664|1664]]</sup> ). The two potential points of obligation are at the processor level or at the individual farm level. Setting the point of obligation at the processor level means that farmers would face limited incentive to change their management practices, unless the processors themselves rewarded farmers for lowered emissions. Setting it at the individual farm level would provide a direct incentive for farmers to adopt mitigation practices, however, the reality of having thousands of individual points of obligation would be administratively complex and could result in high transaction costs (Beca Ltd 2018 <sup>[[#fn:r1665|1665]]</sup> ).

Monitoring, reporting and verification (MRV) of agricultural emissions presents another challenge, especially if emissions have to be estimated at farm level. Again, trade-offs have to be made between accuracy and detail of estimation method and the complexity, cost and audit of verification (Agriculture Technical Advisory Group 2009 <sup>[[#fn:r1666|1666]]</sup> ).

The ICCC is also exploring alternatives to an ETS to provide efficient abatement incentives (ICCC 2018 <sup>[[#fn:r1667|1667]]</sup> ).

Some discussion in New Zealand also focuses on a differential treatment of methane compared to nitrous oxide. Methane is a short- lived gas with a perturbation lifetime of 12 years in the atmosphere; nitrous oxide on the other hand is a long-lived gas and remains in the atmosphere for 114 years (Allen et al. 2016 <sup>[[#fn:r1668|1668]]</sup> ). Long-lived gases have a cumulative and essentially irreversible effect on the climate (IPCC 2014b <sup>[[#fn:r1669|1669]]</sup> ) so their emissions need to reduce to net-zero in order to avoid climate change. Short-lived gases, however, could potentially be reduced to a certain level and then stabilised, and would not contribute further to warming, leading to suggestions of treating these two gases separately in the ETS or alternative policy instruments, possibly setting different budgets and targets for each (New Zealand Productivity Commission 2018 <sup>[[#fn:r1670|1670]]</sup> ). Reisinger et al. (2013) <sup>[[#fn:r1671|1671]]</sup> demonstrate that different metrics can have important implications globally and potentially at national and regional scales on the costs and levels of abatement.

While the details are still being agreed on in New Zealand, almost 80% of nationally determined contributions committed to action on mitigation in agriculture (FAO 2016 <sup>[[#fn:r1672|1672]]</sup> ), so countries will be looking for successful examples.

Australia’s Emissions Reduction Fund, and the preceding Carbon Farming Initiative, are examples of baseline-and-credit schemes, which creates credits for activities that generate emissions below a baseline – effectively a subsidy (Freebairn 2016 <sup>[[#fn:r1673|1673]]</sup> ). It is a voluntary scheme, and has the potential to create real and additional emission reductions through projects reducing emissions and sequestering carbon (Verschuuren 2017 <sup>[[#fn:r1674|1674]]</sup> ) ( ''low evidence, low agreement'' ). Key success factors in the design of such an instrument are policy-certainty for at least 10 to 20years, regulation that focuses on projects and not uniform rules, automated systems for all phases of the projects, and a wider focus of the carbon farming initiative on adaptation, food security, sustainable farm business, and creating jobs (Verschuuren 2017 <sup>[[#fn:r1675|1675]]</sup> ). A recent review highlighted the issue of permanence and reversal, and recommended that projects detail how they will maintain carbon in their projects, and deal with the risk of fire.

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