This literature review compares the two main emission trade schemes: the cap-and-trade scheme and the performance standard scheme. The advantages and disadvantages are compared after which the author presents his view which of the two is more desirable.
Nowadays everyone is, to some extent, aware of the effect that greenhouse gasses and other forms of pollution have on our environment. This increase in awareness over the past few decades has led to increasing public pressure to reduce pollution, but at the same time to do so without harming the economy. This entails the need for a subtle instrument to coax polluters into reducing emissions without impeding economic growth. The solution that is currently favored by many nations is the ‘emission trading scheme’, mainly because it is less restrictive and damaging to the economy than other solutions. There are two main types of emission trading schemes: the so-called ‘cap-and-trade scheme’ and the ‘performance standard scheme’. The ongoing debate on this subject is centred on the two variations on the scheme and which of the two is more desirable on the whole. Questions that have been raised are, amongst others, which is more economically efficient, practical to implement and which will reduce emissions the most. This paper will examine available literature on the subject.
In this review, we will start by providing the theoretical background to pollution regulation and emission trading. After this, a general introduction to emission trading schemes will be provided following which each of the two schemes will be examined more closely. During this examination we will explain the scheme’s particular features and then highlight the advantages and disadvantages that each scheme entails. Finally, the findings will be summarized in the conclusion and the author’s opinion will be offered as to which of the two schemes is more desirable.
In order to understand why one should prefer one system to another, it is first necessary to investigate the underlying theory on externalities, pollution regulation and emission trading. How would an emission trading scheme work? Our starting point is the Coase theorem, which is often described as the “fundamental theorem in the area of externalities.”
Pollution is a case of what some describe as ‘the tragedy of the commons’. Because the good that is being destroyed (the environment) cannot be identified as belonging to anyone, no one has an incentive to act. The obvious solution is to give someone the ownership of the good, but that is hardly practical in the case of the environment. We can however give someone the right to live in a pollution free environment or to pollute. This is described as ‘internalizing an externality’ and it is where the Coase theorem becomes important. The Coase theorem implies that the best way to regulate externalities (such as pollution) is to allow for bargaining between the polluter and the victim of pollution. The theorem does assume that it is possible to identify victim and perpetrator (e.g. that the externality has been internalized to some extent), but in the case of emissions, the perpetrators (producers) and victims (the inhabitants of the affected area) can often be readily identified. Coase’s theorem is therefore applicable to emissions. Coase’s point is that so long as property rights are clearly defined, externalities are best settled by what we now call: ‘Coasean bargaining’.
As mentioned, a central part of the theorem is that it is possible to identify those with rights. But it does not matter who has those rights from an efficiency point of view, the end result in any case would be that the party that values the right to commit, or be free of, the externality the most will end up with that right. Irrespective of who owns the right to pollute (or the right to be free of pollution), the two sides will strike a bargain and the side that values the right the most will compensate the other side. Thus, the effect of the negative externality is not influenced by the allocation of property rights, but the allocation of property rights does determine who must compensate whom.
This concept is best illustrated by an example. A factory entitled to emit pollution would, in theory, be willing to reduce that pollution if properly compensated. In economics terms, the factory will cease polluting if the marginal profits are smaller than the compensation offered. Those willing to provide that compensation could, for example, be the population of the towns surrounding the factory. The population would then pay the factory to stop, or limit, its emissions. Vice versa, if the population owned the right to be free of pollution, the factory would have to compensate the population in order to be allowed to pollute.
The problem arises however, when the transaction costs are too high. Taking our example from before, the bargaining costs would be very high when negotiating with every single inhabitant of the area around the factory. The bargaining process would be time consuming and expensive. This would lead to a rise in the costs of reducing pollution to such an extent that the population of the surrounding towns would no longer be willing to pay that price.
The Coase theorem is thus very relevant to the system of emission trading. Essentially, in the case of emission trading, the government creates a market whereby the polluters can negotiate and buy the right to pollute, in effect keeping the transaction costs of Coasean bargaining low. The question that rises however, is whether the market should be limited or controlled by the government. Should the government retain control over the total amounts of pollution or should the market define the total amount of pollution? When the government determines the total amounts of pollution it is described as a “command and control” system, while if the market defines the total amount it is a “market-based” system. These two systems have been implemented in emission trading schemes, and will be examined in depth in the following chapters.
Emission trading in general is based on the idea that the scheme influences the amount of pollution that is produced. The way in which this is done is dependent on the type of scheme used. The central concept is that the creation of market forces will make pollution expensive enough that the opportunity costs of investing in less polluting production processes will decrease to a level that it is worth the polluters’ while to pollute less. The way in which an emission trading scheme functions is that if a company wishes to expand its volume of emissions, it must bargain with other emission rights owners and buy the rights. Companies that produce less pollution than they are entitled to can then sell these rights to others. As mentioned in the introduction of this review, there are two types of emission trading schemes. The first is the ‘cap-and-trade’ scheme and the second is the ‘performance standard’ scheme. In the following two sections, each of these schemes, as well as their advantages and disadvantages, will be explained.
The cap-and-trade scheme involves the government setting an absolute limit on the amount of pollution and then distributing the pollution rights amongst polluters. The government can distribute these rights either via an auction, by granting them free of charge (known as ‘grandfathering’) or a combination of these methods. Cap-and-trade systems are characterized by:
i. A mandatory upper limit. This so-called ‘cap’ is defined per pollutant per sector. So, for example, for the steel sector the maximum amount of sulphur dioxide emissions will be defined at one level while the maximum amount of sulphur dioxide for the paper mill sector will be at another level.
ii. The number of ‘permits’ or ‘allowances’ is, in total, equal to the sum of the caps. For example, for every kiloton of emissions there will be one permit.
iii. The allowances are freely tradeable on the emissions market. It is permitted to ‘bank’ unused allowances from previous years.
iv. There are no caps for new sources of emission. A new industry, for example, will not be subject to the scheme. New entrants to existing markets are not subject to the scheme until the cap is redefined.
v. The total amount of emissions in a year must equal the total number of allowances used in that same year.
The main advantage of the cap-and-trade system is the extent to which it can be controlled by the government. Because of its ‘command and control’ principles, the government can set targets and enforce these. That means that the government can reduce or increase the amounts of pollution in absolute terms so that if the situation requires a less stringent limit (for example during a recession), the government can adjust the supply of allowances.
Furthermore, polluters have a strong financial incentive to produce less, the allowances that are distributed (under the current European Emission Trading Scheme – ETS) are free. Effectively that means that if a company’s marginal costs are very high, it will be more likely to choose to shut down production than without an emission trading scheme. This is because the sale of allowances will be more profitable than producing.
In terms of international agreements, the cap-and-trade scheme has an obvious advantage. Because the scheme limits the absolute amounts of pollution, it allows for governments to determine, and more importantly, control the absolute amounts of pollution.
The last advantage of a cap-and-trade system is political. The cap-and-trade system is less restrictive so that there is more room for economic growth and more freedom to develop industries. This means that market participants are more likely to accept the scheme.
There are severe disadvantages to the cap-and-trade system. Many of these have come to light over the past few years that the European ETS has been in place. First of all, the ‘command and control’ element means that the amount of allowances is determined by the government. The government projects the required amount of allowances on, amongst other variables, the future fuel prices, the weather conditions and any other variables that may affect CO2 emissions. In essence the government is making an educated guess every year that can have potentially disastrous consequences. If the government does not predict the correct amount of emission rights required by the market, the market will rapidly become saturated with cheap emission rights, defeating the entire point of the system: the idea is that pollution becomes a scarce ‘right’ and therefore costly. An example of this is the ‘crash’ in European ETS forward prices in 2006.
Part of the problem lies in the presumption that ETS allowances are finite, while the EU and national governments have the ability to increase supply at any given moment. This makes the prices of ETS allowances volatile. The European Commission was forced to announce stricter measures from 2008 onwards to ensure that the forward markets for emission rights in 2008-2012 did not collapse.
Another drawback of the governments strong involvement is that a lack of ambition on the governments part could easily mean that the cap is not adjusted downwards each year, but simply kept at the same level as before. Should this happen, the point of the scheme is also defeated. The idea behind emission trading is to reduce the amount of pollution. In a cap-and-trade system an inactive or ineffective government will not achieve this.
But not only from the governmental side is the cap-and-trade scheme potentially problematic. This is because the incentive that is offered to companies can at times be perverse. Since the amount of emission allowances a company receives is determined by the amount of emissions the company produced in the preceding years, companies are in fact rewarded for producing large amounts of emissions in previous years.
In the same vein, companies can reap windfall profits because they have been given an allowance which is too large. This essentially boils down to a handout from the government. In recent years, cases have been brought before the European Court of Justice (ECJ) in which competitors have claimed that some companies have benefitted unfairly from a covert state subsidy in the form of excess emission rights.
The performance standard scheme operates on a government set standard of pollution production. The standard will often be based on the average amount of pollution created by a certain production process. The government compares the amount of pollution produced by the least efficient producers and the amount of pollution created by the most efficient producers and sets the standard accordingly. As such, the performance standard scheme sets emission limits in relative terms, while the cap-and-trade scheme sets emission limits in absolute terms. Producers who pollute more than the standard are required to buy excess pollution rights from producers who pollute less. The characteristics of a performance standard scheme are:
i. A flexible absolute upper limit. There are no limits, except the limits imposed by the increasing marginal costs, in the form of the need to buy more allowances, for producers when they exceed the performance standards.
ii. The number of allowances is, in total, equal to the sum the emission standards. For example, if there are twenty steel factories, and the performance standard is one kiloton of emissions per factory every hour, the amount of allowances will be equal to twenty kilotons of emissions per hour.
iii. The allowances are freely tradable on the emissions market. It is permitted to ‘bank’ unused allowances from previous years.
iv. New entrants to existing markets are treated in the same manner and subjected to the same requirements as established players.
v. As with the cap-and-trade system, the total amount of emissions in a year must equal the total number of allowances used in that same year.
The main advantage of the performance standard scheme is that, theoretically, it should automatically reduce pollution due to increases in efficiency on the part of the worst polluters, leading to a ‘lower’ (i.e. more efficient) performance standard the following year as the average amount of emissions declines. In this manner the market will force producers to continually improve their production processes.
A second advantage is that newcomers to the market using innovative greener technology are favored by the system. In effect, a company that enters the market is given an immediate subsidy for achieving a better emission standard in the form of excess emission rights. The performance standard scheme therefore stimulates innovation more strongly than the cap-and-trade scheme.
The performance standard does not offer the perverse incentive of the amount being based on a company’s previous emission amounts. Every year the company will have to become more efficient or suffer the penalty of having to buy more emission rights.
One final advantage to the system is the allocation: the government is not required to estimate the amount of emission allowances available, the market determines this. The market cannot be artificially oversaturated due to an excess amount of emission allowances made available.
The main disadvantage of this system is that it does not set a cap on absolute amounts of pollution, meaning that the government has less influence on the total amount of pollution produced. If there is a sudden surge in the number of emitting factories then the government is largely powerless to intervene. The new factory will automatically receive the performance standard amount of allowances. This problem also means that internationally agreed emission limits are hard to achieve since these are set in absolute amounts. A performance standard scheme cannot be used by governments to reach those targets.
The second serious drawback is that the scheme depends on market actors to reduce emissions and produce more efficiently. If the producers all produce the same amount of emissions, they all receive exactly the amount of emission allowances they require. This means there will not be a market at all. Under the cap-and-trade system the government could simply reduce the amount of allowances and force the market actors to produce more efficiently.
Finally the performance standard scheme creates political difficulties. Older companies are seriously disadvantaged in the system and are forced to either invest in new technology or to buy more allowances. This leads to potentially serious problems for companies and possibly to bankruptcy. Politicians are not willing to put voters jobs at risk in the name of the climate. The performance standard scheme has that inherent risk.
To conclude, a review of the literature regarding the subject of emission trade schemes has shown that both the cap-and-trade scheme and the performance standard scheme have advantages and disadvantages
The main advantage of the cap-and-trade schemes is that the government retains ultimate control of the absolute amount of emissions. This is an important fact, since emission rights are intended to control and, eventually, reduce emissions. The main disadvantage of the scheme is that it depends heavily on a capable government with the right information at hands, which is nearly never the case.
The performance standard scheme is, in terms of the advantages and disadvantages of the schemes, the exact opposite of the cap-and-trade schemes. The performance standard has as its strong point that it does not depend on the government. It is self-regulating and should reduce emissions through market forces. The downside this entails however is that its functioning is wholly dependent on the polluters. If the market is not functioning optimally or worse, not functioning at all, the point of the entire scheme is defeated.
What emerges from this literature review is that the choice between the two is very difficult. Essentially the choice depends on how much faith one has in the ability of a market to reduce emissions by itself. The author’s opinion is that a performance standard scheme is the most desirable. The market should function; the only reason why the European ETS markets are not functioning optimally is because there is an abundant supply. In a performance standard scheme there should be very little excess supply. The problem of the lack of control over the absolute amounts of emissions can be resolved by the government taking a small role in stimulating ‘green’ behavior by companies.
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