The pros and cons of allowing international trading in emissions permits

by Khairul Rizal*

Introduction

Since international efforts to combat global climate change began; a problem has been existed regarding the nature of climate change as international public goods. In the absence of international government, standard solution of public goods provision by public authority cannot be imposed. Apart of free-rider behavior shown by many countries, a tension emerges as developed and developing countries have different perspectives on the climate change. The former is calling for global climate policy and warning to the growing emissions from developing countries, particularly from China and India (see Bradley and Pershing, 2005) while the later argues that their per-capita emissions remain much below of industrialized countries and that their historical contribution to today greenhouse gas concentrations is still smaller (see Raupach et al., 2007).

Despite the basic problems which are far from being solved, some progress has been made so far. Developed countries have taken a lead in global emissions mitigation through Kyoto Protocol which has been put into force in since 2005. The protocol adopts three flexible mechanisms that countries can use to acquire greenhouse gases reduction credit, which are Joint Implementation, Clean Development Mechanism, and Cap and Trade (also known as tradable permits system).

Since its first time used in the US[1], tradable permits systems has emerged as a preferred instrument for reducing greenhouse gas emissions. It has been used widely as environmental instrument among the EU member countries. More countries such as Australia, Canada, Japan, and the United States are considering tradable permits systems as a primary policy instrument for reducing GHG emissions (Jaffe, Ranson and Stavins, 2009).

However, despite of its massive supporters and preferable use, tradable permits system is not a challenges-free mitigation instruments. Its ability to reduce abatement costs, thus offering efficiency gain in achieving emissions targets, is challenged with potentially higher transaction costs such as cost for verification, monitoring and enforcement as well as cost of uncertainty in carbon market price. Trading supporters argue that the gain from trade would make both buyer and seller countries better off, which can be a powerful incentive for inducing participation. However, international trading might have deterioration effects on the terms of trade of a country that makes that country worse off. Certainly, this becomes a good justification for non-participation. Further, as a quantity instruments, tradable permits system offers a high certainty regarding aggregate amount of emissions that can be emitted, at least in the short-run. The question is can tradable permits system induce clean technology breakthrough to mitigate GHGs emissions in the long-run? Many more pros and cons surrounding international trading in emissions permits take place in climate change discourse. In this regard, this paper tries to explore those arguments and make a review on the ongoing debate.

It is important to aware that the existing debates cover a wide range of issues. Some arguments address technical issues such as how to ensure compliance of actual emissions, while others address more fundamental issues such as whether tradable permits system can induce participation. Therefore, a framework would be helpful to structure the existing debate. After briefly explaining about international trading in emissions permits, then this paper will build this framework and use it in discussing the pros and cons in emissions permits trading. At the end, conclusion will be drawn.

What is an emission permits trading?

Up to now, there are only limited numbers of existing GHG tradable permits systems, which are cap and trade system and emissions reduction credit system (Jaffe, Ranson and Stavins, 2009). This paper will focus only on cap and trade system. Under cap and trade system, countries are assigned a certain target of emissions for a certain period of time (known as assign amount unit or allowance to emit). This unit or allowance is tradable. This means that if countries emit less than their assigned unit, they can sell remaining unit (surplus) to those whose emissions exceed their allowance (i.e. producing more emissions than what is allowed). If two or more countries are involved in this trade, then it is called international trading of emissions permits.

Framework of analyzing arguments in emissions permits trading

In analyzing a complex debate such as emissions permits trading, it would be helpful to put the debate into a framework, thus make it easier to understand the context, weaknesses and strengths of arguments put forward by its defenders. In this analysis, the framework will be derived from the fundamental issues in the climate change discourse as follows.

In the climate change literatures, issue on emissions mitigation can be divided into three broad related issues. The first is issues related to political feasibility. This issue mainly emerges from the fact of free-rider behavior and equity argument. Individual country tends to view its abatement effort contributes only a small fraction to global mitigation while the marginal cost of abatement is increasing. This kind of public good situation makes it difficult to mobilize global mitigation (Barret and Stavin, 2003). Further, developing countries are using historical and per-capita emissions to justify their disengagement in international mitigation agreement (Bohringer and Welsch, 2004). Thus, the pros and cons arguments regarding international emissions trading would be contextualized into this debate, which lead to the question to what extent can international emissions trading encourage global participation.

The second is issues related to economic feasibility. Although most literatures seem to be conclusive on how international emissions trading can bring least abatement cost (Montgomery 1972, Tietenberg 2007), there are interesting discussions regarding transaction costs (Bartoszczuk & Horabik 2007, Godal et al. 2003). Therefore, the pro and cons about international emissions trading would be assessed by looking at the debate about costs associate with international emissions trading. The main inquiry would be how cheap is international trading in mitigating emissions?

The third is issues related to effectiveness. The main source of the climatic change problems is the growing GHG emissions in both stock and flow particularly from developing countries. Thus, it is important to assess the effectiveness of permits trading as instrument in mitigating GHG emissions. One has to aware that something might be effective in the short run but might fail in the long run. Therefore, the debate on the effectiveness of international emissions trading in reducing GHGs emissions will be reviewed under the time horizon. Simply put, would international emissions trading be effective mitigating global emissions in the long run?

The pros arguments

This section will explore supporting arguments on international trade on emissions permits and offsets. There are three main arguments put forward by its proponents: trade ensures compliance on emissions target, results in least-cost of abatement, and distribute financial gain in the form of side payments.

Gain from trade

One prevailing argument that is frequently cited in the literatures is that emissions permits trading minimize cost of abatement (Montgomery 1972, Tietenberg 2007, Bartoszczuk & Horabik 2007, Godal et al. 2003). Cap and trade system has been designed as a cost-effective method of reducing emissions to the desired level. The ‘cap’ would ensure that emissions would not exceed the limit to emit, assuming the presence of effective enforcement. The ‘trade’ would equalize the marginal costs of abatement among pollution sources (Bartoszczuk & Horabik 2007).

The logic underlying this argument is simple. Countries can choose the cheapest way to comply with emissions limit, either by reducing production, investing in cleaner technology or purchasing permits in emissions market. Given the market price of emissions permits, countries have potential to make a cost-saving from purchasing emissions permits instead of abating required emissions by itself if their marginal abatement cost higher than permits market price. On the other hand, supplier countries that has emissions credit surplus can profit from selling it. These cost-saving and profit represent the gain from trade. In the end, the gain from trade would make countries better off.

Quantity instrument ensure effectiveness

There are two market based instrument that often use in emissions mitigation, which are price and quantity instruments (Weitzman, 1974). A permits trade system is basically a quantity instrument since it keeps the overall emissions level fix and allows the price to vary. Under this fixed emissions cap, in which non-compliance will be punished, the permits trading takes place. This design would ensure aggregate emissions within the target. By setting a more ambitious cap over time, the flow of emissions can be pressed to the desired level.

Trade as a private side payment

With emissions trading, developing countries (if they are committed to emissions target) have opportunities to gain profit from the sale of emissions credits. The flow of money that comes from the emissions selling can be viewed as a private side payment from developed to developing countries. This can be done in two ways, either by allocating higher cap to developing countries or by employing offset mechanism. With higher cap and lower abatement cost, it is almost certain that developing countries would have surplus of emissions. This is the case of former soviet union countries where emissions cap allocated to this group of countries is higher from their business as usual emissions, known then as ‘hot air’ issue (Bohringer, 2000). This happened as an impact of economic downturn in that region that considerably cut their emissions production, even without mitigation action. Although this abundant surplus of emissions from the region became a controversy in the EU emissions market, it can be viewed as a side payment from more developed to less developed countries. This side payment then can be considered as a form positive incentive for developing countries to participate in global emissions mitigation. Putting it in Brandt and Svendsen’s words (2005), this flow of money can be seen as, ‘less visible ways of payment to ‘bribe’ countries to participate in an agreement’.

Summarizing the key arguments in favor of trading, international trading in emissions permits allows countries to gain efficiency from international trading in the forms of cost-saving of abatement for importing countries and profit for exporting countries. In this sense, international trading is considered economically feasible. In terms of effectiveness, under cap and trade system, aggregate emissions would be kept inside the desired level. Further, transfer of fund happens from buyers to sellers within international emissions trading can be seen as a side payment since most buyers are from developed countries and most sellers are from less developed countries.

The cons arguments

Although permit trading is a preferable instrument in emissions mitigation, it is not a perfect one. Quite a lot arguments contest this permits trading system. Arguments against international emissions trading do not necessarily challenge the proponents’ arguments vis-à-vis.  Instead, they criticize the weaknesses of the trading system. Three major arguments put forward by opponents of trading are: i) disincentive for the development of clean technology (credibility argument); ii) least abatement cost but potentially high transaction cost; and iii) perverse impact on economy.

Disincentive for the development of clean technology

This is one of the most prevailing arguments against permits trade in the literature (Brandt and Svendsen, 2005). In the presence of permits trading, particularly when the emissions price is quite low, countries would have incentive to purchase permits in the international emissions market as opposed to mitigate emissions domestically. Facing with options whether to mitigate emissions by itself through investment in clean technology or to purchase permits elsewhere, countries would choose the cheapest option they have. In a low carbon price situation, apparently the best choice is to purchase permits. As a consequence, little or no effort will be devoted to develop domestic clean technology. This situation is often known as credibility problem. Less incentive to develop clean technology would lead to the question of the effectiveness of emissions trade in the long-run.

Two proposals have been put forward to address this problem. The first is by setting the price of permits quite high to encourage clean development technology (Nordhaus, 2008). He argues that by raising the price of carbon would achieve three objectives. First, it will be a signal to consumers about the level of emissions of product they bought and should therefore be used more sparingly. Second, higher carbon price would induce producers to substitute to low-carbon inputs. Third, it would give market incentives for inventors and innovators to develop and introduce low-carbon products and processes that can replace the current technologies.

Similar idea but different instrument from what is proposed by Nordhaus is by limiting emissions trade (quantity approach). Motivated by ‘hot air’ issues, this kind of restriction ever been advocated by the EU (Bohringer, 2000). The underlying idea of restriction on the amount of tradable emissions is the principle of supplementary within the Kyoto Protocol. The principle of supplementary means that internal abatement of emissions should take precedence before a country buys in carbon credits. Thus, by limiting the amount of tradable emissions would press up the carbon price and give similar effect to what is proposed by Nordhaus. These ideas, however, are disputed by proponent of unrestricted emissions trade including the US and Australia who want to exploit the full efficiency gain from emissions trading. Nevertheless, some argue that restriction on emissions trading have different effect on carbon-saving technological change, hinged on the position of particular country whether as a permits demanding or supplying country (Matschoss and Welsch, 2006). Restrictions tend to raise investment in clean technology in demanding countries while reducing them in permits supplying countries.

Least abatement cost but potentially high transaction cost

Least abatement cost resulting from emissions trading is at the heart of the proponents’ arguments. Although not specifically neglecting this major advantage of emissions trading, however, some concern with potentially high transaction costs in international emissions trading (Bohringer, 2004). This includes cost of monitoring the actual emissions, verification and certification of eligible permits, and costs associate with risks such as risk from price volatility. Under cap and trade system, for instance, high uncertainty in the amount of emissions inventory (Bartoszczuk & Horabik 2007) and verification could increase compliance cost (Godal et al. 2003). In the absence of effective monitoring and enforcement, countries have high incentive to cheat about their actual emissions. The problem is that such monitoring and enforcement is costly and time consuming to carry out, particularly in the absence of an international government. If such transaction cost is taken into account, as argued by Godal, total cost of abatement would be higher. Some proposals suggest some solutions on this compliance issues, including ex-post or ex-ante verifications, seller or buyer liability (see Keohane and Raustiala, 2009). Nevertheless, these proposals are not cost-free solution. The question is that whether the overall transaction cost is higher or lower compared to the overall efficiency gained from emissions trading.

Moreover, quantity approached adopted in emissions trading, which allows the carbon price to vary, could be considered as another transaction cost. In a complex international trading, the carbon price might fluctuate harshly leading to higher uncertainty in the carbon market. As we all know, uncertainty is bad for business since industries have to bear the cost of adapting to these volatile market conditions. Countries which are highly exposed to international market might consider such uncertainty would affect their domestic market and cost their overall economy as well. Proposals have been offered to address the price volatility issue largely by imposing price instrument such as price floor and/or ceiling and safety valve (Wara & Victor 2008, p. 18). Note that apart of its ability in stabilizing the market price, these proposals also have limitations such as preventing price equalization (Garnaut, 2008).

Perverse impact on economy

Economic impacts of international emissions trading are far from conclusive. As argued by its proponent above, the efficiency gain from trade would make countries better off. However, some point out that emissions trading has perverse impacts on countries’ economy. Theoretical review of international emissions trading by Copland and Taylor (2005) shows a contradictive conclusion that emissions trading would make participant worse off and increase global emissions. Deterioration of terms of trade, where the value of import exceeds export, is argued as the main cause. Another way how emissions trading negatively affect the economy is through its effects on market of other tradable goods (Carbone et al, 2009). Dutch diseases, where other tradable goods becomes less competitive as emissions trade results in appreciation of exchange rate, is used as explanation. However, as argued by Carbone et al, the net effects of emissions trading on economy depend on the profile of economies that are participating in permits trade. The higher carbon-intensity in an economy, the greater is the perverse impact of emissions trading to that economy.

Summarizing the key arguments, international trading in emissions permits diminishes the incentive to develop clean technology which is required to abate long-run emissions. International trading also suffers with high transaction cost to ensure compliance, mainly caused by the absence of international government. Finally, not all countries become better off by engaging in international trade in emissions permits. Some countries might be better off and other might be worse off.

How well is international trading dealing with the key issues in climate change?

Following the debate on the international emissions trading above, it seems not all issues posed in the climate change debates can be solved with a single instrument of international trading. Nevertheless, some of the issues are, though not fully, answered.

In terms of political feasibility, can international emissions trading encourage global participation? The answer seems to be yes it can. I argue so because the opportunities and incentives offered by international emissions trading are enormous. Concerns about free-rider behavior and equity issue are addressed properly, at least in theory, through international emissions trading. Being a free-rider would be unbeneficial in the existence of international trading since countries would waste the revenue that might be gained from trading; while equity issue could be addressed by side payment effects from developed to developing countries through international trading in emissions permits.

In terms of economic feasibility, is international emission trading the least abatement cost instrument? It seems that there is no dispute about the gain from trade argument in the debate. However, some concern with high transaction cost in emissions trading and most of the discussions are actually concentrated on this issue. High transaction cost would diminish the gain from trade, leading to less sustained trading system. In my opinion, this transaction cost tends to be lower in the future as more accurate assessment and measurement of emissions would be established. Further, the ideas such as emissions banking and insurance probably could lower the transaction cost in international trading in emissions permits.

In terms of effectiveness, is international emission trading effective both in the short-run and the long run? In the short run, international emissions trading is likely to be effective in mitigating carbon emissions. In the long run, however, emissions trading system engender less incentive to develop clean technology. Proposing higher carbon price might partly induce clean technology development in demanding countries, but not in supplying countries. Restricting international trading might stimulate technological change; however it might also reduce the gain from trade. Probably the best way to promote the development of clean technology is not through trading system, but through other instruments such as public funding (Barret and Stavin, 2003).

Conclusion

Emission trading becomes a leading instrument in global emissions mitigation. It is an attractive environmental instrument since it offers least abatement cost that can induce broader participation. However, international trading is challenged in its ability to mitigate emissions in the long-run. As climatic change has a long time-lag effect from today, it seems that international emissions trading solely are unlikely to be able to mitigate climate change. Other instruments, such as public funding should be initiated in complement to the trading system.

References

Barrett, S & Stavins, R 2003, ‘Increasing participation and compliance in international climate change agreements’, International Environmental Agreements: Politics, Law and Economics, vol. 3, pp. 349-376.

Bartoszczuk, P & Horabik, J 2007, ‘Tradable permit systems: considering uncertainty in emission estimates’, Water Air Soil Pollution: Focus, vol. 7, pp. 573-579.

Bohringer, C 2000, ‘Cooling down hot air: a global CGE analysis of post-Kyoto carbon abatement strategies’, Energy Policy, vol. 28, pp. 779-789.

Bohringer, C & Welsch, H 2004, ‘Contraction and convergence of carbon emissions: an intertemporal multi-region CGE analysis’, Journal of Policy Modeling, vol. 26, pp. 21-39.

Bradley, R & Pershing, J 2005, ‘Chapter 1: Introduction to sustainable development policies and measures’ in Bradley, R & Baumert, KA, Growing in the Greenhouse: Protecting the Climate by Putting Development First, World Resource Institute.

Brandt, US & Svendsen, GT 2005, ‘Surplus emission allowances as implicit side payments: could ‘Hot Air’ have saved the Kyoto Agreement?’, Climate Policy, vol. 4, pp. 303-318.

Carbone, JC, Helm, C & Rutherford, TF 2009, ‘The case for international emission trade in the absence of cooperative climate policy’, Journal of Environmental Economics and Management, vol. 58, pp. 266-280.

Copeland, BR & Taylor MS 2005, ‘Free trade and global warming: a trade theory view of the Kyoto protocol’, Journal of Environmental Economics and Management, vol. 49, pp. 205-234.

Garnaut, R 2008, ‘Appendix 2: International trade and linkages: issues and options’, Emissions trading scheme, Discussion Paper.

Godal, O, Ermoliev, Y, Klaassen, G & Obersteiner, M 2003, ‘Carbon trading with imperfectly observable emissions’, Environmental and Resource Economics, vol. 25, pp. 151-169.

Jaffe, J, Ranson, M & Stavins RN 2009, ‘Linking tradable permit systems: a key element of emerging international climate policy architecture’, Ecology Law Quarterly, 36/789.

Keohane, RO & Raustiala, K 2008, Toward a Post-Kyoto Climate Change Architecture: a Political Analysis, Discussion Paper 08-01, the Harvard Project on International Climate Agreements. I

Matschoss, P & Welsch, H 2006, ‘International Emissions Trading and Induced Carbon-Saving Technological Change: Effects of Restricting the Trade in Carbon Rights’, Environmental and Resource Economics, vol. 33, pp. 169-198.

Montgomery, WD 1972, ‘Markets in licenses and efficient pollution control programs’, Journal of Economic Theory, vol. 5, no. 3, pp. 395-418.

Nordhaus, W 2008, A Question of Balance – Weighing the Options on Global Warming Policies, Yale University Press, viewed on April, 2010,  http://nordhaus.econ.yale.edu/Balance_2nd_proofs.pdf.

Raupach, MR, Marland, G, Ciais, P, Le Quere, C, Canadell, JG, Klepper, G & Field, CB  2007, ‘Global and regional drivers of accelerating CO2 emissions’, PNAS, vol. 104, no. 24, pp. 10288-10293.

Tietenberg, T 2007, Environmental Economics and Policy, Reading, MA: Addison-Wesley.

Wara, MW & Victor, DG 2008, ‘A Realistic Policy on International Carbon Offsets’, Stanford University Program on Energy and Sustainable Development, Working Paper 74. Weitzman, ML 1974, ‘Price vs. quantities’, The Review of Economic Studies, vol. 41, no. 4, pp. 477-491.


[1] Launching of a first “cap-and-trade” system as part of the US Acid Rain Program in the 1990 Clean Air Act.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s