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Tradeable Emissions Permits: “Cap and Trade” Systems

- Sources: Field and Olewiler, Ch. 13 and Ch. 20 pp. 387-394 (Climate change) - Text: "Transferable Emissions Permits", “Tradeable Emission Permits”

- Sometimes called "Cap and trade systems".

Tradeable Emission Permit Systems:

- Polluters are given permits specifying the quantity of emissions they can make in some time period.

- this is the “cap”;

- just like a “command and control” emissions standard.

- Permits are tradeable (unlike a standard).

- the holder of the permit may sell all or some of its rights to pollute to others;

- a polluter may buy additional permits from others.

- permits are property rights to pollute.

- this right is valuable: allows a firm to avoid abatement costs.

- A permit is retired once the specified emission has occurred.

1 - Role of government (regulator):

- decides on the total amount of emissions to allow (creates the corresponding number of permits);

- decides on the initial allocation of permits among polluters.

- keeps track of the allocation of permits after trade between polluters.

- monitors actual emissions to ensure no one exceeds permitted amounts and penalizes over-pollution e.g. via fines.

- Examples: SO2 emissions (US), European Emission Trading System (greenhouse gases), Western Climate Initiative.

Hahn and Stavins (2010) mention a number of smaller ones in the US: lead permits for gasoline refiners, CFCs, Eastern Ozone Transport NOx, see:

(http://www.rff.org/files/sharepoint/WorkImages/Download/RFF-DP-10- 21.pdf )

- After-trade allocation of permits is decided in a decentralized fashion.

- permit trading determines the final allocation across pollution sources.

- relies on polluters own knowledge of abatement costs.

- creates incentives to achieve an efficient allocation of permits. (potentially cost effective)

- note: similarity to bargains under the Coase theorem.

2 Why might trading permits help achieve efficiency?

- Market trades occur when the value to the seller is less than the value to the buyer.

- Value of permission to emit one more unit of emissions?

- Marginal abatement costs (MAC) the permit allows the polluter to forgo.

- If MACs differ between polluters they have incentives to trade:

- polluters with low MAC at current emissions levels sell permits to polluters with high MAC.

- both gain if they settle on a permit price between the two MACs.

- trade will likely continue as long as there are possible trades that benefit both parties

i.e. as long as MACs differ between polluters.

- so after trade:

- MACs will tend to be equal across polluters (satisfies the equimarginal principle)

- permits will be in the hands of the polluters with high abatement costs

i.e. emissions reductions will be done by those with the lowest abatement costs.

- See numerical example below and text example pp. 244-246.

3 MAC Differs Between Polluters

Emissions Marginal Abatement Costs: ($ 000s) (tons) Firm 1 Firm 2 Where does each of the reductions come from (MAC1) (MAC2) if trying to minimize cost? (Listed 1-10) Firm 1 Firm 2 0 25 11.5 1 23 10.5 2 21 9.5 3 19 8.5 4 17 7.5 5 15 6.5 9 6 13 5.5 8 7 11 4.5 6 8 9 3.5 5 9 7 2.5 10 3 10 5 1 7 2 11 3 - 4 12 1 - 1

Firm 1 produces 12 tons of emissions with no regulation. Firm 2 produces 10 tons of emissions with no regulation.

Regulator decides to reduce pollution by 10 tons (target total emissions = 12 tons)

Option 3: Tradeable Permits (1) Initial allocation: each firm has permits allowing it to emit 6 tons (as in the uniform standard. Cost: Firm 1: 1+3+5+7+9+11 = 36 ( $36,000) Firm 2: 1+2.5+3.5+4.5 = 11.5 ( $11,500) Total Abatement Cost: 47.5 ( $47,500) (2) Trades: (a) Firm 1 will pay up to 11 ($11,000) to emit a 7th ton. Firm 2 will pay up to 5.5 ($5500) to keep its permit to emit the 6th ton. Firm 1 buys a permit from Firm 2: both will agree to a price between 5.5 and 11. After trade: Firm 1 can now pollute 7 tons and Firm 2 can pollute 5 tons. Cost: Firm 1: 1+3+5+7+9 = 25 ( $25,000) Firm 2: 1+2.5+3.5+4.5+5.5 = 17 ( $17,000) Total Abatement Cost: 42 ( $42,000)

(b) Firm 1 will pay up to 9 ($9,000) to emit an 8th ton. Firm 2 will pay up to 6.5 ($6500) to keep its permit to emit the 5th ton. Firm 1 buys a permit from Firm 2: both will agree to a price between 6.5 and 9. After trade: Firm 1 can pollute 8 tons and Firm 2 can pollute 4 tons. Cost: Firm 1: 1+3+5+7= 16 ( $16,000) Firm 2: 1+2.5+3.5+4.5+5.5+6.5= 23.5 ( $23,500) Total Abatement Cost: 39.5 ( $39,500)

( c) Firm 1 will pay up to 7 to emit a 9th ton. Firm 2 will pay up to 7.5 to keep its permit to emit the 4th ton. Firm 2 will not sell another permit to Firm 1.

4 (if allowed to trade less than 1 ton increments: Firm 2 would buy permission to pollute a bit more for a price between 7 and 7.5 and Firm 2 would end up emitting 4-5 tons and Firm 1 between 8-9 tons).

- The outcome after trading is independent of the initial permit allocation.

- Polluters have incentives to trade as long as MACs differ regardless of the intial allocation.

- trade then occurs until MACs are equal across polluters.

- Example above: each firm initially had permission to pollute 6 tons.

- traded until Firm 1 emits 8 tons and Firm 2 emits 4 tons.

- Say instead the initial allocation gave Firm 1 permission to emit 12

5 tons (Firm 2 gets 0 permits).

- Firm 2 buys permits from Firm 1 as long as

MAC2>MAC1

i.e. 1st ton traded: MAC2=10.5, MAC1=1 2nd ton traded: MAC2=9.5, MAC1=3 3rd ton traded: MAC2=8.5, MAC1=5 th 4 ton traded: MAC2=7.5, MAC1=7

- so same result as before: Firm 2 buys 4 permits and emits 4 tons. Firm 1 sells 4 permits and emits 8 tons.

- The initial allocation does affect distribution: permits are valuable - Firm 1 does substantially better if it gets all 12 permits and sells 4 than if it starts with 6 and buys 2.

- Trading could give extreme results for individual polluters:

- a low MAC polluter may end up with no permits (emissions=0)

- a high MAC polluter may buy many permits and not cut pollution.

6 Tradeable Emissions Permits and the Market for Permits

- So far: -value of a permit to polluter rooted in avoided abatement costs.

- given the allocation of permits: differences in MACs create incentives to trade.

(high MAC polluters buy permits from low MAC polluters and both gain from these trades)

-allocation of permits after trade are likely cost efficient (MACs roughly equalized).

- Trade is at the heart of the model above.

- How does this tie into a supply-demand framework?

- Supply of permits: determined by the government or regulator (vertical supply curve)

- Demand for permits: - demand curves measure willingness-to-pay (WTP).

- a polluter's WTP for permits is just the MAC of a unit of pollution.

- The MAC curve is a polluters Demand curve for permits.

- MAC summed horizontally across polluters (combined MAC curve) is the market demand curve for permits.

- With many polluters this is a competitive market: single price result. - no one buys from someone asking too high a price - no one sells to anyone buying at too low a price.

- Price of permits: where supply=demand

- Price or permits is also the price of pollution

7 e.g. often discussions of "carbon price".

- At equilibrium some polluters are buyers, others seller (depends on demand at that price vs. initial allocation of permits).

8 How many permits should be issued ?

- Ideally: set it equal to the efficient level of pollution.

Where: MAC = MD

- MAC here is the “market” version: combines the MAC curves across the individual polluters.

i.e. each unit of emissions reduction is done by the lowest MAC polluter.

9 ( Usual corner solutions are possible too: - issue no permits if MAC

- unlimited permits if MAC > MD on all emissions - What would the price of a permit in this case? )

- Note: - if the efficient level of permits is issued trading ensures that permits end up with the lowest MAC polluters - so outcome is socially efficient.

- if the number of permits is “wrong” (not EEFF)

- trading still gives a cost effective allocation of permits.

- but the level of pollution allowed is inefficient:

Too many permits: some pollution where

10 MD>MAC is allowed.

Too few permits: some pollution where MD

11 Initial Allocation of Permits:

- Once the target level of pollution is identified a decision on how to allocate permits must be made.

- Parties care about the assignment:

- the initial allocation affects the distribution of polluter well-being.

- permits are valuable: can either sell them or use them to avoid incurring abatement costs or buying permits.

- If the regulator had full information it could assign them on the basis of abatement costs.

i.e. give first permit to the polluter with highest MAC, second permit to the next highest MAC, etc.

- result? - initial allocation will equate MAC across polluters (follows equimarginal principle).

- no trades would occur!

- this is the same as an efficient, cost effective non-uniform regulation.

- in practice: regulator does not have enough information on MACs of individual polluters to achieve this.

- advantage of tradeable permits: trading can achieve this allocation with less information.

12 - Assignment often seems to be based on “reasonable” rules-of-thumb.

e.g. - firm size (e.g. amount of output) or firm age. - a fixed share of current emissions - on basis of past abatement efforts.

- incentive issues and allocation rule? - arise if assignment is based on something polluters can change before assignment.

- Auctions:

- The government could sell the permits to the polluters that bid most for them.

- Polluters with the highest MACs have the greatest willingness- to-pay for permits.

- permits will tend to go to high MAC polluters.

- expect the auction allocation to be like the allocation after trading.

- Auction provides the government with revenue. - an advantage? (same issue as taxes) - politically: - more opposition from polluters: no free permits. - auction system is more costly to polluters than receiving permits for free.

- A mix? Some systems use a “rule of thumb” for some permits and auction the rest.

13 Who Should be Allowed to Trade Permits?

- Discussion and examples above: assumed polluters are the only participants.

- Should others be allowed to participate?

- Trading firms: - firms that buy and sell permits as a way of making money.

- act as a middleman: if this makes trading easier it may make the permit market work better (lower transactions costs).

- can this give rise to speculation, bubbles and busts?

- Victims of pollution:

- could allow victim’s of pollution to buy and retire permits.

- if more than the efficient level of permits are issued there will be emissions where: MD>MAC

- so victims are willing to pay more than abatement costs.

- permit purchases and permit retirement by victims could move the outcome towards efficiency.

- like Coase’s theorem: same problems arise if there are many victims.

- if too few permits or the efficient number of permits victims will not be willing to pay enough to buy permits.

14 - Environmental groups: could buy permits and retire them as a way of reducing emissions. - Is this desirable?

- To buy permits: environmental group must be willing- to-pay more than a polluter is willing-to-pay .

i.e. then value is higher to environmental group so this change is efficient.

- This moves the outcome toward efficiency when too many permits are issued.

(if WTP of group = MD could reduce permits to the efficient level)

- In practice? US SO2 trading allows this. (see below)

Differences in Marginal Damages across Pollution Sources:

- Polluters above only differ in MAC.

- assumes that the marginal damage (MD) caused by a unit of pollution is the same regardless of who does it.

- trading will equalize MAC across polluters.

- trading among polluters will not take into account possible differences in MD caused by a unit from a given polluter.

- so some permitted pollution after trading may be relatively high MD than other pollution: outcome is not efficient.

- “Hot spots” can occur. - too much pollution from high MD polluters.

(Text example: most permits end up in one locality and MD depends on total local emissions)

15 - What to do?

- Confine system to polluters with similar MD. e.g. if MD differs significantly by geographic area have regional cap-and-trade systems.

- possible problem: small numbers of traders - limited competition: collusion, market power problems.

- Require high MD polluters to obtain more permits to reduce emissions by a given amount.

e.g. if MD twice as high as elsewhere must buy twice as many permits to emit one unit of pollution.

- this can be complicated.

- regulator needs to have estimates of MD for different polluters to determine ratio of permits to emissions.

- Combining these two solutions? - System confined to regions with same MD. - Allow trading between regions with trades made at terms in line with differences in MD between regions.

Uncertainty and Information Problems:

- As with other policies information on MD and MAC is imperfect: determining the efficient number of permits difficult.

- Cap-and-trade policies specify quantity of emissions (like standards).

- this leaves “price” and cost uncertain (depends on positions of MAC curves)

- this is the reverse of the emissions tax: “price” or cost is certain but actually quantity of emissions reductions is uncertain.

16 Incentives to Innovate with Tradeable Emissions Permits:

- Gains from an innovation that lowers MAC:

- saves abatement costs on current pollution.

- it is cheaper to reduce emissions with a lower MAC.

- for a given permit price profits can be made by innovating, reducing emissions and selling some permits.

(Figure 13-3 example)

- the resulting gain to innovation is the same as in the case of an emissions tax set at the same price as the permit.

17 Offsets and permits:

- Offsets: polluters undertake or finance pollution reducing activities elsewhere in lieu of reducing their own emissions.

- Elsewhere? - Industries other than those covered by cap-and-trade system.

- Other localities or even countries (if a global pollution issue).

- Offsets are an alternative to buying or using permits.

- Can achieve the same results: if offset project reduces emissions by same amount as the permits would.

-Attractive if “offset” activity is a less costly way of meeting emissions targets.

- Complexity: more activities for regulator to monitor and assess.

- Global pollution problems: with offsets will poor countries do the abatement and rich countries finance offsets?

- is this fair?

18 Cap and Trade Systems in Practice: American SO2 Allowances

- US Acid Rain Program:

- Environmental Protection Agency (EPA) website: http://www.epa.gov/airmarkets/progsregs/arp/index.html “Allowance trading is the centerpiece of EPA's Acid Rain Program, and allowances are the currency with which compliance with the SO2 emissions requirements is achieved. Through the market-based allowance trading system, utilities regulated under the program, rather than a governing agency, decide the most cost-effective way to use available resources to comply with the acid rain requirements of the Clean Air Act. Utilities can reduce emissions by employing energy conservation measures, increasing reliance on renewable energy, reducing usage, employing pollution control technologies, switching to lower sulfur fuel, or developing other alternate strategies. Units that reduce their emissions below the number of allowances they hold may trade allowances with other units in their system, sell them to other utilities on the open market or through EPA auctions, or bank them to cover emissions in future years. Allowance trading provides incentives for energy conservation and technology innovation that can both lower the cost of compliance and yield pollution prevention benefits.” EPA Website (2012). (http://www2.epa.gov/airmarkets/acid-rain-program )

- Aimed to reduce SO2 emissions from fossil-fuel fired power plants: - target: 10 million tons less than 1980. - total of 8.95 million. - initial phase started in 1995, eventually covered about 11,500 plants.

- Each permit (allowance) is for 1 ton of SO2 emissions during or after a specified year.

- permits are “retired” when a polluter emits 1 ton of emissions.

- there are 8.95 million permits per year.

19 - Initial allocation of permits: - Basic: “affected utility units are allocated allowances based on their historic fuel consumption and a specific emissions rate.”

- Adjustments: - additional permits if certain emissions-reducing technologies were adopted to speed up emission reductions; or consumer conservation plans were in place.

- Auctions: - each March some additional permits are sold at auction - 125,000 permits auctioned each year

- Plants starting operations after 1996 have no allocation: they must

buy permits for all SO2 they emit.

- Trading: - anyone can take part in trading: not just plants covered. - EPA must be notified of any trades.

An example trade (reported in Callan and Thomas):

- Tennessee Valley Authority (TVA) bought 10,000 allowances (permits) from Wisconsin Power and Light Company (WPLC) for roughly $3 million.

- why? - WPLC was a “clean” producer to start with: more permits than it needed (MAC roughly 0 at the margin)

- TVA would have needed to invest in expensive technology to achieve a 10,000 reduction (estimate: $800 million)

20 - Monitoring and Compliance: - Plants must install systems to continuously monitor emissions. - Penalties if emissions exceed allowances and must reduce subsequent emissions by the excess. (size: $2000-$2500 per ton – large vs. allowance prices)

- EPA keeps records on allowances held and emissions. - Compliance rate has been very high (99% in 2004). - so reductions have been achieved.

- Unused permits can be carried over to the next year. - so a plant may choose to “bank” unused permits rather than sell them.

- why might it be sensible to “bank”? - expect that future value is higher than current value by enough to justify the investment.

- Estimated that the trading systems may have decreased costs of achieving pollution targets by as much as $2.5 billion per year (Ellerman, 2002).

- Permit prices? - Price per permit: range $100-200 1995-2003. - Price spike 2004-05 (in anticipation that targets would be lowered to well below 8.95 million): as high as $1200. - Prices settle fluctuate around $300 in 2006-07. - Price collapse follows (reaches roughly 0 in 2010 to present).

- Price volatility and collapse at the end was linked to policy changes (both anticipated and actual). - Price spike in 2004-05 was in anticipation of a large reduction in the supply of permits as the US government planned to use the program to reach additional Clean Air Act targets.

- Successful legal challenges to the plan lead to prices falling back toward normal levels.

21 - US government implemented its Clean Air Act targets using other

policies. Compliance with these policies reduced S02 emissions to well below 8.95m (e.g. about 5m in 2010) leaving a permanent oversupply of permits and a price of $0 per permit.

(See: Schmalensee and Stavins (2013) “The SO2 Allowance Trading System: The Ironic History of a Grand Policy Experiment” Journal of Economic Perspectives. http://web.mit.edu/ceepr/www/publications/reprints/Reprint_248_WC.pdf )

22 23 European Emissions-Trading Scheme (ETS):

- See: http://ec.europa.eu/clima/policies/ets/index_en.htm

- Looks at European Union’s CO2 trading system.

- Started January 2005.

- EU member countries. - Links to Kyoto inititatives elsewhere in the world.

- Five industries: electricity, oil, metals, building materials, paper. (Air transport added later)

- Supply of permits: - EU allocations: initially distributed free but by 2013 auctions will be the main way of distributing permits. - Developing countries (China and Brazil especially): Certified Emissions Reductions (CERs) – has offsets!

- Demand from polluters.

- There seem to have been some problems (rooted in uncertainty? politics?):

Phase 1, 2005-07: - too many permits (allowances) issued? - price fell from 20 Euros to near 0.15 Euros.

Phase 2, 2008-12: - reduced the supply of permit by 6.5% - Recession hits in 2008 and reduces emissions even more (so demand for permits falls) - permits worth over 20 Euros each June 2007 but prices then fall by 2012 prices were about 8 euros).

Phase 3, 2013-2020: - number of outstanding permits will fall 1.74% each year. - prices remain low. Still too many permits? - plans to ‘manage’ the price (ceilings/floors).

24 Canada and Cap-and-Trade:

- Western Climate Initiative: intention to create a regional cap-and-trade system for greenhouse gases.

- Members: some provinces (Manitoba, BC, Ontario, Quebec), California (goal to have some US States, some Mexican states).

- Planned to start in 2013.

- Quebec and California appear active. Ontario is considering.

- Quebec applies to electricity, industry and fossil fuel distribution. - distributed free and auctions (more to firm exposed to international trade). - supply will fall over time. - allows offsets. - minimum price at auction. - linked to California’s market since 2014; Ontario plans to become part of the arrangement.

(Quebec: http://www.mddelcc.gouv.qc.ca/changements/carbone/documents- spede/in-brief.pdf )

(November permit auction results: (median price $17.23 per permit) http://www.arb.ca.gov/cc/capandtrade/auction/nov- 2015/summary_results_report.pdf )

(WCI: http://www.westernclimateinitiative.org/the-wci-cap-and-trade- program )

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