IPCC Fourth Assessment Report: Climate Change 2007
Climate Change 2007: Working Group III: Mitigation of Climate Change Tradable permits

A steadily increasing amount of research is focusing on tradable permits in terms of, among others, efficiency and equity issues associated with the distribution of permits, implications of economy-wide versus sectoral programmes, mechanisms for handling price uncertainties, different forms of targets and compliance and enforcement issues.

Tradable permit systems can be designed to cover either emissions from a few sectors of the economy or those from virtually the entire economy.[9] A number of analyses have found that economy-wide approaches are superior to sectoral coverage because they equalize marginal costs across the entire economy. Using a variety of models, Pizer et al. (2006) report that in the USA significant cost savings are linked to an economy-wide programme when compared to a sectoral programme coupled with non-market-based policies.[10] Researchers have found similar results for the European Union and the EU ETS. (Babiker et al., 2003; Betz et al., 2004; Klepper and Peterson, 2004; Bohringer and Löschel, 2005).

Not only the coverage of sectors may vary in a tradable permits programme, but also the point of obligation. The responsibility for holding permits may be assigned directly to emitters, such as energy-using industrial facilities (downstream), to producers or processors of fuels (upstream) or to some combination of the two (a ‘hybrid system’).[11] The upstream system would require permits to be held at the level of fossil fuel wholesalers and importers (Cramton and Kerr, 2002).[12]

There are two basic options for the initial distribution of permits: (1) free distribution of permits to existing polluters or (2) auctions. Cramton and Kerr (2002) describe a number of equity benefits of auctions, including providing a source of revenue that could potentially address inequities brought about by a carbon policy, creating equal opportunity for new entrants and avoiding the potential for “windfall profits” that might accrue to emissions sources if allowances are allocated at no charge.[13] (See Box 13.4 for a discussion of this issue).

Box 13.4 The EU Emission Trading System

The EU Emissions Trading System (EU ETS) is the world’s largest tradable permits programme. The programme was initiated on January 1, 2005, and it applies to approximately 11,500 installations across the EU’s 25 Member States. The system covers about 45% of the EU’s total CO2 emissions and includes facilities from the electric power sector and other major industrial sectors.

The first phase of the EU ETS runs from 2005 until 2007. The second phase will begin in 2008 and continue through to 2012, coinciding with the 5-year Kyoto compliance period. Member States develop National Allocation Plans, which describe in detail how allowances will be distributed to different sectors and installations. During the first phase, Member States may auction off up to 5% of their allowances; during the second phase, up to 10% of allowances may be auctioned off.

Market development and prices: A number of factors affect allowance prices in the EU ETS, including the overall size of the allocation, relative fuel prices, weather and the availability of certified emission reductions (CERs) from the Clean Development Mechanism (CDM) (Christiansen et al., 2005). The EU ETS experienced significant price volatility during its start-up period, and for a brief period in April 2006 prices rose to nearly 30 per tonne; however, prices subsequently dropped dramatically when the first plant-level emissions data from Member States were released. The sharp decline in prices focused attention on the size of the initial Phase I allocation. Analysts have concluded that this initial allocation was a small reduction from business as usual emissions (Grubb et al., 2005; Betz et al., 2004).

Consistency in national allocation plans: Several studies have documented differences in the allocation plans and methodologies of Member States (Betz et al., 2004; Zetterberg et al. 2004; Baron and Philibert, 2005; DEHSt, 2005). Researchers have looked at the impact on innovation and investment incentives of different aspects of allocation rules (Matthes et al., 2005; Schleich and Betz, 2005) and have found that these rules can affect technology choices and investment decisions. Ahman et al. (2006), Neuhoff et al. (2006) and Betz et al., (2004) find that when Member States’ policies require the confiscation of allowances following the closure of facilities, this creates a subsidy for continued operation of older facilities and a disincentive to build new facilities. They further find that different formulas for new entrants can impact on the market.

Implications of free allocation on electricity prices: Sijm et al. (2006) report that a significant percentage of the value of allowances allocated to the power sector was passed on to consumers in the price of electricity and that this pass-through of costs could result in substantially increased profits by some companies. The authors suggest that auctioning a larger share of allowances could address these distributional issues. In a report for the UK government, IPA Energy Consulting found a similar cost pass-through for the UK and other EU Member States (IPA Energy Consulting, 2005).

Goulder et al. (1999) and Dinan and Rogers (2002) find that recycling revenues from auctioned allowances can have economy-wide efficiency benefits if they are used to reduce certain types of taxes. Dinan and Rogers (2002) and Parry (2004) argue that free allocation of tradable permits may be regressive because this type of allowance distribution leads to income transfers towards higher income groups (i.e. shareholders) at the expense of households. In contrast, these authors find that government revenues from auctions may be used to address equity issues through reductions in taxes or other distributions to low-income households. Ahman et al. (2006) argue that a gradual transition from free allocation to auctioning might be a politically feasible manner to develop a fairer distribution of allowances.

To date, most emissions trading programmes have distributed emissions allowances almost entirely through free allocations.[14] Experience with the US SO2 programme shows that the no-cost allocation of allowances was critical for gaining political acceptance for the emissions trading concept (Ellerman, 2005). Christiansen and Wettestad (2003) and Markussen and Svendsen (2005) discuss how interest group pressures led to a largely free allocation of allowances in the EU ETS. In a broader sense, the rationale for a policy allowing some free allocation of allowances based on historic emissions is based on the desire to compensate incumbent installations that are affected by the regulation (Tietenberg, 2003; Harrison and Radov, 2002, Ahman et al. 2006).

The number of publications exploring the efficiency, equity and competitiveness implications of allowance allocation approaches is continuing to grow. For example, Burtraw et al. (2001b) and Fischer (2001) found that periodic updates of allocations on the basis of production are economically inefficient. In an analysis of a potential emissions trading programme in Alberta, Canada, Haites (2003b) found that this type of periodic updating of allocations based on each source’s output may reduce the decline in production for some sectors that may arise from an emissions cap but that it may also reduce profits and raise overall costs when compared to a fixed allocation. Demailly and Quirion (2006) find that under certain assumptions, an output-based allocation in the European cement industry would reduce leakage with limited impacts on production. See Chapter 11, Section 11.7.4 for a more extensive discussion on competitiveness issues.

A final issue associated with the distribution of allowances is whether excessive market power can distort prices. Maeda (2003) examines how the initial distribution of permits affects the potential emergence of firms with market power. Tietenberg (2006) summarizes research on market power, including studies on whether different auction designs or initial permit allocation can lead to price manipulation by dominant firms. He concludes that in practice, market power ‘typically has not been a problem in emissions trading.’ There has yet to be an overall assessment of market power in the EU ETS.

Several authors have compared the advantages and disadvantages of absolute targets (i.e., mass emissions limits on a sector or economy) to those of intensity targets (i.e. limits on emission per unit of GDP).[15] Ellerman and Wing (2003) and Kolstad (2006) find that intensity targets can reduce the uncertainties associated with the cost of emission reduction under uncertain economic growth levels. Pizer (2005b) finds that intensity targets may be more appropriate if the short-term objective is to slow, rather than halt, emissions growth, while Ellerman and Wing (2003) show that an intensity target may be set so stringently that it can halt or reverse growth. Dudek and Golub (2003) argue that absolute targets have more certain environmental results and lower transaction costs for emissions trading, thereby creating stronger incentives for technological change. Kuik and Mulder (2004) find that, for the EU, an intensity or relative target would avoid negative effects on competitiveness but would not reduce emissions at the lowest costs. In contrast, an absolute target combined with permit trading leads to efficient emissions reduction, but its overall macroeconomic costs may be significant. Finally, Quirion (2005) argues that, in the most plausible cases, an emissions tax and an absolute target are superior to an intensity target and that the welfare gaps between the two types of targets are very small. Overall, intensity targets are less effective than absolute targets if the goal is to achieve a certain level of emissions reduction, but they may be more effective at addressing costs when economic growth is uncertain.

Although a tradable permits approach can ensure that a certain quantity of emissions will be reduced, it does not provide any certainty of price. Price uncertainty may be addressed by a ‘price cap’ or ‘safety valve’ mechanism, which guarantees that the government will sell additional permits if the market price of allowances hits a certain price (Pizer, 2002; McKibbon and Wilcoxen; 2002, Jacoby and Ellerman; 2004).[16] The underlying reasoning is that GHGs become the focus of concern as they accumulate over an extended period in the atmosphere. There may therefore be less concern about short-term increases in CO2 as long as the overall trajectory of CO2 emissions is downward over an extended period (Newell and Pizer, 2003). While the safety valve mechanism shares some advantages with price-based mechanisms, such as a tax, the former may have the added political advantage of providing emitters with an additional allocation of allowances (Pizer, 2005a). A safety valve mechanism does not provide any certainty that a particular emissions level will be met, and it requires additional administrative complexity to link a domestic programme with a safety valve to a programme without a safety valve or with a different safety valve price.

Experience with trading programmes in the USA has shown significant benefits can be derived from the temporal flexibility provided by banking provisions in cases where the exact timing of emission reductions is not critical to environmental effectiveness (Ellerman et al., 2000; Stavins, 2003). Allowance banking can create a cushion that will prevent price spikes and can hedge uncertainty in allowance prices (Jacoby and Ellerman, 2004).[17] A banking provision allows the arbitrage between actual marginal abatement costs in one phase of a programme and the expected abatement costs in a future phase of a programme. The temporal flexibility of banking is particularly useful for companies facing large capital expenditures because it provides some flexibility in the timing of those expenditures (Tietenberg, 2003). In some emission markets in the USA, banking has been restricted where there was concern about short-term increases in emissions (Tietenberg, 2006). Banking was also restricted between Phase I and Phase 2 in the EU ETS to avoid a large bank that would make it more difficult to meet Kyoto targets.

Several critical elements of an effective enforcement regime for emissions trading have been described in the literature. First, if the goal is strict adherence to the emission limits implied by the number of permits, then excess emissions penalties should be set at levels substantially higher than the prevailing permit price in order to create the appropriate incentives for compliance (Swift, 2001; Stranland et al., 2002).[18] A second component of an enforcement regime is reasonably accurate emissions monitoring (Stranland et al., 2002; Stavins, 2003). San Martin (2003) and Montero (2005) report that incomplete monitoring can undermine the efficiency of trading programmes. Tietenberg (2003) and Kruger et al. (2000) emphasize that public access to emissions and trading data provides an additional incentive for compliance.

Finally, there have been several experiments with tradable permits for conventional pollution control in developing countries and economies in transition (Bygrave, 2004; US EPA, 2004). For example, Montero et al. (2002) evaluate an experiment with tradable permits for total suspended particulates (TSP) in Santiago, Chile and find that permit markets are underdeveloped due to high transaction costs, uncertainty and poor enforcement. However, they also find an improved documentation of historic emissions inventories and an increased flexibility to address changing market conditions. S. Gupta (2003b) and Wang et al. (2004) suggest strengthening the monitoring and enforcement capacity that would be required to implement conventional pollution trading programmes in India and China, respectively. Several authors have concluded that tradable permit programmes may be less appropriate for developing countries due to their lack of appropriate market or enforcement institutions. (Blackman and Harrington, 2000, Bell and Russell, 2002)

  1. ^  Thus far, emissions trading programmes, such as those for SO2 and NOx in the USA and that of the EU Emis-sions Trading System (EU ETS) for CO2 have only covered certain sectors. In the case of the EU ETS, Chris-tiansen and Wettestad (2003) write that the EU restricted the sectors involved to ease implementation during the first phase of the programme.
  2. ^  However, they also find that the exclusion of certain sectors, such as residential and commercial direct use of fossil fuels, does not noticeably affect the cost of an otherwise economy-wide tradable permit system covering electricity production, industry and transportation.
  3. ^  See IPCC (2001b), Baron and Bygrave (2002), UNEP/UNCTAD (2002), and Baron and Philibert (2005) for a discussion of the advantages and disadvantages of these different approaches.
  4. ^  As the discussion below notes, the point of obligation is not necessarily the point at which all permits need be allocated.
  5. ^  A hybrid of free allocation and auctioning or emissions taxes is also possible (Pezzey 2003). Bovenburg and Goulder (2001) and Burtraw et al. (2002) find that allocating only a small portion of permits at no cost while auctioning the remainder can compensate industry for losses due to a carbon policy.
  6. ^  The US SO2 trading programme contains a small reserve auction, which was valuable for price discovery during the early years of the programme (Ellerman et al., 2000). Revenue from this auction was returned to the companies affected in the programme. Only four EU Member States (Denmark, 5%; Hungary, 2.5%; Ireland, 0.75%; Lithuania, 1.5%) decided to auction off parts of their ET budget in the first phase of the EU ETS scheme (Betz et al., 2004).
  7. ^  Intensity targets are also known as “rate-based”, “dynamic,” “indexed,” and “relative” targets.
  8. ^  It is also possible to have a “price floor” to ensure that prices don’t go below a certain level. For example, Hepburn et al. (2006) discuss how a coordinated auction measure for the EU ETS could be used to support a minimum price.
  9. ^  Price uncertainty may also be addressed by “borrowing” of allowances, i.e. using allowance allocations from future years.
  10. ^  The addition of a “make good” provision – that is, the requirement stating that allowances from a subsequent compliance year or period are surrendered for any excess emissions – is a further design element used to ensure that an absolute emissions target is met (Betz and MacGill, 2005).