The externality associated with the non-rival and non-excludable costs of the release of carbon dioxide into the atmosphere is inherently difficult to internalise. Emissions trading has emerged as a popular method of achieving socially optimal emissions reduction. The following analysis discusses the flaws in emissions trading – particularly in light of its use in the European Union – and puts forward suggestions regarding policy initiatives that may help overcome these problems.

The recent use of emissions trading has created a Coasian market for ‘polluting property rights’, which has allowed for increased information sharing, preference revelation and signalling compared with approaches based on strict government intervention (DEFRA, 2003). The so called ‘cap and trade’ system has been used to limit total greenhouse gas emissions and grant allowances to companies giving them the right to pollute. Firms wishing to exceed their allowance must purchase credits from those polluting below their allocation or face heavy penalties.

Both emissions trading and conventional Pigovian taxation provide incentives for individuals and firms to reduce their greenhouse gas emissions to a socially optimal level. Pigovian taxes involve the government increasing the cost per unit of ‘carbon inputs’ while the market determines the efficient quantity. By contrast, ‘cap and trade’ emissions trading schemes involve a government set quantity with a market determined price of carbon based on the reallocation of polluting permits (Gittins, 2007). Controlling either variable theoretically yields the same emissions reduction; however the advantage of emissions trading is that polluting rights are allocated through a market to those who can make the most efficient use of them. Companies that can affordably reduce their emissions will do so in order to sell their credits while firms that generate the highest valued output per unit of input will choose to buy polluting rights (DEFRA, 2003).

To further illustrate this point, if two firms were to face a tax, the emissions target (which would equate to the socially efficient level ‘Q*’ where MB = MSC if perfect information were to exist) would be achieved since neither firm will produce when it is no longer profitable to do so. If tradeable permits were used, the firm for which emissions reductions are more costly could buy permits from the other firm, and ‘Q*’ could be reached without sacrificing as much output. Emissions trading schemes arguably have lower administrative costs due to the incentive for firms to negotiate amongst themselves in order to achieve a ‘least cost’ reduction (Pindyck & Rubinfeld, 2005). It also succeeds in promoting the development of innovative ways to reduce the original externality.

Limited knowledge of climate science creates uncertainty surrounding the probability and magnitude of future consequences, making it impossible to measure the size of the externality and determine the socially optimal level of emissions. This presents a problem for any reduction mechanism, and provides a breeding ground for lobbyists to push their own agenda without the scrutiny that might exist if more accurate information was available. This uncertainty is arguably one of the reasons why Australia is yet to establish an effective emissions trading scheme. Given the possible irreversibility of damage to the Earth’s climate, Wills (2006 p. 350) argues that policy makers ought to follow the maximum decision rule and choose a cautious approach which ‘maximises the minimum outcome’.

While the use of markets appears to succeed in making emissions reductions occur at minimal cost, critics argue that trading schemes can provide a short term incentive to over pollute. Harvey (2007) describes how firms that have already reduced their emissions in the past may ‘lose out’ under such a system. This is because many such schemes allocate polluting permits based on the past emissions of each firm. Companies often have an incentive to increase polluting behaviour prior to a scheme’s implementation in order to inflate past emissions data and receive a higher allocation. Michaelowa and Butzengeiger (2005) describe how this process – coined ‘grandfathering’ – may also result in blatant over-allocation, leading to a market with low liquidity and a low permit prices. Policies that provide allocations on the basis of average industry sector emissions rather than those of individual firms could be adopted in order to virtually eliminate the incentives for individual firms to over-pollute as a means of enhancing their entitlements. The use of reputation could also further encourage voluntary compliance, as many consumers arguably place significant existence value on a healthy atmosphere and would be inclined to support like minded corporations.

The European Union Emissions Trading Scheme (EU ETS)

The European Union Emissions Trading Scheme (EU ETS) was the world’s first large scale trading system for carbon dioxide. Ellerman and Buchner (2007) outline the process of allowance allocation in the EU ETS, and argue that a lack of ‘installation-level’ data has had considerable consequences for the cost of enforcing the scheme. The absence of any existing legal authority to collect the data within the desired time frame meant that planners required extensive industry cooperation. While few examples of fraudulent data submissions exist – likely due to incentives for firms to divulge information in order to receive allocations – the voluntary nature of industry participation highlights the potential costliness in monitoring and enforcing any emissions trading scheme on a large scale. The establishment of concise legal guidelines for firms to submit their emissions data is essential for the future enforcement of emissions trading.

Restricting emissions to reflect past levels formed the basis of Kyoto protocol, which used 1990 as its base year. It was therefore desirable for the EU ETS to base allocations on historical levels, so that participating countries could automatically meet their Kyoto targets. Ellerman and Buchner (2007) found that this was not feasible, again due to fact that ‘installation-level’ data from 1990 was impractical and too costly to obtain. Furthermore, significant growth in certain countries and industry sectors since 1990 makes such a historic base year inappropriate. Future international agreements ought to adopt reduction targets based on a portion of current emissions. Collaboration between local policy makers and those involved in formulating international agreements is essential in ensuring that the cost of gathering the information required to implement global emission reduction targets is minimised.

Beauman (2007) discusses other significant hurdles to any emissions trading scheme in the context of the global steel manufacturing industry. Ninety per cent of the sector’s emissions come directly from the primary blast furnace method, which is far cheaper than environmentally friendly alternatives. Given the inefficiency of this method, firms utilising it must purchase carbon credits, adding significantly to their cost of production. This has led many European steel manufacturers to source semi-finished steel from lower-cost locations such as Brazil and Ukraine, which are not subject to the EU ETS (Beauman, 2007). The obvious implication of this trend is that carbon dioxide emissions are not reduced; they merely occur elsewhere instead. This significant flaw is arguably not inherent in emissions trading; rather it is the result of such a scheme’s inability to include all members of the global economy. Given the interconnected nature of world industry, future policy makers must ensure that any emissions trading scheme also encompasses developing nations in some way. Additionally, the ‘carbon inputs’ used in the overseas manufacturing of imported goods could count towards the emissions of importers as a way of preventing the outsourcing of ‘carbon intensive’ manufacturing.

The diverse range of contributing pollutants and industry sectors undermine the efforts of any social coordination systems to accurately target the cause of climate change. Harvey (2007) discusses how greenhouse gases such as nitrous oxide produced as by products of processes used to manufacture chemicals are not included in the EU ETS, despite contributing nearly five percent of total emissions; a proportion which greatly exceeds the market capitalisation of the chemical industry. The difficulty of any one mechanism to fully internalise an externality resulting from numerous causes could be aided significantly if future emissions trading schemes were to merely measure the effect of various greenhouse gases in terms of their ‘carbon dioxide equivalent’, or the amount of carbon dioxide that would have the same global warming potential. Adopting such an approach could prevent certain industries from avoiding their emission reduction obligations.

The use of emissions trading is an effective means to encourage industry to reduce its greenhouse gas emissions; however flaws in its implementation need to be addressed in future policy initiatives. Any emissions trading scheme needs to be carefully integrated with international agreements to ensure consistent targets, minimal information costs and the possibility of permit exchange between regions. Given the uncertainty over the likelihood and magnitude of future events, policy makers ought to adopt a cautious approach given the irreversibility of climate change damage.

References

Beauman, Chris (2007), “Climate change poses stern challenge” in Financial Times. London (UK): Oct 8, 2007. pg. 4

Ellerman, A. Denny and Buchner, Barbara K. (2007), “Symposium: The European Union Emissions Trading Scheme: Origins, Allocation, and Early Results” in Review of Environmental Economics and Policy, Winter 2007, v. 1, iss. 1, pp. 66-87

Freebairn, John (2003), “Principles for the Allocation of Scarce Water” in Australian Economic Review, June 2003, v. 36, iss. 2, pp. 203-12

Gittins, Ross (2007), “Carbon trading v taxes - a winner eases ahead” in The Sydney Morning Herald 31/03/2007 viewed 10/10/2007 <http://www.smh.com.au/news/business/carbon-trading-v-taxes–a-winner-eases-ahead/2007/03/30/1174761748992.html>

Harvey, Fiona (2007), “Doubt about regime” in Financial Times. London (UK): Sep 18, 2007. pg. 3

Michaelowa, Axel and Butzengeiger, Sonja (2005), “EU Emissions Trading: Navigating between Scylla and Charybdis” in Hamburg Institute of International Economics; Climate Policy, 2005, v. 5, iss. 1, p. 1-9

Pindyck, R. & Rubinfeld, D. (2005) “Microeconomics” 6th ed. Pearson Prentice Hall New Jersey p. 642-653

Stern, Nicholas (2007), “The Economics of Climate Change – The Stern Review”, Cambridge University Press

Wills, I. (2006), “Economics and the Environment: A signalling and incentives approach” 2nd ed, Allen & Unwin NSW p. 5, 240-260

(UK) Department for the Environment, Food and Rural Affairs (2003), “Emissions Trading Schemes”, viewed 03/09/2007 <http://www.defra.gov.uk/environment/climatechange/trading/index.htm>

European Commission (2007), “The Kyoto Protocol – A Brief Summary”, viewed 03/09/2007 <http://ec.europa.eu/environment/climat/kyoto.htm>

Intergovernmental Panel on Climate Change (2007) “Climate Change 2007: The Physical Science Basis” in Contribution of Working Group I to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change

Author unknown (2006), “Govt rules out carbon tax” in ABC News Online 09/11/2006
Viewed 09/10/2007 <http://www.abc.net.au/news/newsitems/200611/s1785099.htm>