INTRODUCTION
Over the last twenty years the use of transferable permits to control pollution has evolved from little more than an academic curiosity to the centerpiece of the US program to control acid rain. It has also become a key ingredient in the UN program to control global warming. Emissions of greenhouse gases—carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs) and sulphur hexafluoride (SF6) —contribute to climate change. The Kyoto Protocol, limits emissions of greenhouse gases in the industrialized countries that ratify the Protocol (Annex B Parties). The Protocol establishes three forms of international emissions controlling economic incentives for greenhouse gases involving all Parties to the Protocol to help the industrialized countries meet their commitments at lower cost. From an environmental perspective, greenhouse gases are ideal candidates for emissions trading. Emissions of greenhouse gases have no direct health or environmental impacts. The effect on climate depends on their concentration in the atmosphere. Since they have relatively long atmospheric lives (decades to millennia), a release anywhere in the world has the same impact on climate. From an economic perspective, greenhouse gases are also excellent candidates for emissions trading. There are millions of sources of greenhouse gas emissions globally, and abatement costs differ widely. Thus the potential cost savings for a given reduction target are significant. The main challenge is to design emissions trading programmes that cover a substantial share of the total emissions with an administratively manageable number of participants. Countries will design and implement domestic policies, including emissions trading programmes, to meet their commitments under the Kyoto Protocol. They may use the Kyoto mechanisms to trade allowances/credits internationally if they wish, although the way the mechanisms can be used by individual sources will depend upon the domestic policies adopted. Since measures to reduce greenhouse gas emissions often lower emissions of other pollutants that have local health and/or environmental impacts a country may favor domestic emission reductions over the use of allowances/credits as a means of meeting its commitment.
EARLY HISTORY
By the late 1950s both economists and policy makers had formed quite well-developed and deeply entrenched visions of how pollution control policy should be conducted. Unfortunately these two visions were worlds apart. Economists viewed the world through the eyes of Pigou. Professor A. C. Pigou had argued that in the face of an externality such as pollution, the appropriate remedy involved imposing a per-unit tax on the emissions from a polluting activity. The tax rate would be set equal to the marginal external social damage caused by the last unit of pollution at the efficient allocation. Faced with this tax rate on emissions, firms would internalize the externality. By minimizing their own costs firms would simultaneously minimize the costs to society as a whole. According to this view rational pollution control policy involved putting a price on pollution. Policy makers, on the other hand, held an equally firm, if substantively different, view. According to this view the proper way to control pollution was through a series of legal regulations ranging from the location of polluting activities to the specification of emissions ceilings. The public sector should: (1) figure out how much pollution to allow each emitter, (2) monitor emissions to establish compliance with these mandates and (3) use penalties and other means of bring non-complying sources into compliance. While communication between the two groups took place, most of it was critical and not viewed by the recipient as particularly helpful. Economists would point out, for example, that these legal regimes, which became known as "command-and-control" regimes, were generally not efficient. Hence either more pollution control could be gained with the same expenditure or the same pollution control could be achieved with less expenditure if policy makers would simply switch to Pigouvian taxes. Policy makers responded that the information burden imposed by the design of efficient taxes was unrealistically high. Furthermore, they continued, if bureaucrats had sufficient information to set efficient tax rates, they could use the same information to set efficient legal regimes. The result was a standoff in which policy-makes focused on quantity-based policies, while economists continued to promote price-based remedies. While the standoff continued, the legal regimes prevailed. Taxes made little headway.
THEORETICAL FOUNDATIONS
While the general properties of the system had been correctly anticipated by idea of charge system designed to meet a predetermined environmental target. Nonetheless the mathematics is perfectly equivalent for the two cases and hence the result derived for a charge system immediately has relevance for a permit system. Pezzey (1992) has laid out the symmetry in a particularly concise and useful way. He was also careful to point out the important point that theoretical symmetry does not necessarily imply symmetry in practice. Political acceptability and distribution issues do differ and they do matter. The main Baumol and Oates result was that a uniform charge would result in meeting the predetermined environmental target cost-effectively. This was important because it suggested that the control authority had to set by one tax rate and impose that same tax rate on all polluters for the allocation to control responsibility to be achieved at minimum cost. Since all firms would equate their marginal control cots to this uniform charge, all marginal control costs would necessarily be equalized across emitters. Equalizing marginal costs was precisely the condition required for a cost-effective allocation. Significantly, this result also implies that the uniform price that would emerge from trading these permits would result in a cost-effective allocation.
The big practical difference between the two approaches, however, was how the “correct” price would be determined. While any price would result in equal marginal costs, only one price would be consistent with meeting the pre-specified standard. In the tax and standards system, this price would be found iteratively. An initial tax would be tried. If the resulting emission reductions exceeded what was necessary to meet the target, the control authority would know that the tax was too high. If the reductions fell short, the tax rate was too low. After each round the control authority would have enough information to establish the necessary direction of change. And it would also have a stopping rule. Once the exact desired reduction was achieved, the associated tax rate would be shown to have been the correct one. Where as in the marketable permits system the tax would be established by the interaction of the demand for and supply of permits in the market. Not only would the control authority would have no role in rate setting, but rates would be set immediately, not following a long iterative procedure.
THE INITIAL ALLOCATION
No other aspect of marketable permit design is as important and is as controversial as the initial allocation. In principle at least three possible ways to define the initial allocation exist: (1) an auction, (2) allocation by criteria, or (3) allocation by lottery.
In an auction the fixed number of permits would be allocated to the highest bidders. Several possible types of auctions exist. In an allocation by criteria the government decides on some specific criteria to allocate the permits (e.g. historical emissions) and allocates permits based upon the degree to which candidates fit the criteria. In the third case the permits are allocated randomly, usually by lottery. A reliance on lotteries is usually motivated by a desire to provide an equal possibility of access to all potential claimants...
Auctions typically involve transfers of resources to the government, whereas allocations by criteria do not. Given these results it is not surprising that most operating permit systems use an initial allocation based upon a specific criterion--historical emissions. Now known as” grandfathering" this approach minimizes the political controversy associated with moving from a command-and-control system to a permits system. It also, however, typically "gifts" existing sources with permits that can be very valuable. The practice of grandfathering can actually increase pollution in the short run if sources are aware that larger current emissions result in larger future permit allocations. Naturally this can create and incentive to elevate current emissions for the purpose of qualifying for a large initial allocation of permits. The case for grandfathering is made primarily on grounds of political acceptability. With a grandfathered system existing sources can be no worse off than they were with the command- and-control system, but they might be better off.
FORMS OF EMISSIONS TRADING
There are three basic types of emissions trading programmes: ‘cap and trade’,‘baseline and credit’, and ‘offset.
Cap and trade
In a cap and trade programme, the participants agree on an overall limit on emissions—the ‘emissions cap’—at the outset. In most programmes, this is the total amount of a pollutant that the participants in the programme are allowed emit in a given period (e.g. emission of a number of tonnes of the pollutant per year). Allowances equal to all of the emissions permitted under the cap are then distributed. The way in which allowances are distributed is a key issue for emissions trading system design. Once the allowances are distributed, they may be traded freely. During the compliance period, each participant must monitor or calculate its actual emissions using specified procedures. Then, at the end of the period, it must hand over to the regulatory authority allowances that are equal to its actual emissions during the period.
Baseline and credit
The participants in a baseline and credit (or ‘averaging’) programme have to ‘earn’ credits before they can begin trading. First, an emission baseline is defined for each participant—in other words the participant is told at the start of the compliance period how much of a pollutant it is allowed to emit. Each participant then makes reductions and monitors or calculates its actual emissions using specified procedures. At the end of the compliance period, the regulatory authority compares the baseline calculation with the actual emission from the source during the period. Participants whose actual emissions are lower than their baseline allocation receive ‘credits’ equal to the difference. Credits can then be traded freely. A participant whose actual emissions exceed its baseline must purchase credits equal to its excess emissions to achieve compliance.
Offset
Offset programmes are used to compensate for (i.e. offset) the additional emissions that would result from creation of a new source of pollution or expansion of an existing one. Under such schemes those responsible for the new or expanding source purchase credits equal to emission reductions achieved by existing sources. The requirement to offset is mandatory for the new or expanding source but the decision by existing sources to reduce is voluntary. The existing sources are given a free allocation which is equivalent to a baseline against which their emissions reductions will be calculated. For the new and expanding sources, the baseline is equivalent to the emissions they are not required to offset.
PROCESSESS INVOLVED IN DESIGNING OF AN EMISSION TRADING PROGARMME
Establishing baselines and distributing allowances
When designing an emissions trading system, establishing baselines in a baseline and credit or offset programme or deciding just how to distribute allowances in a cap and trade programme is usually the most difficult issue to resolve, because it involves the distribution of valuable assets—the emission rights. Baselines represent a free allocation of emission rights to participants. In cap and trade programmes, the emission rights are in the form of allowances. There is a wider range of available options for their distribution and this forms the focus of the discussion below. Allowances can either be sold at auction and/or be distributed free, with any combination of the two being possible. Virtually every emissions trading programme to-date has distributed all of the allowances free to participants but several proposed programmes for greenhouse gases plan to auction some of the allowances.
Passing on the costs and potential effects on taxes and prices
While it is true that participants incur costs to comply with emissions limits, some of the costs are, in fact, shifted to others. They can, for example, be passed on to customers through higher prices, to governments through lower tax payments by firms and individuals, to employees through lower wages and benefits, or to suppliers through lower prices for inputs. It is the remaining portion of the costs, the part that cannot be passed on, that reduces the value of the source’s assets and so is borne by its shareholders. Estimating an appropriate allocation for individual firms would be very difficult. The costs of reducing emissions borne by participants, suppliers, employees and shareholders lead to lower tax payments to governments. To compensate for this loss of revenue, and to sustain the level of government services, some portion of the allowances could be auctioned with the revenue going to the government. Auction revenue could also be used by governments to reduce existing taxes. If the taxes in question are ones that discourage economic growth, their reduction can stimulate the economy and so partially offset the economic cost of the emission reductions. And finally, since all of the costs are ultimately borne by individuals in their capacities as consumers, workers, shareholders or users of government services, auction revenue could also be used to adjust taxes paid by individuals so that the cost is distributed equitably. The way in which allocation is organized can also sometimes be passed on in terms of price increases.
Importance of distribution rules
Establishing rules for distribution of allowances that are considered fair by everyone is one of the most difficult aspects of emissions trading system design. The rule for free allocation of allowances can be based on historic data or can change over time. A rule based on historic data allocates the same percentage of the available allowances to each recipient over the life of the programme. Potential recipients of allowances have a strong incentive to lobby for an allocation rule that will treat them favorably, especially if the allocation is to remain fixed over time. Allocation rules can have a significant impact on the way in which the economic benefits of emissions trading are shared, so it may be very difficult to find a rule that is considered fair by all recipients.
Banking and borrowing
Banking allows those participants in an emissions trading programme which have emissions below their allocated limits to save surplus allowances/credits for use during a later compliance period. Borrowing is the opposite of this, permitting use of allowances or credits from a future period for compliance during the current period, with the implicit commitment that repayment will be made in the form of equivalent reductions in a future period. The main environmental concern regarding banking is the possibility of short term increases in emissions beyond the aggregate cap as participants ‘cash-in’their banked allowances and increase their actual emissions accordingly. However, banking can also yield environmental benefits, by helping to reduce damage from emissions to human health and to the environment. In order to obtain surplus allowances/credits to bank, participants have to make real emission reductions bringing them below their allocated limit. In a situation where total emissions are declining (to be expected during a period of environmental regulation), these reductions will be made at a time when total emissions are still relatively high. The same allowances/credits will be used at a later time when total emissions are relatively lower, and lower emissions mean less environmental damage.
Borrowing creates a fairly evident risk for the environment: a source that uses borrowed allowances/credits to comply in a given period may cease operation before the borrowed allowances/credits are repaid through lower emissions. The participants may then save themselves the costs of compliance while the consequences of this failure are borne by the environment in the form of higher emissions. Although deals can sometimes be brokered to lower this risk, borrowing is rarely allowed
Thus banking encourages sources to make early investments by allowing them to either use or sell entitlements not needed for compliance during the current year. Borrowing gives flexibility by allowing firms to delay investments until such time as they may be optimal from the firm's perspective. The danger of providing this temporal flexibility is that it changes the resulting pattern of emissions and, in principle, could result in a clustering of emissions at a particular point in time. Since clustered emissions cause more damage than dispersed emission, this is a source of concern.
Accurate monitoring
It is a fundamental principle of emissions trading programmes that each to (or similar unit) of emissions reduced has a value that is equal to the price allowance or credit. In order to avoid such under-reporting, emissions trading programmes often require participants to ensure accurate monitoring of emissions. These monitoring requirements are more rigorous and more costly than those required by conventional regulations, but the extra monitoring cost is justified by the savings in compliance cost made possible by emissions trading
Effective enforcement and Penalties
Effective enforcement of compliance is critical for the environmental integrity of emissions trading programmes. Effective enforcement involves audits of a high percentage of participants and penalties that deter non-compliance are critical to the environmental integrity of an emissions trading programme.
Conclusion
In the past, emissions trading was considered an academically intriguing, but ultimately impractical, idea. It had trouble getting on the national agenda. Reformers had few successes. However, that changed once the expectations created by the economic analysis had been confirmed on the ground by the sulfur allowance program. It demonstrated not only the feasibility of the approach, but also its effectiveness. Emboldened by success, expectations and enthusiasm started to outrun reality. In the final stage, the one I believe we are now in, reality once again is beginning to reassert itself. My sense is that both policy makers and academics are beginning to realize not only that emissions trading has achieved a considerable measure of success, but it also that it has specific weaknesses. It has also been interesting to observe the growing prominence of auctioned permits, moving the whole enterprise much closer to the economic point of view that prevailed at the outset. Economic analysis has helped us to understand that not all emissions trading programs are equal. Some designs are better than others. Furthermore, one size does not fit all. Emissions trading programs can (and should) be tailored to each specific application. The observations suggests that while emissions trading is no panacea, well-designed programs, which are targeted at pollution problems appropriate for this form of control, are beginning to occupy an important and durable niche in the evolving menu of environmental policies. This economic idea has come of age.
