Emissions Trading
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Kate Macauley
1. Economics of emissions trading
2. Overview of the EU Emissions Trading
Scheme (ETS)
Cap and Trade
 Quantity regulation: Total allowable
emissions capped. Price determined by
the market.
 Total number of allowances created to
match cap
 Allowances may be traded on a market
 Individual firms abate until MCA = Ppermit
 The way you allocate the allowances
does not impact the market price
Emissions Trading: Economics
 Assumptions
Global pollutants: concerned with
aggregate pollution, not with discharge
location (SO2, NOx, CO2)
Competitive market
Cap set by regulatory body
(cap < emissions in base year)
Marginal cost of abatement (MCA) is
positive and increasing
Emissions Trading Graphically
∆ABD+ ∆ACD > ∆AEF
Therefore, it is more
efficient to allow permits
to be traded than to
specify a uniform level of
abatement across firms.
Emissions Trading
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cost of abatement
marginal cost of abatement is positive
marginal cost of abatement is
increasing
uncontrolled emissions for firm i in the
base year
abatement by firm i
Individual firms
*Sankar, U. (2001). Environmental Economics. New Delhi: Oxford University Press.
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aggregate level of
pollution in base year
Pollution cap
Therefore, we have the following cost minimization problem
subject to the pollution cap restraint:
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Subject to:
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and
*Sankar, U. (2001). Environmental Economics. New Delhi: Oxford University Press.
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Solution:
Firms abate until MCA = ppermit
If the market is competitive, the firms are price
takers and p is determined by the market.
Then for the individual firm:
Minimize (xi): ci(xi) + p(ei-xi)
Solution: ci’ = p for all i
*Sankar, U. (2001). Environmental Economics. New Delhi: Oxford University Press.
Emissions Trading Graphically
Auction versus free allocation
EU ETS: Emissions Trading Scheme
 Proposed in 2001. First carbon dioxide cap-and-trade program
 Trial period: 2005-2007. Second trading period: 2008-2012
 Aim to meet obligations outlined by the Kyoto Protocol during the




2008-2012 trading period, not during the trial period. Plan to
continue after 2012 (post-Kyoto)
Set an absolute cap on CO2 emissions on 12,000 facilities in the EU.
Tradable allowances distributed equal to cap quantity. Most
allowances freely allocated.
Facilities measure and report CO2 emissions. One allowance per ton
of CO2 emitted.
Initially only included 40% of total GHG emissions. Limited to certain
sectors (power, combustion facilities, certain industries -- not
transportation or buildings). Plan to expand over time.
Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading
System in perspective.” Pew Center on Global Climate Change.
ETS cont.
Cap-setting process:
Initial cap = Sum of 25 separate decisions across
member states. Each individual cap approved by
European Commission.
Unknown long-term trajectory for cap. Caps determined
again each trading period.
First period: 2005-2007
Second period: 2008-2012
Third Period: 2013-2020
annual cap declines annually by 1.74 percent across EU ETS
20% below 1990 levels by 2020
Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading
System in perspective.” Pew Center on Global Climate Change.
Linking Directive
 For a specified amount of abatement, firms
can comply through carbon offsets (amount
set by individual member states)
 CDM Clean Development Mechanism (established
by Kyoto)
 Limited to prevent over-supply
 Not significant during trial period, but more
important for future periods
 Concern: Would the offsets have occurred
regardless of the CDM?
Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading
System in perspective.” Pew Center on Global Climate Change.
ETS Trial Period Concerns
1. Price Volatility
2. Windfall Profits
3. Overallocation of permits
Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading
System in perspective.” Pew Center on Global Climate Change.
1. Price Volatility
Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading
System in perspective.” Pew Center on Global Climate Change.
Price volatility cont.
Graph explanation
 Market provides one price signal for MCA
 Dec. 2007 line shows futures contracts scheduled for delivery in Dec. ‘07
 Dec. 2008 line represents contracts for delivery in Dec. ‘08 for second trading
period
 Sharp price decline after September ‘06 because of restriction on trading
between 1st and 2nd periods (*banking and borrowing)
 Sharp decline in April ‘06 after release of 2005 emissions reporting. Several
member states reported lower emissions than expected.
 Expected aggregate emissions determines actual demand for allowances.
When the data was first released, the market adjusted expected price
with the actual demand. Because emissions were lower than expected,
the price of allowances fell. This effect is strongest after the first release
of information.
Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading
System in perspective.” Pew Center on Global Climate Change.
Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading
System in perspective.” Pew Center on Global Climate Change.
Windfall profits
 Higher electricity prices and higher
corporate profits from free allocation
of allowances.
The market price reflects the opportunity
cost of the allowances
 Solution: auction allowances
This would not impact electricity prices
Raises government revenue
Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading
System in perspective.” Pew Center on Global Climate Change.
Overallocation
 Member states allocated too many permits
during the trial period to create a nonbinding EU cap
 Second period EU cap will be about 13
percent lower than the first period cap and 6
percent lower than comparable 2005
emissions
 Still some abatement during trial period because short-term incentive to abate from
high prices
 Estimate: between 2 percent and 5 percent of
covered emissions abated annually during trial
period
Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading
System in perspective.” Pew Center on Global Climate Change.
Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading
System in perspective.” Pew Center on Global Climate Change.
Changes Looking Forward
Banking and Borrowing: inter-period
banking of permits allowed.
2. Majority of permits auctioned, instead of
freely allocated
3. Decentralized nature of the system will
become more centralized (ie. Monitoring,
controlling)
4. Lower cap
1.
Ellerman, D.A. & Joskow, P.L. (2008). The European Union’s Emissions Trading
System in perspective.” Pew Center on Global Climate Change.