Topical Terms in Economics

Emissions Trading

Aktuelles Stichwort: "Emissionsrechtehandel"
Interview with Hans-Werner Sinn (in German)
11.10.2010

Media Library of the CESifo Group

Emissions trading is based on the �cap and trade� principle. A governmental body sets a cap or upper limit on the amount of a pollutant that can be emitted. The amount can be reduced, as required, over the course of time. In this system trade � the transfer of permits or emission allowances for emitting a pollutant � is permitted and as a result it is unclear where the emissions are avoided. The emission trading system is the main environmental policy instrument which European countries use to satisfy their emission quotas for CO₂ as set by the Kyoto Protocol.^[1]

Background

The Kyoto Protocol was adopted as an update to the United Nations Framework Convention on Climate change at the end of 1977 and became effective in 2005. Its aim is to fight climate change and it sets binding values for the reduction of greenhouse gases for the industrial countries^[2] v�lkerrechtlich verbindliche Werte f�r die Reduktion von Treibhausgasen fest. listed in Annex I (called Annex I countries). By 2012 the CO₂ emissions are to be reduced by approximately 5% vis-�-vis the level of 1990. The EU countries have committed themselves to an overall reduction of 8%. Germany agreed to decrease its emissions between 2008 and 2012 by at least 20% below the 1990 level and managed to achieve this goal as early as 2009.

The main idea of the Protocol is the international trade of emissions allowances. In accordance with the reduction targets of the Annex I countries, greenhouse gas allowances are issued to the countries in the amount of the upper limit set for the commitment period. An emission allowance is a permit to emit a ton of CO₂ or a ton of a CO₂ equivalent pollutant. Emission allowances that are not needed to cover a country�s emissions can be traded between countries. In this way the market determines the price of the allowances.

The first multinational emissions trade system � the European Union Emission Trading System (ETS) � was introduced between EU countries and came into force on 1 January 2005.^[3] Currently some 40% of the entire European greenhouse gasses are included in the ETS (as of May 2010.

To help countries meet their obligations, trade with emission allowances is supplemented by two compliance tools: the Joint Implementation Mechanism (JI) and the Clean Development Mechanism (CDM). These mechanisms allow countries to participate in projects that reduce greenhouse gas emissions in countries where it is less expensive than in their own.^[4]

Emissions Trade in the EU � The European Union Emission Trading System, EU ETS

In the European Union emission allowances for a limited amount are issued by the individual countries to European businesses or the operators of plants. These allowances permit them to emit a fixed amount of CO₂.

Emission trade is based on a simple principle: those who emit greater amounts of CO₂ than they are allowed to are forced to either buy emission allowances or reduce the CO₂ emissions of their plants. Those who emit less CO₂ than the amount provided by the allowances they own can sell them and make a profit.

During the first (2005�07) and second (2008�12) phase, the emission allowances were to a large degree allocated to the operators of large industrial plants without cost. As of 2013 a larger portion of emission allowances will no longer be distributed free of charge but will be auctioned off. If greenhouse gases are emitted without allowances a penalty of 100 euros per ton will be imposed.

Enterprises with large CO₂ emissions � for example, energy production plants, operators of incinerators, oil refineries, coke ovens, iron and steelmaking plants as well as plants in the cement, glass, chalk, brick, ceramic, pulp and paper mill industries � must participate in the trade emission system. Currently international aviation and shipping as well as private households are exempted (as of May 2010).

The aim is to achieve a reduction in emissions by gradually reducing the amount of allowances available in the future. Businesses are thus forced to decide whether it is worthwhile buying additional emission allowances or whether it is more economical to modernise their plants using emission-reducing technology and to sell the allowances they save. CO₂ emission allowances are traded on energy exchanges such as the European Energy Exchange (EEX) in Leipzig. The price of every ton of carbon dioxide is determined by supply and demand.

Economics and Climate Protection

Fixing the amount of emission allowances only determines the extent of CO₂ to be emitted. The system does not indicate which firms have to implement the savings and what technology is to be used. This decision is left to the market. Since those responsible for emissions must decide between avoiding CO₂ emissions or paying the price for an alternative, cheaper solution, the system automatically guarantees that the efficient avoidance path will be chosen and the inefficient avoided. Emissions trading is the most effective method to achieve a reduction in CO₂ emissions because, firstly, a given environmental goal can be achieved at the lowest possible costs and, secondly, the maximum environmental protection at costs acceptable to society. The latter point is of particular importance if emphasis is placed on being able to achieve the highest possible reduction in the cap level � and as a result in CO₂ emissions � over time.

For the emissions trade to achieve its goal, the issued allowances must be limited. In the first emissions round, which ran from 2005 to 2007, this was obviously not the case as, towards the end of the period, the price approached zero. In the second round, which will run until 2012, fewer allowances have been issued and even fewer will be available thereafter.

Criticism that the allowances are issued without cost arises because of distribution policies and does not affect the ecological effectiveness of the instrument. No matter whether the allowances are sold or given away, the emissions trade guarantees that the economic costs of CO₂ reduction are minimised (see Coase theorem; Coase 1960). The EU plans to move gradually from issuing allowances free of charge to auctioning them, with the national finance ministers receiving the proceeds.

The current problem is that many CO₂-intensive industries � such as international aviation and shipping as well as private households � are still not included in the trading system. In the EU only energy production is completely in the hands of the ETS. In terms of environmental economics the inclusion of all economic activities is imperative.

The objection is sometimes voiced that the emission savings of one country leads via emissions allowance trading to more emissions in another country with no net gain for climate protection. These critics fail to recognise how the trading system works. The shifting of emission amounts via trade is the pre-requisite for minimising costs and for limiting the cap to the greatest possible degree over the course of time. With the ETS system a central body decides on the total amount of emissions by determining the number of allowances available and not by individual countries seeking to limit their emissions. Individual countries and above all individuals are right to minimise their energy costs (including the costs of the allowances) and not to consider the environment when making their decisions. Given the economic costs of environmental protection this is exactly the way the greatest reduction in CO₂ can be achieved (cf. Sinn 2008).

^[1] Die CO₂ emissions have to be reduced because they contribute to global warming. The effects of CO₂ in the earth�s atmosphere are similar to those of the glass roof of a greenhouse: they result in a continuous rise in the temperature of the earth�s surface. It was the far-reaching consequences of climate change that led the world community to resolve to reduce greenhouse gases in Kyoto in 1997.
^[2] The Annex I countries are those countries listed in Annex I of the 1992 Framework Convention on Climate Change. They include all OECD countries except for Korea and Mexico, as well as all eastern European countries, excluding former Yugoslavia and Albania.
^[3] In Germany the European guidelines for emissions trade (Directive 2003/87/EG) and the law governing greenhouse gas emissions trade (TEHG) have been incorporated into German law.
^[4] Since 2006 the Clean Development Mechanism (CDM) has permitted industrial countries and businesses to generate Certified Emission Reductions (CER) by supporting emission reduction projects in developing countries. The demand for CERs is created above all by businesses that are required to register with the European Emission Trade (ETS). They can purchase a portion of their allowances with CERs. Joint Implementation Projects are implemented between Annex I countries. Credits (Emission Reduction Units; ERUs) are awarded for emission reduction, which as of 2008 have been used to reduce Annex I countries� commitment goals with the ETS.