The concept of emissions trading gained popularity with the successful implementation of the sulfur emissions allowances trading scheme. The allowance trading program is reducing annual emissions of SO2 by nearly 50 percent and is doing so for about one half to one third of the cost that would have been incurred using the approach taken throughout the first twenty years of federal air pollution control1. Several emissions trading programs are underway in Massachusetts, Connecticut, New Jersey, Michigan and California.
According to an article in Science2,
control of sulfuric acid in rain costs about $1B (US) per year, much lower
than the expected costs. This is an interesting phenomena, because twenty
years ago, acid rain was a major problem, and it did not appear that industry
would be willing to spend any amount of money on control of sulfur emissions.
However with the introduction of trading of SO2 emission allowances,
the industry came up with new innovative methods to reduce emission at
prices that were lower than even optimistic predictions.
Today supporters of emissions trading believe that it could work similar wonders if extended to CO2 and other greenhouse gases (GCG) as well. Emissions trading could very well be the instrument to ensure a cleaner environment for the future generation.
Back to contents
For the control of sulfur emissions, a system called an "emissions trading system" (ETS) is used. The case for an ETS rests on the economic theory that it offers a tool to minimize the costs to the nation as a whole by distributing the costs through a market mechanism. In an ETS, participants are allowed to increase emissions through the purchase of permits, which they will do if this entails a lower cost than their taking action to reduce emissions. These permits can be purchased from other participants for whom the cost of reducing emissions, either through efficiency improvements or lowered activity, is less than the price of the permits, or from sellers of emission 'credits' derived from credited sink activity. Through trading of permits, a market price for permits emerges that reflects the marginal economic cost of emission abatements. Emission abatement activities will thus be distributed so that the overall cost of greenhouse gas reductions is minimized across the economy.
Notwithstanding the theoretical advantages of an ETS, its effectiveness in minimizing costs will be determined by the arrangements decided on for its practical application. If an ETS is to be introduced the following design issues will need serious consideration.
The design of an ETS needs to balance the administrative costs (which increase with the number of participants), technical difficulties associated with measurement and verification, and the effectiveness of emission coverage. Administrative costs include the costs associated with setting up the scheme, the initial allocation, keeping records of trades, monitoring and verification of emissions, and ensuring compliance (i.e. a company's emissions do not exceed its permits). If administrative arrangements are complex, transaction costs may be sufficiently large to erode any potential economic gains from trading in emission permits.
The initial allocation of permits is a complex issue, and requires careful consideration of the economic, social, legal, and environmental impacts and implications. Creating an efficient and equitable initial allocation of permits entails a high degree of administrative complexity. It must take into consideration stockholders that currently emit greenhouse gases, but allow for new stockholders to enter the market without excessive "penalties". Additionally, this allocation must be seen to be fair so as to maximize participation, advance the effectiveness of the scheme, and minimize the potential for appeals and litigation. In addition, the scope for and competitiveness of emissions trading will be influenced by the way in which the rights are specified.
A number of basic allocation alternatives have been suggested: (1) grandfathering, i.e. allocating permits free of charge on the basis of past emissions; (2) auctioning; (3) a mix of auction and grand fathering -either simultaneously or time dependent; (4) "grandmothering", i.e. similar to grand fathering but with allocation on the basis of some past pattern of activity other than emissions (e.g. for electricity producers, kWh produced); (5) sale at fixed price. Each of these raises its own equity issues.
Grandfathering permits gives a marketable asset to current operators
at the expense of new entrants. In its simple form, it does not adequately
reward those who have already taken action to mitigate their emissions
(they receive a smaller asset than those who have "free-ridden").
On the other hand, auctioning or sale of permits, while fair to new entrants,
is likely to be resisted by energy-intensive industries as it imposes up-front
costs on them. Auctioning or sale could be an advantage to those
who have a higher level of liquidity at the time of the auction, and similarly
a disadvantage to those whose capital is more in fixed assets. Mixing
methods, such as using grand fathering in one sector and auctioning in
another, raises another set of equity (and legal) issues ("why did company
A get its permits free when company B had to pay for its permits").
Similar cross-sectoral concerns apply to "grandmothering".
Back to contents
The sulfur emissions allowance trading is often used in public discussions as an example of the successful implementation of an emissions allowance trading scheme.
Title IV of the Clean Air Act Amendments of 1990 ordered a sharp reduction
of SO2 emissions that were thought to be responsible for acid rain. The
U.S. Environmental Protection Agency (EPA) used a new approach departing
from the usual regulatory policy. Phase I began in 1995 and affected
263 units at 110 mostly coal burning electric utility plants located in
21 eastern and mid western states. Annual allowances were given out
free to these utility companies; they could then transfer them and even
bank them for the future. The companies were able to choose where
they would make the reduction of emissions. An additional 182 units
joined Phase I of the program as substitution or compensating units, bringing
the total of Phase I affected units to 445. Emissions data indicate
that 1995 SO2 emissions at these units nationwide were
reduced by almost 40% below their required level (see fig below)4.
Before the Clean Air Act Amendments, the marginal costs of abatement for SO2 were estimated by the EPA to be up to $1500 per ton. The EPA expected the allowance price to range around half of the original marginal costs. These numbers were later corrected downwards; in 1995 the marginal price for allowances at the annual auction was between $122 to $140; in 1996 it fell further to around $70.00.
The success of the SO2 program was mainly due to what economists call,
"dynamic efficiency" (i.e. innovation, competition, and discovery of new
ways of compliance). Title IV freed electric power companies from
the constraints of traditional regulations, which effectively spelled out
exactly how a requirement was to be met, and instead gave the utilities
the flexibility to figure out for themselves how to achieve compliance.
Given the new flexibility, many firms have found ways to reduce the cost
of controlling SO2 emissions that do not rely either directly or very heavily
on the allowance trading program. For instance, some utilities have
switched entirely to low sulfur coal, whose price has fallen substantially
over the last five years. Other power plants have begun blending
coals with varying sulfur content in order to reduce average SO2 emissions,
something thought impractical just a few years ago. Deregulation
of the railroad industry has also led to a steep drop in the cost of shipping
low sulfur coal from west to east1.
Back to contents
After Fall 1996, a few states in the U.S. viz. Massachusetts, Texas, New Jersey, Michigan, Connecticut and New Hampshire, have allowed emissions trading among industrial facilities. The focus is mainly on ozone precursors (NOx) and volatile organic compounds (VOC). Some also allow credit trading for particulates, CO and SOx. Today a wide array of companies including Dow, Dupont, BASF, Unocal, Chevron, Mobil and Merck are actively engaged in emissions trading.
The Open Market Trading systems (OMT) used by the states differs from the "cap and trade" Acid Rain and Reclaim programs. Unlike cap and trade programs, OMT-style trading programs do not dictate the universe of participants. They allow any willing facility to participate voluntarily. And they do not cap target pollutants or allocate a pool of emissions credits to any facilities.
OMT programs provide a financial incentive by allowing any willing facilities
to "over-control" NOx and VOC emissions below permit levels, and then to
sell the "discrete emissions reductions(DERs)" or "emissions reductions
credits(ERCs)" to others whose control or abatement costs are higher. While
the credit prices vary widely by state, typical NOx trades are in the $1000-2000/ton
range while VOCs have been trading for $3000-4000/ton. All state level
OMT programs also guarantee a net benefit to the environment, because they
require buyers to "retire" 10-20% of the emissions credits they purchase6.
Back to contents
A problem, not yet fully investigated by economists, which is strongly related to the initial distribution of allowed emissions targets for every country, is the macroeconomic effects of international tradable emissions permits on international financial systems, exchange rates, and international trade itself.
The scenario could be that countries such as the U.S. would be forced to buy large amounts of permits from countries in Eastern Europe, such as Russia, which might be able to sell permits because of its shrinking economy in the past several years. This could lead to huge transfers of wealth from the U.S. and other industrialized countries to Eastern Europe. These countries would therefore be rewarded for having run inefficient and polluting industries in the preceding decades. This problem exists for all forms of uniform emissions targets, but in the case of emissions trading these countries would hold an even greater advantage over countries that increased their abatement efforts earlier, because they now also receive a financial reward for their behavior. This transfer might be very helpful for these countries or for developing countries if they decide to join, but the political acceptance in industrial countries seems questionable.
This international system might not even significantly reduce emissions
since some countries, in particular Britain, Germany and Russia, have already
reduced their emissions from the 1990 levels. These countries would be
able to sell their unused permits to countries that might not be able to
achieve the emissions target. In this case the system would not lead to
much emissions reduction overall; it would only transfer money from one
country to another because of the unbalanced allocation of the emissions
between these countries7,8.
Back to contents
The Clinton Administration is pushing the emissions trading system as a method to reduce carbon emissions9. According to their estimates, the price of carbon permits would be between $14 and $23 per ton, which would be roughly 10% of the cost of a command and control scheme. The problem with this plan is the global nature of carbon pollution. Worldwide, there are millions of sources of carbon, and monitoring them would be a difficult task, especially because the proposed emission trading program reached at Kyoto includes three greenhouse gases, carbon dioxide, nitrous oxide, and methane, as well as three ozone depleters: hydrofluorocarbons, perfluorocarbons, and sulfur hexafluoride10. Additionally, several other problems exist. For example, some countries have large carbon sinks (e.g. replanted forests), which can change the carbon levels measured. Dealing with emerging economies also presents a problem. These countries expect to increase the level of greenhouse gases they produce because their technology is still based on "dirty" fuels, and they feel that since countries like the U.S. were allowed to grow while emitting high levels of these gases, they should be allowed to do so as well. Older technology also presents another problem. Since these processes are less efficient, their emissions generally tend to be higher. It is expected that any emissions reduction plan will be based on the emissions at some base year (e.g. 1990 for sulfur emissions in the US). Thus, if your plants were emitting high levels of these six gases in the base year, your allowance would be higher. The large purchasing power of the countries like the U.S. would also make it easy for them to simply buy emissions permits from relatively poor countries like India, and continue to emit greenhouse gases. The Kyoto treaty has set targets for reductions of the six aforementioned gases. However, this protocol will not take effect until it is ratified by at least 55 countries who must aggregately contribute 55% of the world emissions reductions10 .
Back to contents
The benefits from an ETS need to be weighed up against the financial, social and economic costs associated with setting up, administering and ensuring compliance with such a scheme.
If administrative arrangements are complex, transaction costs may be
sufficiently large to erode any potential economic gains from trading emissions.
Back to contents
on emission trading
World Coal Institute- Climate news
Bill S1246: Air-emissions Banking & Trading
Back to contents
2. Kerr, Richard A., "Acid Rain Control: Success on the Cheap", Science, 282, 1998, p 1024-8
6. Shelley, S. and Crabb, C., "Emissions-trading programs hit their stride", Chemical Engineering, 105, No.6, 1998, p 32-37
7. McKibbin, Warwick J., and Wilcoxen, Peter J., "A Better Way to Slow Global Climate Change," Brookings Policy Brief No.17, 1997, p 5
9. Kaiser, Jocelyn, "Pollution Permits for Greenhouse Gases?", Science, 282, 1998, p 1025
10. Cooney, Catherine M., "Kyoto treaty sets precedent for emissions trading program", Environmental Science & Technology, 32, Feb 1, '98, p 74-5
Back to contents