Emissions trading includes all the transactions by which some industrialized countries purchase carbon credits from others in order to partially comply with the Kyoto Protocol.
“You can not sell anyone the right to pollute,” declared a US senator in 2008. However, in 2005 the European market for the right to pollute was opened. In reality this market of emission permits confers no “right to pollute” in that it only establishes a market price on pollution as an externality, has a social cost. Since buyers and sellers are not much concerned with the externalities of their demand and supply decisions, the market equilibrium may not be effective, that is, not maximize the total benefit to society. The market for the right to pollute is, to some extent, a solution to the inefficiency caused by the externality of pollution.
Carbon emissions trading is emissions trading specifically for carbon dioxide (calculated in tonnes of carbon dioxide equivalent or tCO2e) and currently makes up the bulk of emissions trading. It is one of the ways countries can meet their obligations under the Kyoto Protocol to reduce carbon emissions and thereby mitigate global warming.
Trading can be done directly between buyers and sellers, through several organised exchanges or through the many intermediaries active in the carbon market. The price of allowances is determined by supply and demand. As many as 40 million allowances have been traded per day. In 2012, 7.9 billion allowances were traded with a total value of €56 billion. Carbon emissions trading declined in 2013, and is expected to decline in 2014.
According to the World Bank’s Carbon Finance Unit, 374 million metric tonnes of carbon dioxide equivalent (tCO2e) were exchanged through projects in 2005, a 240% increase relative to 2004 (110 mtCO2e) which was itself a 41% increase relative to 2003 (78 mtCO2e).
Global carbon markets have shrunk in value by 60% since 2011, but are expected to rise again in 2014.
In terms of dollars, the World Bank has estimated that the size of the carbon market was 11 billion USD in 2005, 30 billion USD in 2006, and 64 billion in 2007.
The Marrakesh Accords of the Kyoto protocol defined the international trading mechanisms and registries needed to support trading between countries (sources can buy or sell allowances on the open market. Because the total number of allowances is limited by the cap, emission reductions are assured.). Allowance trading now occurs between European countries and Asian countries. However, while the USA as a nation did not ratify the Protocol, many of its states are developing cap-and-trade systems and considering ways to link them together, nationally and internationally, to find the lowest costs and improve liquidity of the market. However, these states also wish to preserve their individual integrity and unique features. For example, in contrast to other Kyoto-compliant systems, some states propose other types of greenhouse gas sources, different measurement methods, setting a maximum on the price of allowances, or restricting access to CDM projects. Creating instruments that are not fungible (exchangeable) could introduce instability and make pricing difficult. Various proposals for linking these systems across markets are being investigated, and this is being coordinated by the International Carbon Action Partnership (ICAP).
In 2008, Barclays Capital predicted that the new carbon market would be worth $70 billion worldwide that year. The voluntary offset market, by comparison, is projected to grow to about $4bn by 2010.
23 multinational corporations came together in the G8 Climate Change Roundtable, a business group formed at the January 2005 World Economic Forum. The group included Ford, Toyota, British Airways, BP and Unilever. On June 9, 2005 the Group published a statement stating the need to act on climate change and stressing the importance of market-based solutions. It called on governments to establish “clear, transparent, and consistent price signals” through “creation of a long-term policy framework” that would include all major producers of greenhouse gases. By December 2007, this had grown to encompass 150 global businesses.
Business in the UK have come out strongly in support of emissions trading as a key tool to mitigate climate change, supported by NGOs. However, not all businesses favor a trading approach. On December 11, 2008, Rex Tillerson, the CEO of Exxonmobil, said a carbon tax is “a more direct, more transparent and more effective approach” than a cap-and-trade program, which he said, “inevitably introduces unnecessary cost and complexity”. He also said that he hoped that the revenues from a carbon tax would be used to lower other taxes so as to be revenue neutral.
The International Air Transport Association, whose 230 member airlines comprise 93% of all international traffic, position is that trading should be based on “benchmarking”, setting emissions levels based on industry averages, rather than “grandfathering”, which would use individual companies’ previous emissions levels to set their future permit allowances. They argue grandfathering “would penalise airlines that took early action to modernise their fleets, while a benchmarking approach, if designed properly, would reward more efficient operations”.
Effect of externalities on the market
Pollution: a negative externality to production
According to Adam Smith’s Invisible Hand Theory, buyers and sellers who pursue their own goals maximize the total profit that society derives from a competitive market: it can be said that this market is effective. In a market of normal goods, in pure and perfect competition, the price of the good is established at a level which balances supply and demand. The equilibrium quantity is effective in that it maximizes the surplus of the consumer and the producer. Thus, the market allocates resources in such a way as to maximize the value granted by consumers less the costs borne by producers. In the absence of externalities, the market equilibrium is therefore socially optimal.
But negative externalities exist, as well as one of the most polluting industries: that of paper production. Thus, for each unit of paper produced, a certain amount of toxins enter the atmosphere. This pollution increases the risk of health disorders in the population, this is a negative externality.
As a result, the social cost of production is higher than the cost to producers. For each unit of paper produced, the social cost includes the private cost borne by the manufacturers, plus the public cost borne by all those who breathe the polluted air. The marginal social cost curve is located above the private marginal cost curve because of the external costs imposed on the company by the paper producer. The difference between the two curves represents the cost of the pollution emitted.
Effects of pollution on the level of production
The producer then has two options: he can follow the quantity of the market, or the level of production for which the demand curve cuts the social cost curve. If the producer follows the market equilibrium, the quantity he will produce will be greater than the amount of social equilibrium. This is because the market equilibrium only takes into account the private costs of production. Thus, at the point of market equilibrium, the consumer gives paper a value lower than the social cost of production. Therefore, in the presence of externalities, the situation obtained is not effective in the sense of the Pareto principlewhich produces a market failure. As a result, negative externalities to production such as pollution lead markets to produce too much in relation to the socially efficient level of production. Therefore, a reduction in consumption and production below this level of market equilibrium would increase general economic well-being.
Right to Pollute Market
Negative externalities, in production or consumption, lead the markets to produce more than the social optimum. The externality must be internalized by bringing buyers and sellers to integrate the consequences of their decisions. When an externality leads a market to allocate resources in a non-optimal way, the government can intervene in two ways. It may choose to adopt regulatory measures, through Pigou taxes or quotas; or it can adopt market solutions, which will encourage private decision-makers to solve the problem themselves.
Many economists believe that economic incentives are more cost-effective and more effective in environmental policy than government orders. They therefore suggest the use of the right to pollute, ie the payment by companies of a tax on their pollution equal to the amount of external damage – a kind of fine on the polluter pays principle. In this way, the company would be placed in front of the social costs of its activities and the externality would be internalized. In other words, the company would be forced to subtract the marginal social cost of its production activity from the marginal benefit of this same activity. It would therefore have to consider the possibility of an abatement action whose marginal cost might be more advantageous than the payment of duties to pollute.
But rather than having the government fix the amount of the tax, and then let the company determine its level of pollution, we can establish a tradable trading rights system that reverses the logic of the process. In this approach, the State is the one that sets the maximum level of pollution and allocates a corresponding number of permits, that is to say a number of pollution allowances to each company. The price of these permits is then established on the market of the rights to pollute according to the law of the supply and the demand because the companies can exchange between them these emission rights. To meet the quotas imposed, according to its profitability costs, an enterprise can therefore choose between rapidly incorporating technical progress so that its activity is less polluting,
Measuring, reporting, verification
Assuring compliance with an emissions trading scheme requires measuring, reporting and verification (MRV). Measurements are needed at each operator or installation. These measurements are reported to a regulator. For greenhouse gases, all trading countries maintain an inventory of emissions at national and installation level; in addition, trading groups within North America maintain inventories at the state level through The Climate Registry. For trading between regions, these inventories must be consistent, with equivalent units and measurement techniques.
In some industrial processes, emissions can be physically measured by inserting sensors and flowmeters in chimneys and stacks, but many types of activity rely on theoretical calculations instead of measurement. Depending on local legislation, measurements may require additional checks and verification by government or third party auditors, prior or post submission to the local regulator.
In contrast to an ordinary market, in a pollution market the amount purchased is not necessarily the amount ‘consumed’ (= the amount of pollution emitted). A firm might buy a small amount of allowances but emit a much larger amount of pollution. This creates a troublesome moral hazard problem.
This problem may be solved by a centralized regulator. The regulator should perform Measuring, Reporting and Verification (MRV) of the actual pollution levels, and enforce the allowances. Without effective MRV and enforcement, the value of allowances diminishes. Enforcement methods include fines and sanctions for polluters that have exceeded their allowances. Concerns include the cost of MRV and enforcement, and the risk that facilities may lie about actual emissions. The net effect of a corrupt reporting system or poorly managed or financed regulator may be a discount on emission costs, and a hidden increase in actual emissions.
According to Nordhaus, strict enforcement of the Kyoto Protocol is likely to be observed in those countries and industries covered by the EU ETS. Ellerman and Buchner commented on the European Commission’s (EC’s) role in enforcing scarcity of permits within the EU ETS. This was done by the EC’s reviewing the total number of permits that member states proposed that their industries be allocated. Based on institutional and enforcement considerations, Kruger et al. suggested that emissions trading within developing countries might not be a realistic goal in the near-term. Burniaux et al. argued that due to the difficulty in enforcing international rules against sovereign states, development of the carbon market would require negotiation and consensus-building.
An alternative to centralized regulation is distributed regulation, in which the firms themselves are induced to inspect the other firms and report their misbehavior. It is possible to implement such systems in subgame perfect equilibrium. Moore and Repullo present an implementation with unbounded fines; Kahana and Mealem and Nitzan present an implementation with bounded fines. Their work extends the work of Duggan and Roberts by adding a second component which takes care of the moral hazard.
Limits of the market
But while the market for pollution rights offers a solution to the problem of the negative externality that is pollution, it nevertheless presents some flaws. For example, the price of a tonne of carbon dioxide on the European market for the right to pollute was around € 30 in early 2006; but during the year he collapsed to 1.30 € because of the realization that the emissions of a number of countries were well below the generous allowances allocated to their companies. Such a tariff allows polluters to buy permits cheaply and does not encourage investment in clean technologies. If the purchase price of the rights to pollute is too attractive, companies will prefer to rush into the market instead of making real efforts to clean up. Therefore, is it not necessary to establish a more stringent regulation obliging for example the big polluters to real reduction efforts before resorting marginally to the purchase of emission rights?
In addition, on the consumer’s side, the final price of the good becomes an imperfect signal that no longer plays its role in individual consumption decisions because it does not inform him about the ecological impact of his choice. The reduction of pollution therefore appears exclusively as the responsibility of producers, which creates a fracture in the relationship with consumers.
The advantage of using the market is to facilitate the achievement of an overall objective, set by the community, to reduce the discharge of polluting substances. Stakeholders who can go beyond this reduction target will be economically incentivized to do so by valuing their efforts in the form of emission credits. Less fortunate or less willing actors will be able to buy such credits on the market to meet their commitments. Thus, the market makes it possible to achieve at lower cost the initial objective of reducing emissions by allowing a transfer from the most innovative or best placed actors.
Emissions trading has been criticised for a variety of reasons.
For example, in the popular science magazine New Scientist, Lohmann (2006) argued that trading pollution allowances should be avoided as a climate stabilization policy for several reasons. First, climate change requires more radical changes than previous pollution trading schemes such as the US SO2 market. It requires reorganizing society and technology to “leave most remaining fossil fuels safely underground”. Carbon trading schemes have tended to reward the heaviest polluters with ‘windfall profits’ when they are granted enough carbon credits to match historic production. Expensive long-term structural changes will not be made if there are cheaper sources of carbon credits which are often available from less developed countries, where they may be generated by local polluters at the expense of local communities.
Research by Preston Teeter and Jorgen Sandberg has shown that the flexibility, and thus complexity, inherent in cap and trade schemes has resulted in a great deal of policy uncertainty surrounding these schemes. Such uncertainty has beset such schemes in Australia, Canada, China, the EU, India, Japan, New Zealand, and the US. As a result of this uncertainty, organizations have little incentive to innovate and comply, resulting in an ongoing battle of stakeholder contestation for the past two decades.
Lohmann (2006b) supported conventional regulation, green taxes, and energy policies that are “justice-based” and “community-driven.” According to Carbon Trade Watch (2009), carbon trading has had a “disastrous track record.” The effectiveness of the EU ETS was criticized, and it was argued that the CDM had routinely favoured “environmentally ineffective and socially unjust projects.”
Annie Leonard’s 2009 documentary The Story of Cap and Trade criticized carbon emissions trading for the free permits to major polluters giving them unjust advantages, cheating in connection with carbon offsets, and as a distraction from the search for other solutions.
Forest campaigner Jutta Kill (2006) of European environmental group FERN argued that offsets for emission reductions were not substitute for actual cuts in emissions. Kill stated that “[carbon] in trees is temporary: Trees can easily release carbon into the atmosphere through fire, disease, climatic changes, natural decay and timber harvesting.”
Permit supply level
Regulatory agencies run the risk of issuing too many emission credits, which can result in a very low price on emission permits. This reduces the incentive that permit-liable firms have to cut back their emissions. On the other hand, issuing too few permits can result in an excessively high permit price. This an argument for a hybrid instrument having a price-floor, i.e., a minimum permit price, and a price-ceiling, i.e., a limit on the permit price. However, a price-ceiling (safety value) removes the certainty of a particular quantity limit of emissions.
Permit allocation versus auctioning
If polluters receive emission permits for free (“grandfathering”), this may be a reason for them not to cut their emissions because if they do they will receive fewer permits in the future.
This perverse incentive can be alleviated if permits are auctioned, i.e., sold to polluters, rather than giving them the permits for free. Auctioning is a method for distributing emission allowances in a cap-and-trade system whereby allowances are sold to the highest bidder. Revenues from auctioning go to the government and can be used for development of sustainable technology or to cut distortionary taxes, thus improving the efficiency of the overall cap policy.
On the other hand, allocating permits can be used as a measure to protect domestic firms who are internationally exposed to competition. This happens when domestic firms compete against other firms that are not subject to the same regulation. This argument in favor of allocation of permits has been used in the EU ETS, where industries that have been judged to be internationally exposed, e.g., cement and steel production, have been given permits for free).
This method of distribution may be combined with other forms of allowance distribution.
The US Congressional Budget Office (CBO, 2009) examined the potential effects of the American Clean Energy and Security Act on US households. This act relies heavily on the free allocation of permits. The Bill was found to protect low-income consumers, but it was recommended that the Bill be made more efficient by reducing welfare provisions for corporations, and more resources be made available for consumer relief.
Distinct cap-and-trade systems can be linked together through the mutual or unilateral recognition of emissions allowances for compliance. Linking systems creates a larger carbon market, which can reduce overall compliance costs, increase market liquidity and generate a more stable carbon market. Linking systems can also be politically symbolic as it shows willingness to undertake a common effort to reduce GHG emissions. Some scholars have argued that linking may provide a starting point for developing a new, bottom-up international climate policy architecture, whereby multiple unique systems successively link their various systems.
In 2014, the U.S. state of California and the Canadian province of Québec successfully linked their systems. In 2015, the provinces of Ontario and Manitoba agreed to join the linked system between Quebec and California. On 22 September 2017, the premiers of Quebec and Ontario, and the Governor of California, signed the formal agreement establishing the linkage.
The International Carbon Action Partnership brings together regional, national and sub-national governments and public authorities from around the world to discuss important issues in the design of emissions trading schemes (ETS) and the way forward to a global carbon market. 30 national and subnational jurisdictions have joined ICAP as members since its establishment in 2007.
Source from Wikipedia