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Kyoto: trading emissions permits By S.M. Enzler MSc

The efficiency of trading emissions permits to achieve Kyoto targets

General

On our Kyoto emissions reduction page a number of examples were given of ways in which a country may achieve its Kyoto standard. Some of these examples are regulatory instruments. These instruments suggest a high rate of governmental responsibility.

A government can apply three types of regulatory instruments:
- Institutional instruments, such as (international) negotiations. Kyoto is an important example of an international negotiation
- Command and control instruments, such as quotas, licenses and Best Available Technologies (BAT)
- Economic incentives, such as tradable permits, taxes and subsidies

The choice of an instrument to meet emissions targets by a country is determined by a number of criteria. These are mentioned in the table below. Each country may have a different order of importance and relative weight for these criteria and they may not all be applied.

Table 1: criteria for the selection of a regulatory instrument

Criterion Description
Cost-effectiveness Achieving the emissions target with minimal costs
Long-term effects The instrument remains effective on the long term
Dynamic efficiency The instrument is a continual stimulant for companies to act
Indirect profits The instrument is beneficial for both profits and the environment
Equity The instrument does not have a negative impact on income distribution
Dependability The instrument is a reliable regulatory source
Flexibility The instrument can be adjusted when new information is gained
Costs of uncertainties The instrument does not generate high costs upon information errors
Information demand The information demand is not too high

Policy makers often have some additional criteria for the selection of a regulatory instrument. These may be for example health, safety, technical feasibility, economic feasibility or sustainability.



Tradable permits

Explanation and benefits

Trading emissions permits was suggested by the European Union in 2002 as one of the main regulatory instruments for achieving Kyoto targets. This is an economic incentive that has been developed for persuading companies (such as fossil fuel producers) to voluntarily change their behavior. It is about creating markets for externalities.

Trading emissions permits would result in a more efficient share of the costs of Kyoto. The instrument basically causes emission cut-backs to be performed by the country that generates the lowest cost (figure 1). This is made possible because it is argued that it does not matter which country emits greenhouse gases, because dispersion in the atmosphere will cause the impact to be noticeable worldly. Free trade would cause countries that trade permits to both be better off.

The Kyoto Protocol emissions trading system is a cap-and-trade system. Cap-and-trade basically means that total emissions are limited or 'capped' each country or company involved receives an equal amount of permits. Emissions trading prevents receiving penalties for permit exceedance. Illegal discharge is prevented by monitoring. Kyoto also includes some additional mechanisms, such as Joint Implementation and Clean Development Mechanisms (CDM).

The eventual allocation of permits can be performed in two different ways: by grandfathering or by the auction or distribution rule. Grandfathering means that permits are allocated free of charge depending on historical emissions. The auction or distribution rule means that permits are auctioned to countries or companies, using demand curves. This option may be less attractive to countries or companies because it means emissions permits are not free of charge. The degree of trading of permits solely depends on the total number of permits.

Economic incentives such as trading emissions permits score high for cost-effectiveness, long-term effects, dynamic efficiency, indirect profits, costs of uncertainties and information demand, when compared to the other two types of instruments (see above). Equity is not very high when economic incentives are applied. Dependability of the instrument may be increased when its application is inspected.

Discussion on efficiency

All the above-mentioned benefits have caused countries to negotiate on tradable permits as a Kyoto instrument. There is however still a great deal of discussions about using tradable emissions permits as an instrument to achieve Kyoto targets. The larger part of the discussion is about the degree of trade. The European Union wants its own countries to trade amongst themselves, whereas the US votes for a larger degree of trade. The trade mechanism largely determines Kyoto costs. A global trade mechanism generates least costs and no trade at all is most expensive.

After US withdrawal from the Kyoto Protocol in 2001, the demand for emissions permits has decreased. However, the supply shows little difference. The US had expected to be a net buyer, particularly from the Ukraine and Russia. They had expected to spend 16 billion dollars on permit purchases. The widening of the definition of sinks for greenhouse gases (for example forests) would decrease both the demand and the supply of permits because countries would be more likely to handle emissions reductions within their own borders.

Some sources of greenhouse gas emissions, such as methane emissions from livestock, as well as small sources, are very difficult to include in a tradable permit system because it is difficult to measure actual emissions. In practice the emissions cap for the tradable permit system is less than the national emissions limit and some sources need to be addressed by other policies.

Strategic behavior of certain Kyoto countries can create problems for the emissions trading system. It may alter prices and cause cost-effectiveness of the economic incentive to cease. We do not recon Kyoto countries will try to gain extra profits at the cost of each other, but the possibility may not be excluded too soon.

Bjorn Lomborg argues in his book 'The Skeptical Environmentalist' that trading emissions permits may not be an efficient way of reaching Kyoto targets because developing countries are not included in current measures. He does however mention that including all these countries in the process may make the initial allocation of permits much more difficult because of the required redistribution from developed to developing countries and possible future abandonment of agreements by countries with weak administration. Lomborg states that we must wonder whether including developing countries in Kyoto will really be more feasible for us and them than directly investing in the countries, for example in sustainable energy provision. This would help them manage their emissions now rather than obligating them to handle their emissions in the future.


Figure 1: example of trading emissions permits

Sources

Enzler, S.M., Environmental Economics and Environmental Policy, lecture notes. March-April, 2005

Lomborg, B., The Skeptical Environmentalist - Measuring the Real State of the World. Cambridge University Press 1998, United Kingdom, H24: Global Warming

Perman, R., Ma., Y., McGilvray, J. and Common, M., Natural Resource and Environmental Economics. 3rd edition, Pearson Education, Harlow, 2003

Sorrell, S., Emissions Trading After Kyoto. Introduction to Environmental Economics of Science and Technology Policy Research, 2004

Related pages

Climate change glossary

Fossil fuels: characteristics and effects

The greenhouse effect mechanism

Emissions and infrared absorption by greenhouse gases

Explanation of the IPCC SRES scenarios

The IPCC SRES scenarios: causes of climate change

The IPCC SRES scenarios: consequences of climate change

Overview of emission reductions for each country according to Kyoto

Possible policy measures to achieve Kyoto targets

Discussions of the greenhouse effect

History of global warming

Perspectives on the greenhouse effect

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