Comparing Emission Trading with Absolute and Relative Targets *

Transcription

1 Paper presented at the 2nd CATEP Workshop on the Design and Integration of National Tradable Permit Schemes for Environmental Protection, hosted by University College London, March Comparing Emission Trading with Absolute and Relative Targets * A.M. Gielen Ministry of Finance, The Netherlands P.R. Koutstaal Ministry of Finance, The Netherlands Herman R.J. Vollebergh Erasmus University Rotterdam and OCfEB, Rotterdam This version: 15 th March 2002 Abstract This paper evaluates recent attempts to circumvent restrictions imposed by the archetype tradable permit systems, the so-called (absolute) cap-and-trade (C&T) mechanism. In particular, we discuss so-called relative cap-and-trade policies - policies that restrict emissions per unit of output or per unit of input. Using a partial equilibrium model we show that relative C&T amounts to the implementation of an absolute cap-and-trade mechanism together with a subsidy on output or on the input. Abatement efficiency remains guaranteed. However, agents not only benefit from the rents incurred by the cap, but also from this output subsidy. Furthermore, these pemits also do not raise revenue and therefore cannot be used to lower deadweight loss of other distortionary taxes. Finally, the emission constraint is more uncertain and monitoring costs are likely to be higher. Nonetheless, relative targets appear to be more acceptable than absolute targets from the policy perspective. Firms not only do not have to pay for their remaining emissions, expanding production as well as entry is costless as long as there are no decreasing returns to abatement and emissions remain below the relative target. Furthermore, policy makers can more easily combine relative C&T with existing regulation like voluntary agreements. Finally, in the case of uncoordinated policy initiatives, relative targets reduce the loss of competitiveness compared to absolute caps. A coordinated emission trading scheme at the level of the EU would partly address these issues and might make relative C&T less attractive. Keywords: Tradable emission permits, absolute and relative cap-and-trade, externalities and redistribution JEL Code: H 23; Q48 Correspondence: Paul Koutstaal, Ministry of Finance, The Netherlands, P.O.Box 20201, 2500 EE Den Haag, P.R.Koutstaal@minfin.n * Vollebergh acknowledges financial support from the research programme Environmental Policy, Economic Reform and Endogenous Technology, funded by the Netherlands Organization for Scientific Research (NWO).

2 1. Introduction According to the traditional approach to tradable emission permits, cap-and-trade (C&T), the government restricts emissions relative to the status quo or a projected baseline level, and next allows agents to trade with the remaining permits. Thus participating polluters face an absolute cap on their emissions, and then decide to reduce emissions, buy additional permits at the permit market or a combination of both, according to the costs of both options. Although it has been recognised for a long time that auctioning off the initial permits would be important to prevent the new scarcity rent to materialise as a producer rent, practical policy has always been more concerned about its potential negative redistributional effects, in particular in exposed sectors of the economy. In fact, following Pezzey (1992), several authors have argued that (selective) grandfathering of initial permits might indeed be a useful instrument to alleviate redistributive concerns without a loss in efficiency (see Vollebergh, De Vries and Koutstaal, 1997; Pezzey and Park, 1999 and Bovenberg and Goulder, 2001). Interestingly, in the context of climate change policy, the concept of flexibility seems to generate a different approach. As is well known, the Kyoto protocol mentions several flexible instruments, like Joint Implementation (JI), the Clean Development Mechanism (CDM) and Emission Trading (ET), and which share the basic idea to trade emissions in one way or another. JI and CDM can be distinguished from classic C&T systems because they allow for project-based baseline-andcredit trading (Sorrel and Skea, 1999, p. 11; Hargrave c.s. 1998), In recent years, a new variant has been proposed: emission trading with a relative target. Such trading systems are no longer based on an absolute cap of total emissions, but on a much more flexible cap defined in emissions per unit of output or per unit of input. Indeed, such relative C&T policies are becoming increasingly popular. It is part of the recently implemented UK climate trading scheme, in which the so-called unit sector has relative targets. It has also been proposed as the model for the Dutch NO x emission trading scheme scheduled to start within a few years. Also in the Netherlands, a Commission on CO 2 Emission Trading proposes to combine a system of absolute targets for the sheltered sector with a system of relative targets for the exposed sector. This paper evaluates the effects of such attempts to circumvent restrictions imposed by the archetype C&T systems on the efficiency of climate change policy. In the next section we describe the basic characteristics of the relative C&T policies and explain why they are so popular. Next, we compare the relative C&T mechanism with the absolute C&T mechanism using a partial equilibrium 2

3 model. Section four discusses the opportunities and problems of linkage between the two mechanisms in different countries. Section five concludes. 2. Emission trading with relative cap-and-trade From the start, it has been recognised that allowing flexibility in meeting emission targets will be an important element of climate change policy because it can substantially reduce the costs of limiting greenhouse gas emissions. Consequently, the Kyoto-protocol includes three so-called flexible mechanisms: Joint Implementation (JI), the Clean Development Mechanism (CDM) and Emission Trading. JI and CDM are project-based, baseline-and-credit trading schemes. For each individual project, a baseline is determined on the basis of a business-as-usual scenario (a number of different approaches have been proposed for setting baselines, see Hargrave et.al. 1998). Emission reductions below this baseline create credits, which can be used by the buyer of these credits to fulfil his Kyoto obligations. JI is limited to the Annex-I countries of the protocol that have a binding emission reduction target, CDM is targeted at the (mainly developing) countries which do not have a binding emission target in the first budget period ( ). An important difference between emission trading and the project based trading mechanisms is that in the latter, sources which emit more than their baseline do not have to buy permits to cover these emissions. The project-based trading schemes create the possibility to sell credits but do not include the obligation to buy permits. 1 In recent years, the three flexible instruments have been developed in more detail, both at the international and the national levels. As the first budget period of the Kyoto-protocol draws nearer and ratification of the protocol becomes more likely, parties to the protocol, which have binding commitments, are formulating policies to meet their emission targets. The concept of emission trading for climate change policy has been the subject of studies in a number of countries (for example, New Zealand, Australia, Norway, the UK and the Netherlands); the UK and Denmark have recently introduced CO 2 emission trading. In both the UK and in the Netherlands emissions schemes have been implemented (UK) or proposed (the Netherlands for CO 2 and also for NO x ) which include trading based on relative targets. It should be noted that relative targets have also been used in the lead trading programme in the U.S. in the 1980 s, however the lead content of gasoline was finally reduced to zero, therefore the trading programme finally had an absolute cap (Nussbaum 1992). Several reasons can be mentioned why relative targets are an important part of these trading schemes. 3

4 The first reason is that trading with relative targets is more easily combined with existing regulation and policies. In the Dutch proposal 2, relative targets have been proposed for basically the energy intensive sectors, which have signed the voluntary agreement on benchmarking energy efficiency. In this agreement, these sectors have committed themselves for the period up to Their energy efficiency is compared to benchmarks defined as energy use per unit of output. In the CO 2 emission trading proposal, these energy efficiency benchmarks are to be converted to CO 2 benchmarks, which serve as relative targets for CO 2 emission trading. In the UK system, most of the so-called Agreement Participants have targets defined in terms of energy use or emissions per unit of output. In these Climate Change Agreements, participants have committed themselves to targets in exchange for an 80 per cent Climate Change Levy discount. These companies can choose to trade to meet their targets through the scheme, thereby benefiting from extra flexibility and lower compliance costs. A second reason for the popularity of relative targets is the political acceptability. This could be due to two factors. First, polluters only have to pay for emissions above their relative target and not for their remaining emissions, which is a concept more easily communicated to active lobbies than an absolute level. As has been argued above, selective grandfathering of initial permits can also be used to limit payments for remaining emissions. In itself, this argument is therefore not a sufficient reason to explain the preference, which firms have for relative targets (as has, for example, been stated by the Dutch employers organisation). The second factor concerns entry of firms and expansion of output. Relative C&T mechanisms allow entry and expansion at no extra costs as long as emissions per unit of output or input are below the relative target. Grandfathering permits in a classical C&T scheme with absolute targets does not allow for free entry. Instead, firms will have to buy additional permits if they want to enter a market or increase their emissions. Emission trading is not only being considered at the national level, the EU has also made a proposal for CO 2 emission trading in the EU (European Commission, 2000) and recently published a draft directive which is currently being discussed (European Commission, 2001). Basically, the EU proposes a classical cap-and-trade scheme in which absolute caps are allocated to a number of energy intensive sectors. The approach of the Commission is therefore somewhat more traditional than the national proposals. One reason to explain this differenceis the fear, at the national level, of loss of competitiveness if industries are confronted with an absolute cap while these sectors in neighbouring countries are not. In effect, the Dutch proposal states explicitly that emission trading should not 1 See Koutstaal 2001 for an analysis of the efficiency of different flexible instruments. 4

5 reduce the competitiveness of the Dutch industry, which is the main reason for the choice for relative targets for those sectors, which are exposed, to competition from abroad. Because of these perceived negative consequences (whether they are real or not), uncoordinated policy initiatives will tend to favour approaches that limit these consequences. Co-ordinated policies at a sufficient international level (such as the EU) do not have this problem because possible loss of competitiveness will probably be considerably less, explaining the absolute caps in the Commission s proposal. It is interesting to note that in the reactions to the draft directive, the UK has stated a preference for their own initiative while the Netherlands has indicated that they would prefer relative targets. This illustrates how uncoordinated local policy initiatives can result in a lock-in, even though there is an alternative co-ordinated policy at the international level. 3. A comparison between emission trading with absolute and relative targets This section discusses the differences between the two approaches in terms of efficiency, entry barriers, uncertainty for investors, revenue raising and administrative and monitoring costs. 3.1 Efficiency A C&T policy not only restricts emissions through an overall cap on the emissions of an economy, but also allows agents to trade in the remaining quantity. Such a quantity restriction can be introduced in a number of ways. First, all agents can be restricted in the same way relative to some baseline (projection). The regulator can also discriminate between them, for instance between sheltered and unsheltered sectors. Second, agents can receive their permits for free (grandfathering) or they have to buy them at an auction. Moreover, hybrid systems of selective grandfathering and auctions provide opportunities to meet distributional concerns for the regulator. Interestingly, whatever distributional option the efficiency conditions for the cost minimisation problem of the firm remain unaffected. Although this important insight often goes unrecognised in the literature (Pezzey and Park, 1999), the result does not carry over to the relative C&T policy. This section illustrates this important result using a simple model. We start with the familiar cost minimisation problem of a representative firm subject to a C&T program. The firm minimises production and abatement costs C(q,a) with q as the quantity produced 2 in Dutch, with English summary 5

6 and a the level of abatement. Furthermore, the firm does not have market power and therefore the permit price P P is given to him. Total emission E is determined by the quantity produced and the level of abatement, and the firm is restricted to emission level E *.3 The usual restrictions apply. Thus we have the following problem for the individual firm: Min C(q,a) = c(q,a) + Pp (E(q,a) E * ) (1) with c q, c qq, c a, E q, E aa > 0 ; E a < 0 The FOC's of equation (1) are simply: c a = Pp E a (2) c q = Pp E q (3) Equation 2 is the standard cost-efficiency result: marginal abatement costs equals the permit price or the value of the marginal abatement activity. Consequently, marginal abatement costs are equal for all polluters and total abatement costs are minimised. Equation 3 states that marginal costs of production equal the value of production forgone due to pollution, i.e. marginal addition to emissions of raising output times the permit price or shadow price of emissions. In a scheme with trading around relative targets, emissions as such are no longer restricted, but emissions per unit of output, i.e. E/q. That is, the firm's need to buy permits is now also affected directly by its output level. Higher levels of output generate more emissions, but also lower emissions per unit of output. To capture this type of policy target we introduce the relative target (per unit of output) N *. The firm now minimises the following cost function: Min C(q,a) = c(q,a) + Pp (E(q,a)/q N * ) q (4) The second expression on the right hand side of equation 4 shows that a firm will buy permits if its emissions per unit of output (total emissions E divided by the total quantity produced q) are higher than the allowed relative target N *. First order conditions for cost minimisation are: c a = Pp E a (5) c q = Pp (E q N * ) (6) Interestingly, total abatement costs are still minimised (equation 5). Thus, marginal cost of emission reduction is not affected by the relative constraint and still equals the permit price. In other words, because marginal costs are still uniform for all polluters, cost efficiency across the economy is also guaranteed under the relative C&T policy. 3 We (implicitly) assume that this firm acquires the permits E * for free. If not an additional term should be included in equation (1) revealing the auction value of the initial level of permits. 6

7 The second equation, however, reveals a substantial difference with the standard case. The output level now has a distinct negative contribution to total cost (and therefore allows the output level to be higher), and therefore performs as an output subsidy. This is easy to see by comparing equation (6) with equation (3): the relative standard raises the value foregone due to emissions generated by producing output. The additional factor, P p N, lowers marginal costs below the optimal level. In short, the relative output target is a production subsidy. This 'production subsidy' effect of the relative target has consequence for the industry structure, similar to the effects of a pollution standard, a (relative) target without trading, as has been shown by Spulber (1985), Helfland (1991) and Goulder et.al. (2000)4. Long-run optimal equilibrium is only satisfied if there are a correct number of firms in the industry. It is straightforward to show the different consequences for long-run equilibrium of trade with an absolute and a relative cap. The long-run competitive equilibrium is characterised by the zero profit condition (price = average costs) and profit maximisation. For trade with an absolute target these conditions are: P(n q) [c(q,a) + Pp E] / q = 0 (7) P(n q) [c q + Pp E q ] = 0 (8) where P(n q) is the inverse demand curve, n is the number of firms in the industry; P q, P n < 0 ; P qq > 0. Note that the amount of permits grandfathered E * does not enter in the (long-run) average cost function. As grandfathered permits can be sold on the market, they cannot be used for free. Firms have to take their opportunity costs into account, which is equal to their value on the market, the permit price. For relative targets, the conditions are: P(n q) [c(q,a) + Pp E Pp N q ] / q = 0 (9) P(n q) [c q + Pp E q Pp N] = 0 (10) As one might expect both average and marginal costs are reduced with exactly the same value, Pp times the relative target. Therefore total demand n q will increase because P n and P q are negative. The consequences for the optimal size of the firm, q and the number of firms n in the industry depends on the effect of the change in N on the cost structure of the firm, C. This is illustrated in Diagram 1 showing the equilibrium of a representative competitive firm and of the industry (see also Baumol & Oates 1988, p ). For simplicity it is assumed that, 7

8 given a level of abatement, emissions are directly proportional to output. Initially, i.e. before the introduction of absolute C&T, the firm produces quantity Y C at price P C. Here its marginal cost curve MC C intersect its average cost curve AC C (the left-side diagram). An absolute cap raises the marginal cost curve by the price of the permits times emissions per unit of output to MC P. The average cost curve also rises with the permit price to AC P. Consequently, the final product price now equals P C + P P, the original product price plus the permit price. The long-run industry supply curve will shift upwards to S P and total quantity produced declines to Q P. Consumers have to pay the full permit price and therefore will reduce their consumption. For comparison we assume that the relative targets N * are set in such a way that, given the same level of production q as with the absolute cap, the same emission reduction will be achieved and consequently the same permit price will occur on the permit market. Introducing emission trading with a relative cap reduces the final product price with the amount of the 'subsidy' and therefore equals P C + P P (E q N * ). Consumers pay less than they would in the case of an absolute cap and the industry supply curve does not shift as much to the left. Industry output, determined by the intersection of the industry supply curve S R and the demand curve D, is Q R, which is less than the output without a relative target, but more than the output with an absolute cap. Given the same marginal abatement costs as with a relative cap, emissions will be higher compared with the absolute target. 4 An emission reduction subsidy has a comparable effect, see Baumol & Oates 1988, ch

9 Diagram 1 Firm production and industry supply with a relative target Firm Price Price Industry P C + P P E q P C + P P (E q N) MC P MC R MC C AC P AC R AC C S p S R S C P C Y C Production Q R Q C Quantity Q P D As has been shown, introducing a system of relative targets N equal to the number of permits available in a system with an absolute cap will in the long-run equilibrium result in higher emissions. In order to achieve the same emission level, the relative targets will have to be reduced (as is the case with standards, see Helfand 2000). Reducing the relative target not only reduces emissions directly, it will also drive up the permit price. Marginal and average costs will increase because of the decrease of N and the rise of the permit price. This results in decreased production and therefore further emission reduction. In the long-term equilibrium in which emission under a relative target equals those with ann absolute target, the permit price Pp and the level of abatement will be higher compared with those under an absolute cap. The level of production will be also be higher compared with an absolute cap Entry barriers 5 Suppose permit price and therefore (marginal) abatement costs under the relative cap would be equal to those under the absolute cap. Consequently, Pp cap = Pp rel ; E q rel = E q abs. The same emission level under both systems is only realized if production is the same and therefore if prices are equal. Therefore c q cap Pp E q = c q rel Pp E q Pp N. For N > 0, this is only the case if c q cap < c q rel. This will only be the case if q cap < q rel (the abatement costs component of c q is equal, given the equal marginal abatement costs). In that case, the emissions with an absolute cap would be lower than those with a relative cap. N could therefore be reduced in order to equalize final emissions under both schemes, resulting in a lower permit price and a lower level of emissions per unit of output. For equal emissions, output under the relative cap should therefore be higher compared with the absolute cap. 9

10 It has been argued that absolute targets might provide a barrier against entrants, especially when the established firms receive their permits for free. Grandfathering permits however does not necessarily raise entry barriers, because the use of grandfathered permits entails opportunity costs. Entry barriers might be raised if capital markets do not work perfect and therefore entrants have to pay higher capital costs than the established firms. However, the extent to which this would raise entry barriers in the case of CO 2 appears to be limited (see Koutstaal 1997, ch. 4). With a relative target, entrants have to meet the same relative cap as the incumbent firms. Therefore there is no entry barrier; instead there is an incentive for new firms to enter the market, which is one of the reasons for the inefficiency of these schemes, which has been described above. As is the case with an absolute cap (or a tax combined with tax credits, see Farrow 1995) limit the relative target to the established firms and oblige the entrants to buy all the permits they need on the market. However, this would instead create an entry barrier, because the entrant would have higher marginal and average costs than the incumbent firms (N * would be zero for entrants, whereas it is non-zero for incumbent firms, hence the difference in average and marginal costs, see equations 9 and 10). 3.3 Uncertainty With emission trading with an absolute cap, the emission target is given, regardless of the a priori uncertain level of economic growth. Instead, the costs of achieving the emission target are uncertain. The higher economic growth, the higher will be the costs which have to be made to achieve the target. With a relative cap, the target is uncertain. Higher than expected economic growth increases the level of emissions above those expected. Consequently, costs will not rise as much as in the case of the absolute cap. The marginal costs are in themselves uncertain, this in contrast with a tax where the level of emissions is uncertain but the price level known. Trade with a relative cap therefore has both the uncertainty about the target, equivalent to the tax, as the uncertainty about costs, although the uncertainty about the costs which results from the uncertainty about future economic growth is less with a relative cap compared with the absolute cap. It should be noted that the Weizman theorem (Weizman 1974), which states that under uncertainty the preference for either price control through taxes or quantity control with tradable emission permits depends on the relative steepness of the marginal cost and marginal benefit curves, is not affected directly if instead of absolute caps, trading with relative caps is analysed. 10

11 3.4 Revenue raising An important outcome from the double dividend discussion (Pezzey 1998) is that lowering existing distortionary taxes with the revenue from carbon taxes or the revenue from an auction of CO 2 emission permits can substantially lower the costs of meeting carbon emission targets. The use of relative targets implicitly means that permits are grandfathered; when permits are auctioned, relative targets are meaningless. Consequently, it will not be possible to reduce distortionary taxation, which will increase the costs of CO 2 emission abatement. 3.5 Administrative costs and monitoring The grandfathering of permits can be complex in the case of absolute targets. It has to be decided how to divide the permits among the participants, which may need extensive negotiations. Furthermore, it has to be avoided that those who have not reduced emissions in the past are rewarded by a large amount of permits, which would be the case if permits are distributed strictly on the basis of historic emissions. A relative cap can be easier, especially when the rate can be based on existing performance standards. However, if such a rate does not exist, it will be more complicated, as has been illustrated in the Netherlands in the voluntary agreement on benchmarking, for example because it is difficult to assign CO 2 emissions because a firm produces many different products. Furthermore, verification and monitoring not only requires that emissions or fossil fuels use are monitored, it will also be necessary to keep track of the output produced. 4. Linking of trading schemes with a relative and an absolute cap Both at the national and the international level, trading schemes with absolute caps might be linked with those with relative targets. For example, both the U.K. scheme and the proposed Dutch scheme feature both approaches and allow trade between the systems. Obviously, the consequence of allowing trade between the schemes is that the scheme with the absolute cap will not guarantee anymore the realisation of the emission target because permits can be bought in the relative sector. In the U.K. scheme, this has been addressed by the concept of the gateway, which only allows sale of permits from the sector with the relative target as long as total emissions from this sector remain beneath a certain level. Another approach to assure that sectors with relative targets remain within a certain emission limit is to reduce the relative targets. At regular intervals, the actual emissions are compared to the emission targets for the sectors involved. If emissions exceed the planned target, the 11

12 relative caps will be reduced. In order to reduce the increased uncertainty this might create on the market about the value of the permits, it has to be made clear in advance what the conditions are for a reduction of the relative targets. Linking the two approaches will also have consequences for the relative position of the sectors in the two different systems. Those sectors which have a relative target will produce at a higher than optimal level because of the implicit subsidy of the relative target. However the emission target is achieved (through a lower than optimal cap for the absolute sector or lower relative targets for the other sector), the absolute sector has to pay the price in terms of higher output prices because of the higher than optimal permit price. Output prices in the relative caps sector will be lower than the optimal level. If on average the scheme with the relative target has lower marginal costs (as is expected in the Dutch scheme), it will be a net seller of permits. Consequently, output prices will not only be lower than the optimal level, but prices in the relative sector will actually fall when the trading scheme is introduced. Linking different schemes in different countries poses additional problems. First, a country which operates a system with a relative target will become an attractive location for industries which have to face an absolute cap in other countries, especially if it would become a net seller of emission permits. In effect, locating production in the country with the relative target would be subsidised by the production subsidy element of the relative target. As a result, emissions in that country would increase while those in the other country would fall. Given the absolute emission targets which have been agreed in the EU-burden sharing agreement, the consequence would be that either the relative targets would have to be reduced or emission reductions achieved through other policies in other sectors would have to be increased. Not only would emissions increase through relocation from abroad, they will also increase because of the increased competitiveness for the sectors with a relative targets vis-à-vis these sectors in the other country which have to meet an absolute target. Combining schemes with relative targets in some member states of the EU with absolute cap trading in other countries will therefore harm the internal market. Grandfathering permits in a classical cap-and-trade system with absolute caps will not affect the marginal costs and therefore it will not influence the competitiveness of firms in different member states. 6 6 Grandfathering might have wealth effects, which could influence competitiveness, however these effects are likely to be less severe. Moreover, grandfathering will have to comply with state aid rules. The European Commission has proposed that the member states set up national allocation plans for the allocation of permits in the CO 2 trading scheme, which subsequently have to be approved by the European Commission. 12

13 Combining the two systems might also raise problems because of the consequences for the choice between direct and indirect measuring of emissions form electricity generating. Direct measuring of emissions means that emissions are taken into account at the location where emissions take place: at the electricity generating plant. Generators have to have emission permits and will pass on the price of the permits they need to cover emissions to their customers (at least, in a classical C&T system with an absolute cap). With indirect measuring, the electricity consumers have to cover the emissions, which have occurred with the generation of the electricity they use. They will have a direct incentive (not indirect through the price mechanism as in the case of indirect measuring) to use electricity with the lowest associated CO 2 emissions. Linking schemes in which electricity emissions are measured both direct and indirect might result in double counting (Vis, 2001). For example, electricity from a member state with a direct scheme will have a mark-up on the price equal to the costs of the necessary permits. In a member state which has an indirect scheme, electricity generated within that member state will not have such a mark-up because electricity consumers will have to pay for the permits they need themselves. Consequently, emissions for electricity imported from abroad will be counted double, first at the point of production and again at the point of consumption. The result is that electricity from the direct scheme will be at a disadvantage, both in the other member state as within its own borders, because emissions from electricity imported from the indirect scheme will not be counted at all. In a system with relative caps, all emissions, including those from electricity, are compared to the relative target. Otherwise, it might be attractive to switch to electricity because these emissions are not taken into account. This depends on whether the electricity price includes a mark-up for the emissions, which occurred at the generating plant, as would be the case in direct system. If the electricity price would include a mark-up, for example, because emissions would be measured directly, there would be no price difference between either emissions from fossil fuels and emissions from electricity generating. However, this would mean that firms with a relative cap would have to pay for the emissions related to their electricity use, which would undermine the acceptability of the emission trading scheme. 5. Conclusions The table below shows the differences between emission trading with relative targets and emission trading with absolute targets analysed in this paper. 13

14 Absolute cap (AC) Relative cap (RC) Efficiency Yes No Uncertainty Costs Costs and targets Revenue raising Yes, in case of an auction No, with grandfathering No Administrative costs Simple and at relative modest costs More costly due to accounting problems Entry barriers Possible No Implementation Should be introduced instead of existing regulation Can be introduced in addition to existing regulation The main conclusion is that trading with a relative cap is less efficient than trading with an absolute cap because a relative cap is a combination of a price on emissions and a production subsidy. Consequently, output will exceed the optimal output level and permit price and abatement costs need to be higher in order to meet the same emission target as in an efficient system with an absolute cap. There are a number of other reasons why relative targets are less efficient or less attractive than absolute caps. The uncertainty is larger with relative caps, no revenue will be raised which could be used to lower dead-weight loss of distortionary taxation and monitoring costs will be higher. However, relative targets are more acceptable than absolute targets. Firms not only do not have to pay for their remaining emissions, as is also the case with grandfathering in classical cap-andtrade with absolute caps, production expansion and entry are also free if emissions are below the relative target. The popularity of relative targets with policy makers can be explained by the fact that they can be more easily combined with existing regulation and policies such as voluntary agreements. Furthermore, in the case of uncoordinated policy initiatives, relative targets will reduce the loss of competitiveness, which might occur with absolute caps. A co-ordinated emission trading scheme at the EU level will probably considerably reduce this problem. Furthermore, it would ensure that adverse consequences for the internal market which would occur if relative target systems are combined with absolute cap schemes would be avoided, as well as possible double counting problems if electricity emissions would be addressed directly in some member states and indirectly in member states which have relative targets. 14

15 In the draft directive on CO 2 emission trading, the European Commission s proposes trading with an absolute target. However, both the UK and the Netherlands have voiced reservations with respect to the EU scheme, which might partly be explained as a lock-in effect of the implemented and proposed schemes in these countries. 15

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