Carbon Trading Schermes

Carbon trading is a system of limiting carbon emission through granting firms permits to emit a certain amount of carbon dioxide.

The amount of permits is decided by the government and then permits are given to firms depending on various criteria (such as how much output a firm produces)

With the permits, a firm can then buy and sell these permits in an open market. For example, if a firm wanted to emit more pollution it could be buy more permits. If it reduced its pollution emissions, it could sell its surplus permits on the market.

Benefits of Carbon Trading.

• The argument is that firms are free to choose the most cost effective way of meeting permit requirement. For example, they have an incentive to develop better technology which limits carbon emissions. However, if the price of permits is low, they may decide to buy more.
• Gradual reductions in Permits. The idea with carbon trading is for governments to gradually reduce the amount of available permits from year to year. Therefore, firms need to increasingly find more ways to reduce carbon emissions.

Arguments Against Carbon Trading

• Complex. It can become complicated deciding how many permits to allow. For example when the EU introduced a system of carbon trading, in the initial period of 2005-07 the price of carbon permits were driven down to zero because the EU misjudged the amount of permits. However, any scheme will take a while to be effective.
• Difficulty of measuring how much a firm is actually polluting.
• Transaction costs involved in buying and selling permits.
• Free Rider Problem. The problem of excess carbon emissions is a global problem. Therefore, there needs to be a global solution. If carbon trading is introduced in one country but not others, it may cause production to shift to countries without the scheme. Often countries don’t start carbon trading precisely for the fear other countries will be free riding on their efforts.
• Carbon Tax may be more simple, transparent and easy to administer.
• Carbon Trading may have a greater impact on those with low incomes and poor areas who have less flexibility to change their lifestyles.

Pollution

Pollution is seen as an example of market failure. In particular, pollution is an example of a negative externality – a cost imposed on a third party. For example, when driving a car, other people suffer from the emissions e.g. global warming, air pollution. Therefore, in a free market there tends to be overconsumption of goods which create negative externalities. Therefore governments implement anti pollution measures which can include

1. Taxes. Higher taxes on fuel emissions will reduce demand and pollution. However, demand tends to be quite inelastic for these goods.
2. Subsidies. Subsidising alternative sources of energy can provide an incentive to increase supply of different fuel sources
3. Pollution permits. Pollution permits are a tradeable permit scheme which give firms and countries an incentive to reduce pollution, otherwise they have to buy more permits.
4. Regulation. Regulation can limit the amount of pollution; for example, banning cars on certain days.

Evaluation of anti-pollution measures

• Global co-operation. The problem with anti pollution measures is that they require global cooperation and this is often difficult to achieve. For example, the Kyoto agreement on global warming was never ratified by the US. This creates a free-rider problem, countries can rely on others to improve the air quality, but not make efforts themselves.
• Business costs. Anti-pollution measures involve higher taxes and regulations, which increase the cost of business, leading to higher prices for consumers.
• Government failure. There is always the possibility of government failure with uncertainties about the right type of intervention.

Tradable pollution Permits

Cap and Trade Systems

Carbon Emissions Trading

Carbon emissions trading in the EU

Carbon Emissions Trading
1. Emissions trade - launched Jan 2005 and is a market-based mechanism to incentivise reduction of C02 emissions in a cost-effective and efficient manner.
2. EU scheme operates through the allocation and trade of CO2 emissions allowances. It creates a market in the right to emit C02. One allowance represents one tonne of C02 equivalent.
3. Cap is set on the emissions – this creates the scarcity required for the market. At the end of each year businesses within the scheme are required to ensure they have enough allowances to account for their installation’s actual emissions. There are heavy fines for those without such permits (Euro 100 per ton)
4. The aim of carbon trading is to create a market in pollution permits and put a price on carbon. In this way, policy can help internalize external costs of firms’ production and encourage lower emissions to tackle climate change. In a cap and trade system, the volume permits would gradually decline. As the price of the permits rises, so the economics of investing in cleaner technologies will change. 
i. Assets: If a carbon emitting business can under-use its initial allowance by better energy efficiency, it can sell its surplus on the market. 
ii. Liabilities: If a business is faced by high costs to reduce its emissions, it must buy extra allowances

A market based system might work as shown in the chart below

Weaknesses of EU carbon trading scheme

1. The system has suffered from government failure because of the initial over-allocation of carbon quotas and national freedom to allocate carbon permits.
2. Allowances were handed out for free rather than being auctioned off in Phase 1
3. Not all industries are part of the scheme – aviation initially left out – scheduled to be included soon
4. In recent times, carbon price has collapsed - driving up the demand for coal fired energy! – A dirtier fuel! (example of law of unintended consequences)
5. Carbon prices have fallen further because of the recession hitting EU economy. The recession has caused reductions in output in steel, paper, cement and glass and a sharp decline in production has led to a sell-off of carbon credits
6. That has caused a drop in the market price of carbon permits - meaning there is less incentive for companies to stop polluting and there are fears for the future of many clean energy projects. Some economists have called for a minimum price to be applied to the carbon market. Grantham Research Institute believes min of Euro 40 per ton tom meet climate change targets.
7. There is political resistance to introducing tougher low emissions targets to drive the market price of carbon high enough to prompt cleaner fuel investments.

Should we make the polluter pay?

Pollution Permits

• Pollution Permits involve giving firms a legal right to pollute a certain amount e.g. 100 units of Carbon Dioxide per year.
• If the firm produces less pollution it can sell its pollution permits to other firms.
• However if it produces more pollution it has to buy permits off other firms.
• Therefore there will be a market for pollution permits. IF firms pollute a lot there will be low supply and high demand therefore the price will be high for permits.
• Therefore there is an incentive for firms to cut pollution
• These pollution permits are used in the form of Carbon credits. Each country has been given a permit to produce Carbon dioxide pollution which causes Global warming. If it pollutes less than its quota then it can sell it to other countries. Therefore there is an incentive to pollute less.

Problems of Pollution Permits

• It is difficult to know how many permits to give out. The government may be too generous or too tight.
• Difficult to measure pollution levels. There is potential for hiding pollution levels.
• Administration costs of implementing the scheme.
• Countries who pollute more than their quotas can simply buy permits off other people. Therefore rich developed countries have been buying permits of less developed countries. This has not reduced pollution.