Design options for flexible instruments

Transcription

1 Design options for flexible instruments Andries Nentjes Paper for the European-US conference on Post-Kyoto Strategies Semmering (Austria) September 6-8, 1998 Introduction The Kyoto Protocol of December 1997 sets legally binding emission targets and timetables for Annex I countries. Among the mechanisms that have been accepted to enhance cost effectiveness the Protocol is emission trading. Under article 17 an Annex B country will be allowed to purchase the right to emit greenhouse gases (GHG) from other Annex B countries that are able to cut GHG emissions below their "assigned amounts". Designing the rules governing emissions trading has been deferred to subsequent conferences and what exactly is meant by emission trading still has to be agreed on. What is exactly meant by emission trade? A rather familiar view is that GHG emission trade is a transfer of GHG quota between governments. Emission trade then is defined as a public activity. An other view is to see emission trade primarily as a transfer of emission quota between private parties, in particular polluting industries. If such a trade transaction is performed between sources located in different countries it falls under the definition of article 17 of the Kyoto Protocol. Whether the word 'emission trading' in article 17 of the Kyoto Protocol refers to the 'government trading' scheme, or to the 'sources trading' design, or perhaps to both is presently a matter of political discussion. In this paper the strengths and weaknesses of the two types of emission trading will be compared and their implications discussed. first a short presentation of government emission trade is given; followed by a more extensive discussion of a design for private emission trade. Then the major arguments for and against the two schemes are given and rounded off by the conclusions. In an addendum we summarize the results of a Dutch study into the cost saving of emission trade between end users in The Netherlands. Government emission trading International GHG emission trade is very often viewed as transfer of GHG quota between governments. The view implies that the only function of international emission trade is to allow parties of the Kyoto Protocol to revise their legally binding emission targets. After transfer of emissions national governments would have to adjust their national GHG control policy, for example by changing standards or carbon taxes. The gain of such a scheme of government emission trade is that it allows governments of countries with relative stringent emission ceiling and consequently high (marginal) cost of emission reduction to lower their cost by buying additional emission quota from countries which can sell, thus decreasing their assigned amounts, since they can comply with an even more stringent emission target at relatively low cost. In short: there are efficiency gains.

2 An other strong point of government trading is that the mechanism is easy to understand. This facilitates its political acceptation. Third, the government trading scheme can be implemented on the short term, since it does not ask for many additional rules or institutions next to those which will be designed anyway by the COPs to come. Private emission trading This conception of emission trade differs from the concept of emission trading as an instrument of national (or regional) policy aiming at containment of national (respectively regional) emissions. In this approach, developed by economists and adopted in the US for emissions of sulfur dioxide and some other pollutants, a national government distributes the allowed assigned amount of GHG emissions among national sources by way of a scheme of nationally tradeable GHG emission permits. A source which could reduce emissions to its available amount of permits at high cost only can buy extra permits from a source which can reduce at low cost its emissions to a lower level than the permits it initially owns. If schemes for national GHG trading between sources are introduced in a number of national states and if the schemes are compatible the schemes can be linked, creating a scheme of international trade in emission permits between sources in these Annex B countries with well functioning national schemes of emission trade. Allowing international emission trade implies that a source (a firm or other private party) in country A can sell permits to, or purchase permits from a source in country B. In contrast with the first scheme, in which governments have to find other governments as trading partners and have to negotiate and conclude emissions exchange contracts the second scheme expects them to abstain from trading actions. The government's only task is distributing emission permits among sources, monitoring and enforcement. International emission transfers will be implemented through the market. Basically the two schemes differ in the same way a scheme of international private grain trade between producers in some countries and importing firms in other countries differs from international state grain trade between governments, (where the selling government has to devise ways and means to collect the grain and the purchasing government has to create a distribution system). Outline of a GHG emission trading scheme between private entities Since national permit trade is a precondition for international trade we first state the essentials of national emission trade, using tradeable CO 2 permits as example. 1. The government defines a unit of pollution, for example tons of CO 2 emissions. A tradeable permit is the allowance to emit a unit of pollution. This implies that each firm or household in the programme is allowed to emit units of pollution only if it is in possession of a sufficient number of permits. At the end of the year the participant has to turn over to the supervising authority a number of permits equal to its emissions. 2. The government decides how many permits will be issued each year during a period of considerable length. In this way it simultaneously decides on average annual emissions of all participants in the programme taken together.

3 3. Two types of issue are to be distinguished. Permit auction: permits are sold by the government to the highest bidders; another option is distribution for free (grandfathering to specific groups). 4. Permits can be traded. A polluting source that wants to emit more than the permits it owns can buy additional permits; firms and households that manage to emit less than the permits in their possession are allowed to sell the surplus. The above features of a national tradeable permits scheme make it clear that such an instrument can be established and operated successfully only if the country's environmental policy has evolved to such a stage of institutional maturity that the following conditions are met: a. Binding national emission targets and timetables; b. A reliable registration of the parties to which the permits will be allocated ; c. Monitoring and reporting of emissions (or fuel use and other inputs in which GHG gases are embedded) should be well developed; d. There should be a tradition of effective enforcement aimed at detection on non-compliance and application of sanctions. If these requirements are not fulfilled any policy geared to GHG emission reduction is in danger of not being effective. In case of tradeable permits the outcome would be disastrous. In working out the basic elements a choice has to be made between different options, taking into account among others the criteria of administrative feasibility and political acceptability. One of the first choices to be made is between an upstream or downstream system. In a downstream trading system permits are allocated to end users. The conventional wisdom seems to be that such a scheme would entail high administrative cost, since there are so many sources to monitor. Therefore the criterium of administrative feasibility would be met better by an upstream trading system where permits are allocated to fuel producers and importers. They would pass on their permit cost in a mark-up on the fuel price to end users (the emitters). In a system of upstream trading the number of regulated entities is small, keeping administrative cost low. A second major choice is between auctioning and grandfathering. In our view an upstream trading scheme is only compatible with auctioning. Grandfathering would imply a transfer of wealth to importers and producers, which are not the entities that make major costs of CO 2 emission reduction. However, auctioning will impair the political acceptability of the scheme since end users would have a double expenditure: the cost of reducing emissions by restricting fuel use and next to that the mark up for permit cost in the fuel price. In a downstream trading scheme allocating permits by grandfathering them to end users compensates them partly for their cost of emission reduction. That will reduce their resistance against climate change policy. In opposition to what conventional wisdom says a downstream scheme can be organized in such a way that administrative cost will be low. In the scheme presented below all permits are grandfathered, to large emitters as well as to small sources (van Duijse et. al, 1998). To shorten the discussion we shall identify large sources with emissions of firms and small sources with consumer households. The share each category receives of the total number of permits can be set equal to its share in total emissions in a reference year. TCPs for individual

4 large scale fuel users are grandfathered proportional to their carbon use in a reference year. Taking the historical rights of established firms as a base fits in with the usual approach when quantity is rationed and quota are distributed among firms. Grandfathering to small users (households) has a general basis: it is proportional to CO 2 emissions resulting from average fuel use per adult person in a reference year. In this way the administrative cost of establishing the fuel use of each single person, or household in a reference year is avoided. We also expect that it will be politically more acceptable to grant permits for a basic good, such as fuel for consumer households, on an egalitarian base rather than proportional to past use. In the proposed scheme TCPs can be traded freely, allowing firms and households to adjust the number of permits to their actual CO 2 emissions. Families living in small, well isolated apartments and without a car will end up with a permit surplus at the end of the year, which can either be banked (to cover emissions next year or later), or sold. The task of monitoring and enforcement is delegated to a national agency. To keep the administrative cost of implementing the tradeable permits scheme low, gas and electricity distributors are under the obligation to keep the account of customers' permits. Permits are withdrawn from customers' accounts for the carbon emissions of the energy supplied. The national authority concentrates its monitoring on the distributors, which have to demonstrate periodically (for example once a year) that they have acquired a number of permits equivalent to the carbon emissions of the fuels supplied to the distributor's customers. This arrangement makes in the distributor's own interest to monitor and enforce the permit scheme vis a vis its clients. The intermediation of gas and electricity distributors, which have an existing scheme to monitor fuel use of their customers, administrative cost can be kept low. For CO 2 emissions from car fuel use it should be possible to design a scheme with permit chip cards which can be loaded at certain points by withdrawing permits from the account registered by the gas and electricity distributor. The loaded chip card can be used to transfer permits to the oil distributor when the fuel bill is paid after filling up. An alternative is that car fuel distributors buy the permits they need to cover their fuel sales and charge the permit price as a mark-up on the price of car fuel. International linkage of national emission trading schemes Once a national carbon permit market is established, it is possible to engage in carbon emission trade with countries that also have organized a national scheme of TCPs. This implies direct trade between firms in different states. If firms in country A are net purchasers of TCPs the CO 2 emissions ceiling for country B is raised. Essential is compatibility of national schemes. This requires that permits are defined equally or that conversion factors between permits are fixed. Next to that an international clearing house has to be established. Its major task is to keep account of international GHG emission trade by administrating transfer of permits between traders located in different countries. As a result the clearing house also administrates changes in permits per country. By the end of each year the agency should inform the existing UNFCCC institutions responsible for monitoring and reporting about each country's permit position, which determines the country's maximally allowed emissions. In such a scheme of internationally linked national emission trading schemes the national government is accountable for monitoring and enforcing the emissions of single sources on its territory. If the country has

5 been a net seller of permits over a year sources will own a lower number of permits by the end of the year than they did before and therefore the sum of their emissions has to be lower. The national government has to see to this by way of a solid policy of emission monitoring, allowance tracking and tough enforcement in case of noncompliance. Since UNFCCC institutions will be informed on the change in assigned amounts of countries, caused by international emission trading of private parties, the national government of a net selling country can be hold responsible for complying with its international, more stringent, post-trade emission commitment. Consistency requires that the scheme applies the principle of seller liability. (Seller meaning the government of the country that is a net seller.) As a consequence the government of a country that is a net purchaser is not accountable in case the selling country fails to comply. The risk that net sellers will remain in default is mitigated in the scheme of international private emission trade since only countries can participate that meet the quality requirements (mentioned before) as to their national GHG emission control policies. Since not all Annex B countries would meet the requirements for carbon permit trade an international system of linked national tradeable permits schemes might initially start with only a handful of countries, although it does not preclude its subsequent expansion to include other qualified countries according to the rules of procedure agreed before trading begins. Such an expansion will bring more emission sources into an international TCP scheme, reduce the leakage effects and increase the scope for efficiency gains. Arguments for and against private emission trade vis a vis government trading Compared with government emission trading the scheme of private trade has a number of advantages. It operates between the entities that have the information as well as the incentive to secure the opportunities for minimizing the cost of GHG emission control. If there are no major market failures the market will allocate emissions among sources in participating countries in such a way that total costs of emission control are minimized: cost effectiveness is maximal. On the other hand, if international emission trade is restricted to trade between governments transfers of emissions are based on the views these governments have of their national (marginal) control cost. Such information is incomplete and the government's incentive to reduce cost might also be less, or be mixed with other motives. Therefore cost effectiveness is limited. Basically the arguments for preferring the sources trading scheme are identical with the argument to prefer private grain trade to state grain trade. In short private emission trade brings full national and international efficiency. Government trading brings only partial international efficiency. A second argument for private emission trading is the effectiveness that can be expected from such a scheme. Governments will meet their post-trade emission commitments. The effectiveness stems mainly from the institutional quality criteria which have to be met before a country can join the club of internationally linked national emission trading schemes.

6 In our discussion of government trading schemes we have not mentioned such quality requirements. This means that there is less certainly that a selling country will be able to meet its more stringent emission targets. This can be due to defects in national implementation such as enforcement, but also be inherent to the instrument applied; for example the impact of emission taxes on emissions is uncertain, perfect standard setting requires a fully informed national planner etc. Related to the effectiveness argument is the argument that private emission trading requires a transparent system of national monitoring of emissions and of national and international allowance tracking. This facilitates the detection of failures which could become or already are a cause of non-compliance of national governments to their international emission commitments. In case of governments trading the monitoring scheme still has to be designed. A last argument for private emission trade is that it has a built-in mechanism for adjustment of emissions over time. The intertemporal flexibility pertains to individual sources as well as to emission targets of countries. New information on costs of emissions reduction, clean energy etc. can be absorbed and translated in adjustment of emissions immediately, without affecting the government's compliance with international emission commitments. The flexibility can be further increased by incorporating emission permit banking as part of the scheme. With government trading the flexibility is considerable less. Transfer of assigned amounts makes sense in the years sufficiently far before the budget period , stated in the Kyoto Protocol, begins. The revised emission commitments can then be translated in national policies, whatever they are: benchmarking, voluntary agreements, energy efficiency standards or emission, resp. fuel taxes. However, during or shortly before the budget period begins the translation of acquired of yielded emission quota into national measures will be difficult, since its planning, implementation, monitoring and enforcement will take time. The government trading scheme therefore is much more inflexible, making it dynamically less efficient than the private trading scheme. The private emission trading scheme also has its minuses relative to government trading. Implicitly they have already been stated. In the first place schemes of private trading are more intricate and therefore less easy to understand than government emission trading. Lack of knowledge thwarts acceptance of the private scheme by politicians and interest groups. Second, preparation and organisation of national private trading schemes and next their international linkage require many years. Government trading on the other hand seems to be possible almost instantaneous, although one should not forget that translation into national policies also will take considerable time. Apart from the above mentioned bottlenecks there is a major political stumble block. Tradeable permits are in place if political decision makers want policy to be effective in realizing the emission targets. Casual observation does raise doubts whether climate change policy has evolved sufficiently from being mainly symbolic to the stage where emission targets are considered to be hard. If not, then it will be impossible to organize sufficient political support for internationally linked national schemes of tradeable GHG emission

7 permits and the second best option of emission trade between governments of Annex B countries will be the chosen instrument. Conclusions Applying the criteria efficiency and effectiveness there is no doubt that a scheme of international emission trade between private entities, meeting the requirements mentioned in this paper, is the best choice. Such a scheme can operate at relatively low administrative costs if an appropriate design is chosen. The major bottleneck is lack of understanding of such a scheme of emission trading and possibly also the lack of willingness to apply an instrument that is hard because of its built-in effectiveness. Supposing that the idea of an international scheme of private emission trade has been accepted politically, time is needed to organize the scheme. Next to that, the requirement of a solid domestic policy of GHG emission reduction restricts the number of participants from the list of Annex B countries. For these reasons two routes could be followed sumultaneously. In the short term government emission trading can and will be developed. It will be welcomed as an instrument to relax the emission constraints of countries that made the most stringent GHG emission reduction commitments in Kyoto. Simultaneously Annex B countries can start the discussion on and the preparation of national schemes of emission trade between private entities. International consultation and coordination from the start on key elements, like compatibility of permits and whether rules for permit allocation should be agreed upon, will speed up the moment of introduction of international linkage of the national schemes of private emission trade.

8 Addendum - Cost effectiveness of private CO 2 emission trading - a Dutch case study The cost effectiveness of tradeable permits stems from the flexibility it leaves the single source in choosing its emission level. A recent study (van Duijse et. al, 1998) illustrates how formidable the cost savings can be. The study compares the cost of CO 2 emission control of a domestic scheme of tradeable permits in The Netherlands with the cost of a package of measures proposed by the Dutch Minister of the Environment in a letter to Parliament in October 1997 (the 'Kyoto letter'). The cost calculation focuses on 4 sectors: the energy sector, energy intensive industry, energy extensive industry and agriculture (including horticulture). Transport, other services and consumer households are excluded from the study. It has been assumed that the target of Dutch Climate Change policy is a reduction of CO 2 emissions by 30 mton in the year 2010 compared with unrevised CO 2 control policy. It implies a 6 percent reduction of CO 2 equivalent emissions in The policies proposed in the Minister's Kyoto letter aim at controlling emissions in the energy sector, mainly energy saving and investment projects for CO 2 removal. Emission control is concentrated in the energy sector which produces for the home market and has little to fear from foreign competition. However, marginal control costs are high compared with the marginal cost of emission control in the exposed sector (industry). The major instrument to implement the programme is a rise in CO 2 tax in the sheltered sector and subsidies for the investments in energy saving and CO 2 removal. Other instruments are direct regulation (energy efficiency standards) and voluntary agreements. The cost of the scheme proposed in the Minister's 'Kyoto letter' is 720 mln NLG per year (about 0.1 % of Dutch GNP in 1997). If instead a scheme of tradeable CO 2 emission permits is introduced for the four sectors and assuming that the permit market works perfectly, exposed sectors, which have low marginal CO 2 control cost in the 'Kyoto letter' scenario, will have an incentive to increase their energy efficiency. CO 2 reduction by energy saving in industry is 8 mton higher in the tradeable permits scheme than it is in the 'Kyoto letter' scheme. Energy saving, CO 2 removal and sustainable energy in the energy sector are curtailed by 7 mton. The more efficient allocation of CO 2 reduction makes that the tradeable permits scheme has net benefits of 40 mln NLG (due to a lower energy bill) instead of costs. If there is no international emission trading and the price per CO 2 permit, which reflects the cost of the most expensive control option, is 147 NLG ( = $ 73) per ton CO 2 in the tradeable permit scheme. This makes clear that the target of 30 mton emission control in the four sectors is quite ambitious. A tradeable permit scheme applied in the EU would result in lower marginal CO 2 control cost and a permit price. Calculations with the PRIMES model and POLES model, assuming a 10 percent CO 2 emission reduction for the EU in 2010 relatively to 1990, suggest a price of 40 NLG. Cooperative implementation with Eastern European countries would reduce price and total control cost even further. Dr. Andries Nentjes is professor in Economics and Public Finance at Groningen University and coordinator of the NRP-project "International CO 2 control strategies: tradeable permits". Department of Economics and Public Finance Faculty of Law Groningen University P.O. Box 716, 9700 AS Groningen

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10 References Dijkstra, B.R. (1998), The Political Economy of Instrument Choice in Environmental Policy, diss. RUG, Groningen; to be published by Edward Elgar in the series `New horizons in environmental economics'. Dijkstra, B.R. and A. Nentjes (1998), The political choice of instruments in environmental policy, in D. Requier- Desjardins, C. Spash and J. van der Straaten (eds.), Social Dimensions of Environmental Decision Processes, Kluwer, Dordrecht.. van Duijse, P., A. Nentjes, J. Krozer, K. Blok en M. van Brummelen (1998), Verhandelbare CO 2 - emissierechten, VROM-raad, Achtergrondstudies 002, Den Haag. Zhang, Z.X. and A. Nentjes (1998), International Tradeable Carbon Permits as a Strong Form of Joint Implementation, in J. Skea and S. Sorrell (eds.), Pollution for Sale: Emissions Trading and Joint Implementation, Edward Elgar, Cheltenham, England.