WORKING PAPER SERIES n Supplementarity in the European carbon emission market

Transcription

1 FACULTY OF ECONOMICS AND APPLIED ECONOMIC SCIENCES CENTER FOR ECONOMIC STUDIES ENERGY, TRANSPORT & ENVIRONMENT KATHOLIEKE UNIVERSITEIT LEUVEN WORKING PAPER SERIES n Supplementarty n the European carbon emsson market Johan Eyckmans (K.U.Leuven-CES) Jan Cornlle (UCLondon) February 2001 contact: Isabelle Benot KULeuven-CES Naamsestraat 69, B-3000 Leuven (Belgum) tel: +32 (0) fax: +32 (0) e-mal: Isabelle.Benot@econ.kuleuven.ac.be

2 Supplementarty n the European carbon emsson market* Johan Eyckmans and Jan Cornlle frst verson February 14, 2001 Abstract: In ths paper we nvestgate emsson tradng wthn the EU and, more specfcally, some proposals to mpose celngs on emsson tradng. We compare dfferent proposals put forward by the EU negotators at the nternatonal level n the framework of the Kyoto Protocol and apply them to ntra-eu greenhouse gasses emsson tradng. It turns out that these proposals mply mportant dfferences n the dstrbuton of emsson tradng gans among the EU member states. A publc choce approach s used to nvestgate whch EU countres would beneft from mposng mport and/or export celngs. We try to nterpret the celng proposals as the outcome of a votng game among the EU member states on unform celng rates. The smulatons suggest that the most lkely celng proposals match closely the nterests of the bg EU member states France, the UK and n partcular Germany. The smulaton model we are usng conssts of a set of margnal cost of carbon emsson abatement functons calbrated to PRIMES smulaton results reported by Capros and Mantzos (1999). keywords: emsson tradng, margnal abatement cost curves, supplementarty * Fnancal assstance by the Belgan Prme Mnster s Offce, Federal Offce for Scentfc, Techncal and Cultural Affars, contract number CG/DD/243 (CLIMNEG project), s gratefully acknowledged. Ths paper benefted substantally from comments by Matt Vano (EC) and Dense Van Regemorter (K.U.Leuven- CES) but, of course, all remanng errors and flaws reman ours. Correspondng author, malng address: K.U.Leuven-CES, Energy, Transport and Envronment, Naamsestraat 69, B-3000 Leuven, Belgum. tel. +32(0) , fax. +32(0) , e-mal: johan.eyckmans@econ.kuleuven.ac.be. Johan Eyckmans s Postdoctoral Fellow of the Fund for Scentfc Research Flanders FWO. Student Master of Scence n Envronmental Economcs, Unversty College, London. 1

3 Table of contents Table of contents Introducton A model of EU-wde carbon emsson tradng...5 Notaton and basc defntons...5 Free trade emsson market equlbrum...6 Constraned emsson market equlbrum...8 Emsson market equlbrum wth market power...9 The lnk between celngs and market power...10 A smple measure of barganng power Smulatons of free carbon emsson tradng n the EU...11 Constructng MAC curves...11 The EU Burden Sharng agreement...12 Smulatons of the EU free trade emsson market Smulatons of constraned emsson market equlbra...15 Dfferent proposals for caps on emsson tradng...15 Barganng power mplct n the celng proposals Smulatons of unform celngs...20 Identfyng a unform mport cap...20 Identfyng a unform export cap...23 Identfyng a unform mport-export cap Conclusons...25 References...26 Appendx

4 1. Introducton The European Commsson s Green Paper on Greenhouse Gas Emsson Tradng Wthn the European Unon (EC (2000)), advocates the use of tradable emsson permts wthn the EU as a way of ncreasng cost effcency of European clmate polcy. Greenhouse gas (GHG) emsson tradng s one of the flexble mechansms provded for n the 1997 Kyoto Protocol on the reducton of GHGs. The Kyoto Protocol 1 stpulates that ths nternatonal emsson tradng mechansm can only come nto acton after the start of the frst commtment perod, hence from 2008 onwards. The ECs Green Paper calls however for nstallng a European GHG emsson market already earler, from 2005 onwards. Ths exclusvely EU emsson market would have several advantages. Frst, t would gve EU companes some tme to get used to the permt tradng system. Snce Europe has lttle experence compared to the USA wth emsson permts, t s often feared that European companes would not be ready for competng on an nternatonal GHG emsson market n Secondly, t would gve the EU an opportunty to show to the secretarat of the Kyoto Protocol some demonstrable progress towards the achevement of the 8% emsson abatement target for the European Bubble. Fnally, and perhaps most mportantly, the ECs Green Paper shows that ths EU GHG emsson market could lead to substantal cost savngs compared to uncoordnated natonal clmate change polces. Accordng to smulatons wth the PRIMES model 2, total cost savngs from adoptng emsson tradng wthn the EU mght amount to more than 9 bllon annually. For the broader nternatonal GHG emsson market, smlar mportant cost savngs have been reported n several studes, see Weyant and Hll (1999) for a recent survey. It should be recognsed however that the EU poston towards emsson tradng s somewhat ambguous. In the framework f the nternatonal negotatons n the aftermath of Kyoto, the EU has pleaded strongly for the so-called supplementarty clause n the Kyoto Protocol. Artcle 17 of the Kyoto Protocol contans a reference to supplementarty n the sense that emsson tradng should be supplemental to domestc actons. The dea s that t would be unfar that some rch countres would smply buy all of ther commtted GHG emsson reducton abroad wthout mplementng a substantal domestc clmate polcy. Countres als 1 For the text of the Kyoto Protocol, see 2 PRIMES s a EU-wde energy system optmzaton model developped by the Natonal Techncal Unversty of Athens NTUA, see Capros and Mantzos (1999,2000) or 3

5 fear adverse mpacts on compettveness f other Partes would buy ther way out. Subsequently, the EU has proposed some quanttatve celngs on emsson tradng 3. But, behnd ths rhetorc of supplementarty a much stronger argument of self nterest s hdden. It was convncngly shown by Ellerman and Wng (2000) that celngs on permt mports are a way of exercsng monopsony power. Indeed, by restrctng demand for permts on the nternatonal market, the permts become less scarce and ther prce wll fall. Smulatons for Kyoto GHG emsson tradng reported by, among others, Ellerman and Wng (2000) and Crqu et al. (1999), suggest that the EU and USA would beneft strongly from the mposton of moderate mport celngs. Hence, behnd the debate on supplementarty, one mght suspect a struggle for the gans of emsson tradng. In ths paper we want to extend ths logc to the European pre-kyoto GHG emsson market. As far as we know, there are no proposals yet for adoptng restrctons on emsson mports and exports but we wll argue that chances are hgh that the supplementarty debate wll affect the EU market as well snce for some countres, the stakes are hgh. After demonstratng theoretcally the pont that celngs on permt mport or exports can be nterpreted as a way to exercse monopsony or monopoly power, we turn to some smulatons of the EU GHG emsson market n solaton. We use a smple smulaton model, the core of whch conssts of a set of margnal GHG emsson abatement cost curves (MAC), one for each EU member country. Ths model was developed n Eyckmans and Cornlle (2000) and bulds upon Cornlle (2000). The MAC curves were estmated usng smulatons results of the European PRIMES energy model by Capros and Mantzos (1999,2000). We borrowed the MAC methodology from Ellerman and Decaux (1998). We wll make use of two approaches to nvestgate celngs n the EU market. Frst, we compute the constraned emsson market equlbra for the dfferent celng proposals that the EU negotators have put forward n the nternatonal clmate negotatons. Usng a smple measure of barganng power, we compute whch EU countres would gan or lose from adoptng a partcular proposal n the EU permt market. Secondly, we adopt a publc choce approach and try to predct the outcome of a European votng game on unform mport/export celngs. We plot cost ratos of the constraned market outcomes for all EU 3 The dfferent proposals can be found n Ellerman and Wng (2000) or n the offcal documents of the UN Framework Conventon on Clmate Change: 4

6 member states and try to nfer what would be ther most preferred celng rate. Usng some smple or qualfed majorty rule we then dentfy a lkely celng rate and compare t to the dfferent proposals we computed earler. Ths paper s focus s manly postve or descrptve,.e. we try to reveal the ncentves behnd the celngs arguments. From a normatve pont of vew however, we feel that emsson tradng restrctons should be avoded for two reasons. Frst, there s a pure effcency argument snce celngs create substantal market dstortons and ncrease the overal cost of achevng the EU GHG emsson reducton target of mnus 8% by Secondly, we see a dstrbutonal argument. Our smulatons suggest that even moderate export celngs would generate mportant redstrbutons of trade gans beneftng relatvely rch EU members lke France, the UK and Germany to the expense of for nstance Portugal. In our opnon, ths redstrbuton s not transparant. Equty consderatons concernng the EU GHG emsson abatement burden sharng should be taken nto account whle negotatng the ndvdual member s commtment nstead of beng msused to advocate the mposton of trade restrctons. Ths paper s organsed as follows. Secton 2 presents the model and contans the theoretcal statement of the clam that mport/export celngs can be nterpreted as means to exercse market power. Secton 3 presents some reference smulatons of the EU burden sharng agreement wthout trade and the free trade emsson market equlbrum. Secton 4 presents the dfferent EU proposals on supplementarty and computes the constraned market equlbra f these proposals were to be mplemented n the EU market. Secton 5 tres to dentfy lkely celng rates under the assumpton that the tradng restrcton s adopted unformly n all EU member states. Fnally, secton 6 concludes. 2. A model of EU-wde carbon emsson tradng Notaton and basc defntons Let EU denote the set of member states n the European Unon. The cardnalty of EU s denoted by m. Per capta GDP n the year 2010 n country s defned as: x = X n wth X total GDP level and n populaton of country n Let Y denote the projected Busness-As-Usual GDP level and E projected BAU carbon emssons for the year Total GDP n the Kyoto complance perod s gven by: X = Y C ( R) where C ( R) 5

7 denotes the emsson abatement cost (AC) for country for reducng ts emssons wth R tons compared to projected BAU emssons. Actual emssons n 2010 are defned as BAU emssons mnus abatement: E = E R. The emsson abatement cost functon denotes the GDP loss ncurred by country f t has to curb ts carbon emssons wth R tons n These losses nclude, among others, nvestment costs for fuel swtchng (e.g. coal or ol to natural gas) n energy producton, the cost for desgnng and producng more effcent cars, nsulaton costs to ncrease fuel effcency n prvate houses etc. The cost functon s assumed to be twce contnuously dfferentable, strctly ncreasng ( C > 0 for R > 0) and strctly convex n abatement ( C > 0). Hence margnal abatement costs are rsng as more emssons are abated. Furthermore, t s assumed that the frst unt of abatement s free ( C (0) = 0 and C (0) = 0) and that t s nfntely costly to abate the last unt of emssons ( lm C ( R ) =+ ). R E Assumng a European carbon emsson market where permts can be bought at a fxed and unform prce p and where all EU member states have been assgned an ntal permt quotum of Q E, we can wrte a country s GDP as follows: ( ) ( ) T T Q T T Q T X = Y C R + p E E = Y C R + p E E + R EU (1) Every country can choose between reducng ts emssons more than requred by the quotum Q E and sellng the surplus n the permt market at unt prce p, or reducng ts emsson less than requred and buyng addtonal permts n the nternatonal market. Free trade emsson market equlbrum Assumng prce takng behavour and wthout constrants on the tradng volumes 4, a free trade market equlbrum for permt tradng s defned as a vector of emsson reducton efforts such that every ndvdual country maxmses ts per capta ncome: max 0 R E ( ) Q Y C R + p E E + R EU (2) 4 Of course, some natural lmts apply to the amount of emsson reducton feasble. Emsson abatement (relatve to some Busness-as-Usual scenaro) s restrcted to be nonnegatve and cannot exceed the BAU emssons: 0 R E. 6

8 The frst-order necessary and suffcent condton for ths maxmsaton problem says that every country wll reduce ts carbon emssons up to the pont ts margnal abatement cost s exactly equal to the market prce 5 : ( ) C R = p EU (3) These frst-order condtons defne well-behaved, contnuous and ncreasng emsson reducton supply curves: 1 ( ) ( ) RS p = C p snce C s strctly monotone, contnuous and strctly convex n abatement. Total market supply s defned as the sum of all ndvdual supply curves: RS( p) RS ( p). The market clearng prce s defned as the prce EU level p * for whch total market supply s suffcent to acheve the EU Kyoto oblgaton: * KYOTO RS( p ) R EU =. The free trade market equlbrum wll be denoted by an astersks *. Totally dfferentatng ths market clearng condton shows that the equlbrum prce s strctly ncreasng n the overall Kyoto oblgaton: * p = = = > 0 KYOTO * * R ( ) ( ) 1 EU RS p RS p EU C EU (4) Hence, the steeper the margnal emsson abatement cost functons, the stronger the prce effect of a change n the overall EU abatement objectve KYOTO R EU. Whether countres are net seller or buyers of permts at the free trade market equlbrum depends on ther ntal allocaton of permts E Q and on the equlbrum market prce p *. They are net permt mporters (exporters) f Q * 1 * ( ) ( ) E < > E = E R = E C p. The lower ther assgned amount of permts ( E ), the hgher ther BAU projected emssons ( E ) and the lower the Q equlbrum market prce ( * p ), the more lkely a country s a net permt mporter. Returnng to the frst-order condtons n (3), t follows drectly that free emsson tradng leads to a cost effcent soluton snce all countres margnal abatement costs are equalsed. However, f mport and/or export caps (.e. quanttatve restrctons on the traded amount of permts) apply, or f the assumpton that all countres are prce takers s not fulflled, equalsaton of margnal costs wll not always be acheved. 5 Because of the assumptons on the lmt behavour of the margnal abatement cost functons we need not consder corner solutons. 7

9 Constraned emsson market equlbrum Some countres advocate that free trade s unjust because some countres mght consder buyng all of ther emsson abatement oblgaton abroad wthout domestc measures to curb emssons. Some other countres feel that some major permt exporters would obtan too large a share n total emsson tradng gans. Therefore, the use of quantfed celng on permt mports and/or exports s currently a hot topc n nternatonal clmate negotatons. Some EU member states extrapolate ths reasonng to the EU level. Assume that the mport and export caps are gven by the constrants 0 R R R E on ndvdual reducton efforts 6. How does a compettve emsson market look lke n ths case? Lke before, every ndvdual country s assumed to be a prce taker on the emsson permt market and to maxmse ts GDP wth respect to ts emsson reducton effort. However, t should take nto account the celngs on emsson tradng: max R R R ( ) Q Y C R + p E E + R EU A constraned market equlbrum (denoted by a superscrpt c ) s charactersed by the followng system of frst-order condtons: C ( R c ) = p c + µ c EU (6) (5) and by the condton that the market prce p c clears the permt market. The Lagrange multpler c µ captures the effect of the mport/export cap. If µ > 0, ths mples that c c c C ( R ) > p. Hence, buyng permts nstead of reducng domestcally consttutes a cost savng. Country would lke to mport more emssons at the prevalng prce level but s c prevented from dong so by a bndng mport cap. If, on the other hand, µ < 0, the country c c would lke to export more permts than allowed for by ts export celng snce C ( R ) < p. Producng addtonal emsson abatement and sellng t at the prevalng market prce s a c proftable operaton. When nether the mport nor the export cap are bndng, µ = 0 and condtons (6) bol down to the free trade market equlbrum charactersed by condtons (3). 6 Dfferent proposals crculate for emsson mport/export caps. All of these caps can always be expressed as constrants on the reducton effort varable R. In partcular, a celng that requres that the net permt mport (export) of a country, n percentage of ts emsson reducton commtment, should not exceed some gven percentage translates nto a lower (upper) bound on emsson reducton effort R ( R ). 8

10 Emsson market equlbrum wth market power Not only celngs can prevent full cost effcency from beng attaned by allowng for permt tradng, also market power can gve rse to dstortons. If some bg countres can manpulate the equlbrum prce of permts by alterng ther supply or demand, addtonal dscrepances between margnal abatement costs can arse. An emsson market equlbrum wth market power s defned as a noncooperatve Nash equlbrum n whch every country (or coalton of countres f cartels would form) maxmses ts GDP takng as gven the emsson abatement strateges of the other players n the game. We wll assume that the set of players EU can be parttoned nto s m dsjont and nonempty cartels such that : EU = K1 K2 Ks. An emsson market equlbrum wth market power s charactersed by the followng system of frst-order condtons (denoted by superscrpt ο ): ο ο ο dp B ο C ( R ) = p + Ej Ej R j Kl, l {1,2,, s} ο + dr (7) j Kl Comparng (7) to the compettve market condtons (3), we see that cost effcency s no longer guaranteed. In every cartel K l the cartel members equate ther margnal emsson abatement cost to the market prce plus a mark up. Ths mark up conssts of the multplcaton of two factors: the effect of small change n reducton on the equlbrum market prce tmes the cartels net supply of emsson permts. The frst factor, the total prce effect of a change n emsson abatement by country on the equlbrum prce, was shown by Ellerman and Wng (2000) (appendx) to be negatve and s the same for all countres and ο ο ο ο cartels: dp dr = dp dr 0. The second factor, the net supply of permts s specfc to j the cartel. Ths mples that wthn every cartel, margnal abatement costs wll be equated, but across cartels, dfferences n margnal costs may exst. ο When no country has market power,.e. dp dr ο = 0, condtons (7) smply reduces to (3), the market power equlbrum bols down to the free trade emsson market equlbrum. ο However, f countres can nfluence the market prce,.e. dp dr ο 0, the market power equlbrum wll devate from condton (6). If cartel K l s a net mporter of permts,.e. E B E + 0 K Rο ο ο ο <, we obtan that C ( R ) > p f dp dr ο < 0. Hence the members of l ths cartel reduce emssons more than n the free trade benchmark case wthout market power. Another way of nterpretng ths result s by sayng that permt mporters favour an 9

11 mport celng. By restrctng ther demand (hence, by reducng emsson more domestcally), permt mporters can drve down the equlbrum market prce. On the other hand, f cartel B K l were a net exporter of permts,.e. E E + 0 K Rο >, l ο ο ο we obtan that C ( R ) < p f dp dr ο < 0. Bascally, ths means that permt exporters are n favour of an export celngs because by reducng ther supply of permts (hence, by abatng less domestcally) they can drve up the market prce of permts. The lnk between celngs and market power We notce an nterestng lnk between the market power case and the tradng celngs. Indeed, comparng expressons (7) and (6) we can nterpret celngs as a partcular expresson of market power. One can always defne emssons-tradng celngs such that the constraned market equlbrum concdes wth the market power equlbrum. In other words, we can nterpret the celngs as just of way of enforcng market power! Ths nterpretaton wll drve our smulatons of the EU permt market. Usng a publc choce approach, we wll try to dscover behnd the dfferent celngs proposals, whch countres or cartels are ganng from t. We wll compute constraned market equlbra for dfferent celng proposals and we wll compare them to market power scenaros. A smple measure of barganng power Snce we want to analyse the poltcal economy of celngs n the EU permt market we wll employ a publc choce type of approach by vsualsng the barganng postons of the dfferent EU member states n the debate. Takng dfferent proposals (see later) for celngs on permt mports and/or exports, we can compute the correspondng constraned emsson market equlbrum. For evaluatng the barganng postons of the EU member states we propose a smple measure of barganng power. The barganng weghts are defned by the followng system of equatons: C C ( ) λ ( ) λ C R = j C j Rj j EU λ = 1 EU and the requrement that all weghts are postve λ 0. The last equaton s a normalsaton of the weghts. Snce ths system of equatons s lnear n the weghts λ there exsts a unque soluton to ths problem f the coeffcent matrx s of full rank. Accordng to (8), the (8) 10

12 smaller the emsson reducton assgnment C R of a country, the hgher ts barganng weght λ because margnal abatement costs are nversely proportonal to the barganng weghts. Bascally, ths defnton of barganng weghts follows from mnmsng a weghted sum of emsson reducton costs of the EU member states under the constrant that total abatement should add up to the overall EU Kyoto commtment: mn λ C ( R) { R} EU s.t. EU EU R R KYOTO EU Hence, we try to fnd the barganng weghts that make a partcular dstrbuton of emsson abatement effort the soluton of a weghted cost mnmsaton exercse. Therefore, the barganng weghts can be nterpreted as reflectng the relatve power of the countres n the negotatons leadng to the allocaton of emsson abatement effort dstrbuton. Ths approach s smlar to the nverse optmum approach used n Eyckmans and Cornlle (2000) except for the fact that n ths paper we use utlty functons that are lnear n ncome. 3. Smulatons of free carbon emsson tradng n the EU (9) Constructng MAC curves The quanttatve analyss of the emsson market n the next sectons are based on smulatons usng margnal abatement cost (MAC) curves and emssons data for 14 European Unon member states (Luxembourg s excluded). In Eyckmans and Cornlle (2000) we have estmated MAC curves on the bass of calculatons carred out by Capros and Mantzos (1999). The fgures were drawn from smulatons wth the PRIMES energy model,.e. a partal equlbrum model of energy demand and supply. Ths model s based on a least cost methodology. It computes the least cost energy supply technology mx for meetng demand for energy servces. We estmated MAC curves of an exponental functonal form wth standard ordnary least squares technques: MAC ( R) = C ( R) = α R β (10) The estmated coeffcents are reported n Table A.1. n Appendx. A plot of the MAC curves can be found n Eyckmans and Cornlle (2000). The EU Burden Sharng agreement 11

13 In 1999, an agreement was reached among the EU member states to redstrbute the overall EU commtment of 8% greenhouse gas emsson reducton under the 1997 Kyoto Protocol, see EC (1999a), COM(1999)230. Ths redstrbuton was made takng nto account both arguments of cost effcency (assgnng larger effort to low abatement cost countres) and equty (less strngent abatement requrements for poorer EU members). Table 1 summarses the most mportant features of the EU Burden Sharng agreement (BSA n the sequel) wthout emsson tradng 7. We postpone the dscusson on emsson tradng untl the next secton. TABLE 1: EU Burden Sharng agreement wthout emsson tradng R E/E 1990 E/E 2010 AC AC/GDP AC/POP MAC AU BE DK FI FR GE GR IR IT NL PO SP SV UK EU mtco 2 % % m % /head /ton CO 2 The frst column (R) reports absolute emsson reducton n mllon tons of CO 2 measured as the dfference n emssons between the BAU scenaro and actual emsson n The second and thrd column contan relatve emsson reducton as a percentage compared to the 1990 base year (E/E 1990 ) or to the 2010 BAU scenaro (E/E 2010 ). In partcular, column E/E 1990 contans the reducton efforts agreed upon n the EU Burden Sharng Agreement. Columns four to sx report on total abatement costs n absolute terms (AC), as a percentage of GDP (AC/GDP) or per capta (AC/POP). The last column contans the margnal abatement cost estmate. 7 All smulatons were performed usng GAMS software (General Algebrac Modellng System, All programs and data are avalable from the authors upon smple request. 12

14 Overall, the Burden Sharng Agreement would cost the EU economy slghtly more than half a percent of ts projected GDP n The EU average per capta cost would amount to /head. However, ths relatvely low fgure hdes mportant regonal dfferences whch range from about 30 /head n Germany and France to as much as 661 /head n the Netherlands. The EU average margnal abatement cost amounts to about /ton CO 2 (equvalent to about 567 /ton C or approxmately 500 US$/ton C 8 ). Ths MAC estmate for the EU Burden Sharng agreement s relatvely hgh compared to other studes, e.g. Ellerman and Decaux (1998) or Crqu, Mma and Vguer (1999). The reason s that the total EU reducton requrement s estmated to be about 487 mtco 2, whch s almost double the requrement used n the other two studes. Agan, the EU average MAC estmate hdes substantal regonal dfference. Margnal abatement costs for mplementng the EU Burden Sharng Agreement are relatvely low n Germany and France (77.78 and /ton CO 2 respectvely) and are as hgh as /ton CO 2 n the Netherlands. These large dscrepances n MACs ndcate that the EU Burden Sharng Agreements remans far from achevng a cost effcent mplementaton of the EU Kyoto reducton objectve. Hence, there exst large opportuntes for permt tradng wthn the EU. Smulatons of the EU free trade emsson market Snce there are strong dfferences n MACs n the EU BSA, there exsts a strong argument for allowng emsson tradng among the EU partners. Recently, the EU Commsson s Green Paper on emsson tradng (COM(2000)87) supports ths vew. Table 2 summarses the ntra-eu free trade emsson market equlbrum. 8 One ton of carbon (C) s equvalent to 44/12=3.667 ton of carbon doxde (CO 2 ) n molecular weght As exchange rate we used 1 =0.88$. 13

15 TABLE 2: Free trade EU emsson market equlbrum E/E1990 MAC EXP AC/GDP IC/GDP TC/GDP AU BE DK FI FR GE GR IR IT NL PO SP SV UK EU % /ton CO 2 % % % % (p= /ton CO 2 ) As can be seen from the second column (MAC), unrestrcted emsson tradng leads to cost effcency snce margnal abatement costs are equalsed across all EU member states and amount to /ton CO 2. The hgh margnal abatement cost countres n the Burden Sharng agreement wthout trade (Table 1) mport emsson abatement from the low margnal abatement cost states. Imports (exports) of permts correspond to negatve (postve) entres n the thrd column (EXP). These mport/export amounts are relatve to the total emsson reducton requred by the BSA ( E E 2010 Q ). Hence, Austra exports permts for about 17.6% of ts assgned emsson reducton n the Bubble agreement. The Netherlands, Portugal and Belgum are relyng heavly on mports of carbon emsson permts. For the Netherlands, these mports exceed 50% of ts BSA assgnment. The man exporter of permts s Germany. It exports for about 68% of ts BSA emssons. Column four (AC/GDP), fve (IC/GDP) and sx (TC/GDP=AC/GDP + IC/GDP) contan the abatement cost, permt mport cost and net costs as a percent of GDP. Compared to the BSA wthout tradng (Table 1), total EU abatement costs fall from 0.52% to 0.41% of 2010 GDP. Allowng for emsson tradng represents a cost savng of about 9.11 bllon annually. Indvdually, all EU member countres are better off wth than wthout tradng (comparng last column of Table 2 and column AC/GDP n Table 1) but some gan more than others. E.g., the Netherlands can lower ther total costs from 3.02% to 1.79% of GDP, 14

16 Portugal from 2.33% to 1.86% of GDP. Notce that Germany faces almost no costs snce t can sell a bg amount of permts to other EU members. 4. Smulatons of constraned emsson market equlbra Dfferent proposals for caps on emsson tradng In the negotatons on the Kyoto Protocol n the dfferent Conferences of the Partes (CoP) of the UN Framework Conventon on Clmate Change (UNFCCC), the ssue of supplementarty s a hot topc. Artcle 17 of the Kyoto Protocol contans a reference to supplementarty n the sense that emsson tradng should be supplemental to domestc actons. Subsequently, the EU has proposed a quanttatve celng on emsson tradng (see: These celngs have been at the heart of the supplementarty debate ever snce. The dfferent proposals are summarsed below: 1990 Q ˆ E + E E = 0.05 (IC1) { } ˆ Q E = 0.5 max E, E,, E E { } E ˆ = max IC1,IC2 15 (IC2) (IC3) 1990 Q ˆ E + E E = (EC1) ˆ 2010 Q E = 0.5 E E (HC) These tradng celng should be nterpreted as annual lmts on the amount of carbon emsson permts mported or exported. In Table 3 we calculated the dfferent proposals for the EU market. The celngs are all reported as a percentage of BSA commtted abatement: ˆ 2010 Q E E E. The shaded rows n Table 3 correspond to countres that are net permt exporters under the free trade regme. The frst mport celng proposal IC1 takes 5% of the average emsson levels of 1990 and the EU Burden Sharng commtment. IC1 s more strngent for countres that agreed to an ambtous emsson reducton target (a low Q E ) n the EU Burden Sharng agreement and that are charactersed by relatvely low 1990 emsson levels. Comparng the permt exports (EXP) n the free trade equlbrum n Table 2 we see that proposal IC1 s very restrctve. All mportng countres except Italy and Span would face a bndng cap. The Netherlands would mport about 50% of ther BSA commtment but are restrcted to only 12% n the IC1 proposal.

17 TABLE 3: emsson tradng celngs (% of BSA commtment) IC1 IC2 IC3 EC1 HC AU BE DK FI FR GE GR IR IT NL PO SP SV UK IC2 allows for more choce. Bascally, a country can mport permts up to half of the dfference between ts maxmum emsson level n the perod from 1994 untl 2002 and ts commtment under the EU BSA 9. Comparng to the free trade stuaton, proposal IC2 would mply substantal mport constrants for the Netherlands and Portugal only. IC3 takes the maxmum of the prevous two proposals IC1 and IC2. For all countres, except for France, ths amounts to the IC2 cap. EC1 defnes an export celng accordng to the same formula as IC1. Only Germany would be constraned by ths proposal. It would lke to export up to 68.62% of ts commtment under free trade but s restrcted by EC1 to 56.23%. The next proposal, IC3+EC1, denotes the combnaton of the mport celng IC3 wth the export celng EC1. It s not shown n Table 3 but t consequences can easly be deduced from IC3 and EC1. Fnally, the so-called However Clause (HC) defnes a combned mport and export celng amountng to 50% of the emsson abatement commtment. Agan, ths proposal would only affect Germany as an exporter. No permt exporter mports more than half of ts commtment under free trade. For each of these dfferent celng proposals, we report n appendx the detals of the constraned market equlbra that they defne. Table 4 summarses the margnal abatement 9 Snce Europe Energy Outlook (1999) does not provde detaled estmates for all the relevant years we had to complete the seres by ordnary extrapolaton usng average annual growth rates. 16

18 costs for the dfferent proposals and compares them to the free trade (FT) case and the EU Burden Sharng allocaton wthout trade (BSA). Shaded cells refer to constraned market partcpants. TABLE 4: Margnal emsson abatement costs BSA FT IC1 IC2 IC3 EC1 IC3+ HC EC1 AU BE DK FI FR GE GR IR IT NL PO SP SV UK EU p Notce frst that the Burden Sharng Agreement wthout permt trade s manly benefcal (n terms of MAC) for Germany, France and the UK. On the other hand, t s to the expense of the Netherlands and Belgum. Purely based on cost effcency arguments, the fgures suggest that Belgum and the Netherlands should have been allowed to emt more greenhouse gases whereas Germany, France and the UK should have been allocated a hgher emsson reducton target. Invokng some dstrbutonal concern calls for even hgher reducton oblgatons for the rcher countres (n partcular Germany and the Scandnavan countres) and a laxer treatment of the southern member states Portugal and Greece, see Eyckmans and Cornlle (2000). These conclusons are n lne wth the fndngs of Böhrnger et al. (1998). It s nterestng to compare the dfferent proposals n terms of the market clearng equlbrum prce. Recall that under the free trade regme, the EU permt prce amounts to approxmately 153 /ton CO 2. The mport cap proposals are drvng the market prce down (to 133 /ton CO 2 n case of IC1) whereas export celngs are drvng prces up. The ntuton for ths s clear. Import celng suppress demand and makes emsson permts less 17

19 scarce. As a result, the equlbrum market prce must fall. Hence, mport celngs can be nterpreted as a way of enforcng monopsony power on behalf of the permt mporters. Conversely, export celng lmt the supply of permts makng them more scarce and drvng up the market prce. Export celngs can be nterpreted as monopoly power exercsed by the permt exporters. A formal proof of the celng mechansm can be found n Ellerman and Wng (2000). When both mport and export celngs are used smultaneously, the effect of the equlbrum prce depends on the balance of the monopoly and monopsony power. Our smulatons suggest that n the However Clause Germany s monopoly power would be domnant. It can drve up the equlbrum market prce by about 7 /ton CO 2.e. approxmately a 5% prce ncrease. In the combned proposal IC3+EC1, the monopsony power of the permt mporters completely offsets the monopoly power of Germany and the equlbrum prce s almost equal to the prce n the free trade regme. Pay offs (n per capta) are reported n Table 5. TABLE 5: Pay offs ( per capta) BSA FT IC1 IC2 IC3 EC1 IC3+ HC EC1 AU BE DK FI FR GE GR IR IT NL PO SP SV UK EU For the EU as a whole, the restrctve IC1 proposal s the most expensve. Cost savngs from emsson tradng are reduced by almost 30% whch s equvalent to about 3.43 bllon annually. The other proposals are much less costly for the EU as a whole. 18

20 For ndvdual countres, all depends on the fact whether they are net mporters or exporters of emssons n the free tradng equlbrum. Exportng countres prefer ether the However Clause HC or the export celng regme EC1. On the other hand, most mporters prefer the IC1 or IC2 proposal. The Netherlands and Portugal would prefer no restrctons on permt mports at all snce they rely heavly on foregn abatement to cover ther emsson reducton commtments. Generally speakng, the dfferent celngs proposals mply mportant redstrbutons of the cost savngs from emsson tradng. E.g. for the Netherlands, the dfference between free tradng and the IC1 proposal amounts to more than 140 per capta. Barganng power mplct n the celng proposals Table 6 translates the MAC cost estmates nto barganng weghts. TABLE 6: Barganng weghts BSA FT IC1 IC2 IC3 EC1 IC3+ HC EC1 AU BE DK FI FR GE GR IR IT NL PO SP SV UK In the free trade regme, margnal abatement costs, and hence also the barganng weghts, are equalsed across all EU member states. Ths case wll serve as benchmark n the sequel. The IC1 proposal clearly favours permt exporters to the expense of the mportng countres. Especally the countres that rely heavly on permt mports (the Netherlands, Belgum and Portugal) are hurt by IC1. The barganng weght of the Netherlands s only 35% of the weght of an exportng country lke Germany. Proposals IC2 an IC3 are less restrctve and mply low barganng weghts manly for the Netherlands and Portugal. The export celng proposal EC1 and the However Clause HC 19

21 gve a substantal advantage to Germany, up to about 22% n the HC case. Under the combned proposal IC3+EC1, the barganng weghts of exporters and mporters are convergng compared to the However Clause. Our general apprecaton of the dfferent proposals s the followng. Clearly, the dfferent proposals should be nterpreted as a way of achevng a balance of power or a dstrbuton of emsson tradng gans between the extremes of the Burden Sharng Agreement wthout trade BSA and the free tradng regme FT. IC1 entals a more equal dstrbuton of barganng power than BSA but stll remans very restrctve for the Netherlands and Portugal. Moreover, t would gve permt mporters a strong nstrument to explot ther monopsony power vs-à-vs the exporters. In our opnon, the EU heavy weghts Germany, France and UK wll never accept a proposal that s so strongly aganst ther nterest. On the other end of the spectrum we fnd that the However Clause gves mportant monopoly rents to Germany only. The mporters group wll resst ths type of regulaton of trade and, more mportantly, the coheson between the exporters wll become under strong pressure. In our opnon, the However Clause s too extreme at the other sde of the spectrum. Most lkely, some ntermedate proposal combnng mport and export restrctons (IC3+EC1 for nstance) has the hghest chance of servng as a compromse proposal. 5. Smulatons of unform celngs How do these dfferent proposals relate to ndvdually optmal celngs on permt trade. In order to answer ths queston, we wll focus on unform mport/export caps only,.e. a celng (expressed as a percentage of commtted emsson reducton) that s the same for all EU member states. In ths secton we wll calculate constraned emsson tradng equlbra for ever more strngent celngs and we wll plot the pay off of the dfferent market players. Ths wll enable us to () vsualse who wns and loses from mposng the celngs, () show the most preferred unform celng percentage for every country and () judge the relatve gan compared to the free trade reference stuaton for every EU member state. Ths nformaton on most preferred celng levels ( peaks ) wll enable us to make some predctons on lkely outcomes of negotatons processes takng nto account dfferent decson rules lke ordnary or qualfed majorty rule. 20

22 Identfyng a unform mport cap The pcture of wnners and losers of mposng a unform mport cap s rather complcated. In Table A9 we show the net cost per capta (TC/POP) for dfferent values of mport caps. We manpulated the per capta cost fgures n Table A9 and plotted them n the followng Fgure 1. For dfferent values of mport caps, Fgure 1 shows the rato of costs n the constraned equlbrum over the free permt trade stuaton. Ths way of representng celng allocatons s also used by Ellerman and Wng (2000) and Crqu et al. (1999). The fgure should be read from rght to left. An mport cap of 55% (meanng that 45% of abatement should be domestc) or hgher has no effect snce none of the EU members mports that much of ts reducton oblgaton. In ths case, the cost fgures n Table A9 correspond to the free trade cost n Table 2 and the cost rato n Fgure 1 equals one. However, below 50%, the unform mport cap becomes bndng for the Netherlands frst and the market prce starts fallng (plotted aganst the rght axs n Fgure 1) snce total demand for permts s lower. In the extreme case of a zero percent mport cap, mplyng that all reducton should occur domestcally and trade s prohbted, we are back to the EU Burden Sharng Agreement wthout trade (Table 1). FIGURE 1: Unform Import Cap 5.00 SP 3.00 SV AU FR p PO UK BE EU NL GE

23 Notce that the cost ncrease of mposng mport caps s born manly by the permt exportng countres (dotted lnes) Austra, France, Germany and the UK. Indeed, mposng an mport cap lowers demand and hence depresses the EU permt prce. Ths causes export revenues losses for permt exporters. On the other hand, the cap makes t possble for many mporters to explot ther monopsony market power. For many of the permt mporters, the reducton n the expenses for buyng permts outweghs (ntally) the ncrease n abatement costs for these constraned permt mporters. However, for severe mport caps, also the mporters start loosng and ther costs converge to the EU Burden Sharng Agreement fgures n Table 1. Ellerman and Wng (2000) explan n detal the effects of mport caps on constraned and unconstraned permt mporters. Ths monopsony effect can be observed for most of the permt mportng countres. However, the extent to whch mporters can explot ther monopsony power s very dfferent. The Netherlands are beneftng only very lttle from a 50% mport cap (ths becomes more clear lookng at the cost data n Table A9 than n Fgure 1). For more strngent celngs, they start loosng. Belgum and Portugal would gan somewhat more than 1% compared to the free trade scenaro by mposng a EU wde mport cap of 40%. Fnally, for the EU as a whole, the costs are unformly ncreasng n the cap percentage. Any restrcton of permt trade prevents some cost savngs from beng realsed. Overall, we see that the mporters can ndeed explot some monopsony power but the gans compared to the free trade regme are rather moderate. What can we say about the most lkely outcome of the unform mport cap game among the EU member states? The shaded cells n Table A9 ndcate the most preferred choce for the dfferent permt mporters of a unform mport cap. They correspond to the peaks n Fgure 1. In partcular, the Netherlands prefer an mport cap of 50%, Belgum and Portugal of 40%, Denmark, Fnland, Greece, Ireland and Italy of 20%, and Span and Sweden of 10%. The exporters would prefer no cap at all. Gven ths confguraton, we can compute the medan value 10 of most preferred caps, whch les between 20 and 40%. However, t s qute unlkely that such an mportant matter would be settled among EU members by 10 Snce we have an even number of players (14), the medan outcome s n fact an nterval of mport celng between the peaks of the 7 th and 8 th player. We should menton also that strctly speakng, preferences over mport celngs are not sngle peaked. For strngent celng rates (5%), some countres experence a secondary rse n the cost rato. Ths mples that we should be carefull when applyng publc choce results (medan voter theorem etc) n ths context. We wll mostly neglect the extreme strngent celng results n the sequel snce they are not realstc. 22

24 ordnary majorty votng. Gven that most mportant EU member states lke Germany, France and the UK are n favour of no mport restrcton at all, we beleve that the most lkely outcome s a nonbndng mport cap somewhere n between 100% and 55%. Hence, the requrement would be that countres perform zero to 45% of ther emsson reducton commtment domestcally. Identfyng a unform export cap We can repeat the same analyss for the case of a unform export cap. Germany, France, UK, Austra, Sweden and Span would gan from mposng a moderate celng on permt exports whereas all other countres (and the EU as a whole) would loose. In partcular Germany could gan more than 20% (compared to the free trade stuaton) when a EU wde export cap of approxmately 55% of ts commtted emsson reducton effort s adopted. The EU wde permt prce would rse only slghtly to 158 /ton CO 2. The other ganers preferred export caps are much more strngent: up to 25% for France, 20% for the UK and Austra, and even 5% for Span. The countres hurt most by the export caps are the man permt mporters: the Netherlands, Belgum and Portugal. Ths s straghtforward, snce they have to pay hgher prces for emsson permts. FIGURE 2: Unform Export Cap 23

25 p UK AU SV SP FR GE PO EU NL BE Fgure 2 suggest that Germany has an mportant ncentve to strve for the mposton of a unform export cap of about 55%. Ths fgure s remarkably close to the celng proposals EC1 (56%) and the However Clause (50%) we dscussed n Table 3. Usng ordnary majorty vote, we see that the medan outcome s stuated rght of Germany s 55% peak. In that outcome sx players want a strctly postve export cap and eght prefer no export cap at all. Ths s rather naccurate as predcton as any celng rate between zero and 55% s consstent wth our data. However, usng a qualfed majorty rule, t s clear that the EU heavy weghts wll be able to have a bgger weght n the decson makng. Therefore, we beleve that an export celng of approxmately 50% s the most lkely outcome of a votng game between EU member states on unform export celngs. Identfyng a unform mport-export cap In ths secton we nvestgate a combned mport-export cap of the same magntude n all EU countres. The pattern n Fgure 3 resembles closely the prevous Fgure 2. For a relatvely hgh combned mport-export celng rate (between 100% and 50%), only the export part s bndng snce none of the mporters buys more than half of ts commtted abatement effort abroad. The combned celng s therefore dentcal to a unform export celng and we now from the prevous secton that Germany would be able to exercse substantal monopoly power n that case. The mport restrcton only comes nto effect for relatvely low celng rates. Recall that the Netherlands, the largest mporter n relatve 24

26 terms, s mportng for about 50% of ts commtted emsson abatement n the free trade scenaro. The mport celng results n the monopoly power of the permt exportng countres other than Germany, beng tempered. Careful nspecton of Fgures 2 and 3 reveals that France, the UK, Austra, Sweden and Span gan less under a combned celng system compared to a unlateral export celng. FIGURE 3: Combned Import-Export Cap p GE UK SV 0.00 SP EU 0.20 NL PO BE FR AU Concernng the poltcal economy of the choce of a combned mport-export celng, the same conclusons as under the export celng apply. The medan combned celng rate les somewhere between 100% and 55%. As t s more lkely that some knd of qualfed majorty rule wll be used on these ssues, we mght conclude that a 50% combned celng s the lkely outcome of an ntra EU negotaton process. Ths s exactly the however clause proposal we nvestgated hgher. 6. Conclusons Ths paper nvestgates celngs on permt tradng wthn the European Unon. Usng margnal GHG emsson abatement cost curves calbrated to PRIMES smulatons, we frst computed constraned emsson market equlbra for the dfferent proposals put forward by 25

27 EU negotators n the aftermath of the 1997 Kyoto Protocol. The mport celng proposal turns out to be benefcal for the small EU member states lke Belgum and Portugal. However, they are strongly aganst the nterest of the permt exporters Germany, France and the UK. Gven the current balance of power wthn the EU, we beleve that there s lttle scope for strngent mport celngs n the EU market. Export celngs on the other hand would gve strong monopoly power to France, the UK, and most mportantly, Germany. The latter mght mprove tself consderably even for relatvely moderate export celngs of 50% of commtted emsson abatement. Combnng the fndngs we beleve that a combnaton of a moderate export celng and an almost nonbndng mport celng consttutes a reasonable compromse n the balance of power between permt mporters and exporters n the EU. Ths fndng s n lne wth the so-called however clause proposal accordng to whch both mports and exports of permts would be lmted to maxmally 50% of a country s commtted emsson abatement. The focus of ths paper s descrptve,.e. we try to reveal the ncentves of the EU member states to strve for some emsson tradng restrctons. Our conclusons should not be nterpreted as an argument n favour of celngs. On the contrary, we feel that trade restrctons are to be avoded, because they generate mportant neffcences and obscure redstrbutve transfers. Equty and farness consderatons should be taken nto account whle negotatng the EU member state s abatement commtment and should not be msused to promote emssons tradng restrctons. In ths respect, we agree and fully support the argument put forward by Ellerman and Wng (2000) and Crqu et al. (1998). Our analyss s ncomplete n several respects. Important topcs for future research nclude, frst, a rgorous theoretcal analyss of market power n emsson permt markets. The mportant work by Westskog (1996) and Ellerman and Wng (2000) e.g., does not deal wth the ssue of cartel stablty or endogenous coalton formaton among permt mporters or exporters. Secondly, the numercal smulaton model depends strongly upon the PRIMES margnal abatement cost estmates reported by Capros and Mantzos (1999). Gven the fact that these estmates are relatvely hgh compared to other estmates n the lterature, a senstvty analyss s needed. 26