Emissions Trading (Cap and Trade) Kate Macauley. 1. Economics of emissions trading 2. Overview of the EU Emissions Trading Scheme (ETS)

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Emissions Trading(Cap and Trade)

Kate Macauley

1. Economics of emissions trading2. Overview of the EU Emissions

Trading Scheme (ETS)

Cap and TradeQuantity regulation: Total allowable

emissions capped. Price determined by the market.

Total number of allowances created to match cap

Allowances may be traded on a marketIndividual firms abate until MCA =

Ppermit

The way you allocate the allowances does not impact the market price

Emissions Trading: Economics

AssumptionsGlobal pollutants: concerned with

aggregate pollution, not with discharge location (SO2, NOx, CO2)

Competitive marketCap 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

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

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*Sankar, U. (2001). Environmental Economics. New Delhi: Oxford University Press.

aggregate level of pollution in base year

Pollution capQuickTime™ and a




Therefore, we have the following cost minimization problem subject to the pollution cap restraint:



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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


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: 2005-2007Second period: 2008-2012 Third Period: 2013-2020

annual cap declines annually by 1.74 percent across EU ETS20% below 1990 levels by 2020


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-supplyNot significant during trial period, but

more important for future periodsConcern: Would the offsets have occurred

regardless of the CDM?


ETS Trial Period Concerns

1. Price Volatility2. Windfall Profits3. Overallocation of permits


1. Price Volatility


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.



Windfall profitsHigher electricity prices and higher

corporate profits from free allocation of allowances. The market price reflects the

opportunity cost of the allowancesSolution: auction allowances

This would not impact electricity prices

Raises government revenue


OverallocationMember states allocated too many

permits during the trial period to create a non-binding 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 pricesEstimate: between 2 percent and 5 percent of

covered emissions abated annually during trial period



Changes Looking Forward

1. 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


Documents

Emissions Trading (Cap and Trade) Kate Macauley. 1. Economics of emissions trading 2. Overview of the EU Emissions Trading Scheme (ETS)