By Rosemary Irving and Rosa Hill, University of Canterbury
Rosie and Rosa are undergraduate students. They won the Motu Environment Economics Essay prize in 2017. You can find out more information about Motu's proposal for the Emissions Trading Scheme (ETS) and our wider ETS work.
|Rosie Irving and Rosa Hill|
Economic Rationale: How an Emissions Trading Scheme Works
|Figure 1: Command-and-control (equal |
| Figure 2: Emissions trading scheme |
Achieving emissions reduction through an ETS is done by transferring one unit of reduction from the emitter with higher marginal costs of abatement (MAC2) to the emitter with lower costs of marginal abatement (MAC1) through trade. On an aggregate level, this is the most efficient way to reduce emissions as it costs the emitter with the lower abatement cost less to undertake the reduction (Hanley, Shogren & White 2013). On the other hand, command-and-control approaches create an efficiency loss, with the reduction of emissions (from E to Eopt) having a higher cost of abatement. Both ETS and command-and-control policies set a cap for the optimal aggregate quantity of emissions. However, in ETS, the market sets the price through trade whereas the price in a command-and-control approach is reflective of the costs of abating to that level (Schmalensee & Stavins, 2017).
The ETS model recognises the inherent heterogeneity in emissions abatement costs amongst firms. Unlike command-and-control approaches, where all firms are regulated to cut emissions by the same amount, market-based approaches such as the ETS achieve reductions at a lower cost by equating the abatement costs across sources (Schmalensee & Stavins, 2017). Cost savings from using a trading program as opposed to command and control were estimated to be 20% in the U.S. Phasedown of Leaded Gasoline and to be at least 15% and possibly as great as 90% in the U.S. Sulfur Dioxide Allowance Trading Program (Schmalensee & Stavins, 2017). Newell and Stavins (2003) suggests that the greater the differences in emissions abatement costs across firms, the greater the cost savings are likely to be from using a market-based approach.
Another key feature of an ETS’s success is the incentives it provides firms to not only reduce their emissions but to go beyond minimum requirements. Being able to sell surplus emission allowances encourages firms to develop technical innovations that allow them to produce at lower emission levels. This has the advantage of allowing firms the flexibility to decide the most cost-effective way to reduce emissions (Schmalensee & Stavins, 2017).
|Photo by Rosa Hills|
Key Considerations when Establishing an Emissions Trading Scheme
While ETSs have proven to be an effective mechanism for reducing greenhouse gases, the program’s success lies in its details and design (Schmalensee & Stavins, 2017). By analysing past experiences of ETS programs, some key trends in design can be observed as critical for successful implementation. The following factors are crucial to starting an ETS program successfully.
Establishing rules prior to implementation
Establishing rules and corresponding penalties prior to the program’s implementation increases compliance, as it limits uncertainty and price volatility and ultimately allows firms to plan. The importance of establishing rules prior to implementation is noted in the example of the NOx Trading in the Eastern United States. The program faced high levels of uncertainty as a result of trading beginning before some rules were in place. Consequently, there were high levels of price volatility during the first year of the program (Schmalensee & Stavins, 2017). Establishing rules early on can assist in limiting policy uncertainty, which is particularly important in achieving the goals of an ETS as uncertainty can create unwillingness to invest in innovation to reduce emissions (Lopez, Sakhel & Busch, 2016).
Free initial allowances
Free initial allowances are often critical to gaining political support to kick start the program in its pioneering stage. However, after the initial stage, independent phasing into allowance auctions becomes important as it allows the market to set the price without compromising the environmental performance or raising costs (Schmalensee & Stavins, 2017).
Low transaction costs
Low transaction costs are a contributing factor to the success of trading in ETS programs such as the Phasedown of Leaded Gasoline and the Sulfur Dioxide Allowance Trading Programme. If transaction costs are too high like they were in the US Environmental Protection Agency's early emissions offset systems due to requirement of government approval prior to trades, significant trading will not occur (Schmalensee & Stavins, 2017).
Banking allows firms to collect and save permits for later use or trade. The importance of banking was highlighted in the case of southern California's Regional Clean Air Incentives Market (RECLAIM) in which banking was not permitted. Faced with the 2000-2001 Californian electricity crisis, the industry saw a steep increase in allowance prices, resulting in the temporary suspension of the program (Schmalensee & Stavins, 2017). It also became critical to allow banking from one phase to the next to avoid a price collapse, as seen at the close of the EU ETS’s first phase (Ellerman, Marcantonini & Zaklan, 2016).
Price collars set a maximum and minimum price that permits may sell for. This decreases the risk of major price fluctuations and stabilises costs. Highlighted through the US Regional Greenhouse Gas Initiative (RGGI), setting a reserve price for permits enables a price floor, while releasing permits from a reserve when prices get exceedingly high allows for a price ceiling (Schmalensee & Stavins, 2017). Price collars become particularly important when economic conditions change. They prevent the cap from becoming non-binding if emissions fall below it as well as prevent excessive price spikes from occurring when the economy experiences growth (Schmalensee & Stavins, 2017).
Leakage poses a potential to impair the effectiveness of the ETS. Leakage occurs when emission production is moved outside of the regulated area into a less stringent area. Leakage can also occur when firms sell their older, more polluting equipment and firms in sectors of less stringent regulations purchase it (Wrake, Burtraw, Lofgren & Zetterberg, 2012). In RGGI, only nine northeastern states currently take part. Because some states border others which have not been part of the initiative, there has been significant possibility of leakage (Schmalensee & Stavins, 2017).
Ellerman, A. M. (2016). The European Union Emissions Trading System: Ten Years and Counting. Review of Environmental Economics and Policy, 10(1), 89-107.
Hanley, N. H. (2013). Introduction to Environmental Economics (Vol. 2nd). USA: Oxford University Press.
Lopez, J. M. (2016). Corporate investments and environmental regulation: The role of regulatory uncertainty, regulation-induced uncertainty, and investment history. European Management Journal (35), 91-101.
Newell, R. G. (2003). Cost heterogeneity and the potential savings from market-based policies. Journal of Regulatory Economics, 23(1), 43-59.
Schmalensee, R. & R. Stavins (2017). Lessons Learned from Three Decades of Experience with Cap and Trade. Review of Environmental Economics and Policy, 11(1), 59-79.
Wrake, M. B. (2012). What Have We Learnt from the European Union's Emissions Trading
System? Royal Swedish Academy of Sciences, 12-22.