Course: Current Issues in Global Environment Change (U of Toronto)

 

Submitted by: Rory O’Brien

 

Submitted to: Doug Whelpdale, Ron Williams, Ted Munn

 

Date: March 26, 1998

 

 

Table of Contents

 

Introduction...

Tradable Permits as a Policy Instrument.....

Voluntary Initiatives...

Command and control measures...

Market based instruments

Examples of Applied Trading Systems........

Phase-out of lead in gasoline in the United States........

Sulphur dioxide reductions in the United States and Europe......

Ozone depleting substances and the Montreal Protocol....

New Zealand’s transferable fishing quotas.....

Kyoto Protocol and Tradable Permits for Reducing Greenhouse Gases..........

Tradable Emissions Permits....

Related policies and activities..

Implementation of a global emissions trading regime...................

Allocation

Trade Units...............

Participants...............

Trade pathways.

Market mechanisms...............

Monitoring and compliance...............

Administration and transaction costs.......

Related issues......

Market power.

Phasing

“Leakage”...........

Conclusion..

Bibliography

 

 

Introduction

 

In December 1997, the Kyoto Protocol was agreed upon by most of the world’s nations in order to take more concrete action to reduce greenhouse gas emissions. The main economic mechanism to be used to accomplish this reduction is that of tradable emissions permits. Due to the inextricable and complex linkages between energy use, greenhouse gas emissions and general human activities, this new global trading system in emissions will have a very great influence on world economics, politics, social welfare, and ultimately, one hopes, on the environment. What is remarkable, however, is the fact that such a system is relatively untried in real-world settings. This mechanism is as much a grand experiment as the problem it is designed to solve, and both leave very little room for failure.

 

This paper will provide a general overview of the nature of tradable emissions permits as it relates to the Kyoto Protocol to the Framework Convention on Climate Change. Designed as a relatively short, introductory reference for the layperson, it will try to answer the following questions: what are tradable permits, how have they been used in the past, why they are being used to control greenhouse gas emissions as part of the Kyoto Protocol, how might they be implemented, and what are the main issues that need to be addressed for them to be used successfully?

 

Tradable Permits as a Policy Instrument

 

 

Cassils (1991) outlines three broad categories of policy instruments that are  used to create planned, operational changes in an industry in order to alleviate environmental problems: (i) voluntary initiatives, (ii) command and control regulations, and (iii) market based instruments.

 

Voluntary Initiatives

 

Voluntary initiatives are those activities undertaken by industry that are not previously mandated by government through legislation, or are not the result of market forces. The adoption of industry standards, such as ISO14000,  is one example of a policy or procedure adopted voluntarily. In some cases, such as with voluntary agreements and voluntary challenges, industry and government work together on the initiative. In the case of GHG emission reductions, voluntary challenges were adopted by industry with facilitation by government both in the United States and Canada. The fact that they did not succeed in reaching reduction targets[1] was undoubtedly a factor in the promotion of market-based policy instruments at the Climate Change Conference in Kyoto in 1997.

 

 

Command and control measures

 

Command and control measures are those activities imposed on industry through government legislation, particularly for pollution abatement purposes. This has been the traditional policy instrument used by government and generally entails setting limits on the amount of pollution allowed to enter the natural environment, specifying abatement technologies, and establishing pollution reporting systems. Industry has usually complied with reluctance to such policies, feeling it hampers their autonomy as well as their competitiveness internationally. Environmentalists have also decried the typical “end-of-pipe” solutions favoured by governments, feeling they prevent longer-term, more benign pollution prevention solutions from being enacted.

 

Market based instruments

 

Market based instruments (also called economic instruments) are also policy measures initiated by government. They differ from command and control ordinances by allowing more freedom on the part of  industries to respond in ways they deem most beneficial to themselves. These may take the form of charges or fees levied on emissions or usage of public waste treatment and disposal services.  The polluting company has the choice to save money by cutting back on the waste they create. Subsidies can also be used as an economic incentive to encourage compliance with emission standards.

 

It is in the area of market creation, however, that government regulation can best spur industry to meet and exceed abatement standards. One of the best examples of this mechanism is in the area of tradable permits.  The basic operation is fairly simple - an overall limit on the total emission of a pollutant is established, followed by a schedule for periodically reducing that total amount. A reasonable unit of pollution is set, divided into the total amount, and allocated to the individual firms in an industry on some kind of equitable basis (such as an historical baseline, or an auction).  These units become permits to pollute, and the owners treat them as property rights which, like other assets, they are freely allowed to sell or use as they see fit.

 

By separating the policy control of government from the implementation control of business, both parties are able to satisfactorily remain within their own respective areas of expertise. The increasing awareness of the effectiveness of market-based incentives may have prompted over 2,300 leading economists to announce in a statement that market-based policies are the most efficient approach, and that an international emissions trading agreement is required.[2]

 

Examples of Applied Trading Systems

 

There have not been many instances of large-scale implementations of permit trading regimes, so it is important to note the lessons derived from these previous experiments. The following initiatives will be presented and discussed: phase-out of lead in gasoline in the U.S.,  sulphur dioxide reductions in the U.S. and Europe, ozone depleting substances and the Montreal Protocol, and New Zealand’s transferable fishing quotas.

 

Phase-out of lead in gasoline in the United States

 

To reduce the level of toxic lead in the environment, the U.S. Environmental Protection Agency in 1973 instituted a program of mandated reductions in the amount of lead added to gasoline. In 1982, to provide small refiners with more flexibility in meeting new, lower lead limits, the EPA set up a system for allowing refineries to trade their rights to add specified quantities of lead to the gasoline they produced. The difference between the amount a refiner was allowed, and the reduced amount it actually added, could be sold to other refiners, or, beginning in 1985, banked for future use or sale. The program ended in 1986 with the complete phase-out of lead additives, although firms with banked rights were able to use them to the end of 1987.

 

Hahn and Hester (1989), who studied this trading program in depth, considered it to be quite successful. It resulted in the elimination of lead in gasoline within a short timeframe, and did so in a cost effective manner - it was estimated that the program saved refiners $226 million.[3] The simplicity and clarity of the regulations, coupled with the fact that self-monitoring and reporting mechanisms was already in place, meant that transaction costs were minimal. Perhaps the most significant factor in its success, however, was the existence of a network of refinery personnel conducting transactions in a previously existing market for refinery products, including various additives. This interactive network greatly facilitated the deployment of the lead trading system.

 

Sulphur dioxide reductions in the United States and Europe

 

In 1995, the first phase of the US Acid Rain Program was instituted, with 110 large coal-fired electric utilities participating in a sulphur dioxide (SO₂) emissions trading regime. Individual emission limits were based on historical production levels, and the companies were allowed to sell or bank surplus emission allowances. Phase II, to begin in 2000, will see the program expand to include all other utilities, under significantly reduced emission limits.

 

The EPA has designed the trading system to allow for minimal government involvement. Mandatory equipment to allow for continuous monitoring and reporting of emissions has been installed in the utilities and a central computerized compliance tracking system set up in the EPA offices. Trades must be reported, but no prior approval is required.

 

The allowances are distributed freely to the utilities, although the EPA holds back 2.8% of total allowances yearly and auctions them off. The auction serves to deliver price signals to the market, and ensures that allowances are available to new power producers.

 

Trading has increased steadily since the program’s inception, facilitated by private sector exchanges and trade information brokers, using trade association newsletters and electronic bulletin boards. Anyone is allowed to buy and sell allowances, and some allowances have been purchased by environmental groups in order to ‘retire’ them, thereby cutting overall emissions sooner.

 

A 1997 MIT research study pronounced the program a success, with the authors estimating that the trading system reduced compliance costs by about one-third, compared to alternative approaches,[4] The US General Accounting Office has calculated such savings at more than $1 billion per year.[5]

 

In Europe, a related initiative is in development - the 1994 Oslo Protocol has set local limits on SO₂ emissions based on regional environmental sensitivities. Although the countries that are party to the protocol are allowed to pool their commitments and exchange allowances within such ‘bubbles’, to date there has been no trading. The main barrier has been the difficulty in establishing trading rules.

 

Ozone depleting substances and the Montreal Protocol

 

In 1987, the Montreal Protocol established an agenda for gradually phasing out a suite of Ozone Depleting Substances (ODS), such as chlorofluorocarbons (CFCs), from production and consumption. Parties to the protocol are allowed production and consumption quotas according to an historic base-year, with declines required periodically until complete phase-out (1996 for the industrialized countries). Developing nations have an extended timeframe. Flexibility was also built in to the system, with the schedule being accelerated several times in light of new scientific evidence of ozone destruction.

 

Trading is permitted domestically and between parties, although only member countries of the European Union, as a regional economic integration organization, are allowed to pool consumption quotas under an EU bubble.  There is no trade in ODS with non-participating countries and national legislation has been implemented to ensure compliance (there have been instances of illegal trading).

 

Quotas for each substance are measured in ozone-depleting potentials, enabling a standard unit to be used for equivalency trading of all ODS. Banking of unused quotas is allowed, but only for consumption, not production.

 

National monitoring and reporting systems were already in place, for the most part, so administrative overhead was kept low. Developing countries that require it have recourse to a related Multilateral Fund for resources to establish such systems.

 

The Protocol’s trading system has been successful. It has led to reductions in ODS within the agreed-upon time limits and done so with reduced administrative costs.[6]

 

New Zealand’s transferable fishing quotas

 

To deal with the problem of over-fishing, in 1986 the government of  New Zealand set a Total Allowable Catch (TAC) limit for 33 fish species in domestic waters, and established a trading system of individual catch quotas for firms in the commercial fishery.

 

Individual Transferable Quotas (ITQs) were set according to an historical baseline for each fishing permit holder (grandfathering). Initially, the quotas were fixed tonnages of catch, which resulted in the government having to purchase quotas and retire them in order to meet reduced TACs. After 1990, however, ITQs were defined as a proportion of the annual TAC, giving more flexibility for changing circumstances.

 

Trading is permitted by New Zealand residents or companies less than 25% foreign owned, with restrictions on quota aggregation to prevent abuse of market power. Quotas are not transferable between fish species, except for minor “by-catch” allowances.

 

Fishers are allowed to carry over 10% of  any unused ITQs to the following year, and also to “borrow” up to 10% of the following year’s quota. Both of these provisions, however, will end in 1998/99 when the system is simplified.

 

Initial quota allocation procedures and establishing monitoring systems (paper based) were costly for the government initially, though there has been no significant increase in ongoing administrative costs.

 

Some problems have been difficult to resolve and have led to conflict with the commercial fishers: the catch of the non-commercial fishery has not been limited, leading to charges of over-allocation of fishing rights to that sector; and disagreements over the calculation of maximum sustainable yield, upon which the commercial limits are based. Overall, though, trading has allowed increased sustainability of the fishery at less than the cost of alternative policies.[7]

 

Kyoto Protocol and Tradable Permits for Reducing Greenhouse Gases

 

 

Representatives from almost every country met in Kyoto in December 1997 to negotiate the Kyoto Protocol to the Climate Change Convention in order to curb atmospheric greenhouse gas (GHG) emissions and reduce the probability of severe climate change effects. The signed Protocol set binding limitations on the amount of CO₂ and related gases that the countries of the OECD and the former Soviet Union and Eastern Bloc [Annex B countries] could emit. The target is to have average reductions of 5.2% from each country’s 1990 baseline emission rate, to be achieved within the period 2008-2012.

 

Tradable Emissions Permits

 

 

How is this reduction of 5.2% to be achieved? Though policies supporting energy efficiency will be promoted, along with research into deployment of non-fossil fuel-based energy sources, the primary means of reaching the targets is to unleash the power of the market by setting up a system of tradable permits for GHG emissions.

 

Article 16 bis explicitly states,

 

“The Conference of the Parties shall define the relevant principles, modalities, rules and guidelines, in particular for verification, reporting and accountability for emissions trading. The Parties included in Annex B may participate in emissions trading for the purposes of fulfilling their commitments under Article 13 of this Protocol. Any such trading shall be supplemental to domestic actions for the purpose of meeting quantified emission limitation and reduction commitments under that Article.”[8]

 

Other paragraphs mention that “emission reduction units” (i.e., permits) can be transferred between parties, and can be saved, if unused, for subsequent commitment periods. But exactly how such a permit trading system would be put into place has been left to various committees and subsequent meetings of the parties.

 

Related policies and activities

 

There are several key references to related policies and activities, however, which will have an impact on trading. One of these is the mention of  a “clean development mechanism”, which is to be a funding resource for projects to reduce GHGs in developing countries (which, at this point, have made no binding commitments to limit emissions).  Activities Activated Jointly (AIJ), also known as Joint Implementation (JI), is a similar venue that allows direct collaboration between parties on such projects. In both cases, the reduction in GHG emissions that result from such intervention will be applied to the total of the funding country. It is in this way that the poorer nations will be able to fund emission abatement measures in their own countries, and the richer nations will be able to offset their own reductions.  It is important to note, however, that such reductions are to be supplemental to domestic actions to reduce emissions.

 

The other related clause has to do with emissions from sources and removal by sinks, referring in particular to forestation efforts. Deforestation is a major source of  atmospheric CO₂, and afforestation and reforestation act as sinks by sequestering CO₂ from the air. Provided a verifiable means is found to reliably measure the CO₂ amounts, this could be used as a way for tropical countries to enhance their forests with funding from the OECD countries.

 

 

Implementation of a global emissions trading regime

 

 

There are few precedents, and many unknowns at present, regarding the implementation of tradable emissions permits on a global scale. The following is a review of some current ideas about how to initiate and maintain a trading system.

 

 

 

Allocation

 

The emission limits set by the Kyoto negotiations are the basis for setting national permit allocation. Although some economists (Helm 1991; Bertram 1992) have advocated an allocation based on population as a means of meeting developing nations’ equity concerns, this has not been seriously considered.[9] Flexibility in allocation must be considered to deal with limit revisions resulting from future negotiations and new scientific evidence, with adjustments announced on a pre-determined schedule. Rules for adding participants must be very clear.

 

Banking of permits is recommended for market flexibility, although borrowing from future emissions is not, due to the risk of bankruptcies and reduced market liquidity if this option were exercised by most parties in lieu of trading.

 

Trade Units

 

The units of trade should be clearly defined, and standardized for full exchangeability. It would be useful to develop equivalencies in GHGs via calculation of global warming potentials. An attempt should be made to include all verifiable GHG sources and sinks in the trading system.

 

Participants

 

The more participants, the better the market will operate. To this end, the system should be kept simple, with use of comparable inventorying practices, and non-restrictive compliance requirements. Participation by countries that have not adopted emission limits could reduce the value of the permits.

 

 

Trade pathways

 

There are several possible pathways for trading  permits, with participants including governments, industries (as a sector), individual firms trading domestically or in an international marketplace. Transactions could be made directly, or through an intermediary such as a broker, or an electronic exchange.

 

International trading for individual emitters would only be feasible if they had emission limits established beforehand as part of a domestic trading system. An international trading system should be designed to accommodate a variety of national trading systems, with the corollary that such national systems should be as integratable as possible internationally.

 

Some countries may wish to include only sizable emitters in domestic systems for ease of monitoring and enforcement. Governments that decide it is too costly to set up a domestic operation may want to tax all emission sources, mandate energy efficiency standards or promote voluntary agreements with industry.

 

Trading with countries that have not established limits for GHG emissions would only be possible on a project or sector basis, providing individual limits were set for these circumstances.

 

Market mechanisms

 

Existing market mechanisms, such as stock exchanges, information services, and payment mechanisms could be employed for GHG emissions trading. Brokers will be needed who specialize in trading permits in order to reduce a participant’s transaction costs of finding buyers and sellers and obtaining an optimal price.

 

Organized exchanges, possibly in many different regions, will be the venue of choice when the transaction volumes increase, particularly if GHG units were standardized. Aside from facilitating trades through ease of communication, and standard transaction procedures and costs, exchanges could help set prices through periodic auctions. Some kind of international accreditation of mediating mechanisms may be needed.

 

The trading system will need to be serviced by newsletters and electronic bulletin boards. The Internet is poised to become the venue of choice for such communications.

 

Legal liability concerns will require mechanisms for ensuring permits are valid prior to their purchase. A dispute resolution procedure will be necessary.

 

It may be useful to set up an international permit ‘reserve’ to ensure a pool of permits for new entrants to the market,  for purchase by countries facing non-compliance, or to ensure market liquidity.

Monitoring and compliance

 

Tradable permits must be verifiable, or there will be risk of a failure of the trading system due to participants uncertainty and reluctance to trade. Information must be collected and reported, adequate auditing and review procedures put in place, and enforcement of commitments ensured.

 

National monitoring mechanisms will account for trades and emissions. National inventories, compliant with international guidelines, will ensure that net emissions do not exceed the permits held by the individual countries. Comparable methods for estimating emissions and setting emission baselines for individual sources, coupled with common reporting formats, will be of benefit. Climate Change Convention signatories are currently reporting on emissions on a yearly basis, and this may be a useful means of reporting on trading as well.

 

Compliance on a national level is easier to enforce than on an international level. This may presuppose that participants enact national legislation prior to beginning trades internationally. Binding agreements on penalties and  dispute resolution will be needed to ensure a credible and effective trading system.

 

Administration and transaction costs

 

The system should be designed from the outset to minimize administrative overhead and transaction costs. Requiring approval for individual trades would hamper the workings of the market. A centralized administration would help facilitate international trades, and may be funded through a GHG unit levy.

 

Simplicity of operation in the form of clearly defined procedures and a hands-off stance by government, along with adequate verification and oversight, will bolster confidence in the market. This means lower such “insurance costs” as requiring letters of credit and legal opinions. An automated, continuous monitoring system can also reduce the costs of collecting information on emissions.

 

Related issues

 

Market power

 

Having a few larger participants dominate the market through accretion of GHG units is a possibility that is best thwarted by designing the system to encourage a large number of diverse participants to join. This can be accomplished by allowing units to be bought and sold by any individual or entity. Countries should strive to develop domestic systems that are compatible internationally to assist domestic unitholders to trade within the larger international market. Periodic auctions and reserves held by an international body will also help avoid concentration of market power.

 

Phasing

 

The market in tradable emissions permits will evolve gradually over time, expanding in the number of countries, participants, and units traded, as well expanding to include all sources and sinks. Careful system design will allow for growth along these lines and may take one of several initial forms: an initial ‘pilot project’ of a small number of traders with good emission monitoring and a diversity of GHG mitigation costs to make trading worthwhile; a system of bilateral trades among governments, such as within the European Union; or having domestic systems set up to provide experience and insights prior to trading at an international level.

 

“Leakage”

 

Another major concern is that of carbon “leakage”, i.e., reduction strategies pursued in one region that could result in an increase in emissions in another region (such as when an oil refinery finds it cheaper to operate in a country that has not set binding emission limits and therefore doesn’t impose costly compliance measures). International emission trading reduces this concern as it reduces compliance costs, and this is further enhanced by having non-participating countries begin trading, thereby having an incentive to pursue GHG abatement measures.

 

Conclusion

 

Governments, business, and their economic advisors are increasingly favouring systems of tradable permits as a market-based policy instrument, preferring them to voluntary initiatives and command and control regulations. Examples of successfully applied permit systems include: phase-out of lead in gasoline in the U.S.,  sulphur dioxide reductions in the U.S. and Europe, ozone depleting substances and the Montreal Protocol, and New Zealand’s transferable fishing quotas.

 

The Kyoto Protocol signed in 1997 contained an explicit statement on the utilization of tradable emissions permits, along with mention of a “clean development mechanism” as a way to fund GHG reduction projects in countries without binding emissions limitations, i.e., richer funders acquire extra permits and poorer nations receive extra development aid for ‘green’ technologies. How the permit system might evolve is still a matter of conjecture, and several remaining issue areas require detailing.

 

I have endeavoured in this paper to present an overview of the emerging use of tradable emission permits as a means to reduce global greenhouse gas emissions. I hope it has been of some use in clarifying the matter at hand, for climate change will affect all of us, as will any attempts to resolve the problem. We need to know what is going on, and be prepared to act.

 

 

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