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Tradeable CO2 emission permits in Europe : a study on the design and consequences of a system of tradeable permits for reducing CO2 emissions in the European Union

(1996) Koutstaal, Paul Rudolf

On the agenda of environmental problems, the enhanced greenhouse effect has nowadays acquired a prominent place. Although there is still much uncertainty about its extent and its consequences, there is an important rationale for addressing the possible problem of climate change now: whatever the specific consequences may be, they are to a large extent determined by the actions we take (or do not take) today. Emissions from greenhouse gases will determine the atmospheric concentrations of these gases for centuries to come. Because of the increase in anthropogenic CO2 emissions, starting with the industrial revolution and the rise in the use of fossil fuels which it has caused, the concentration of CO2 in the atmosphere has risen by 25 percent since 1750. If we want to limit the increase of CO2 concentrations, action must be taken now.
Within the broad area of research on climate change, one specific strand of economic research has focused on the problem of how to reduce emissions from greenhouse gases, especially the emission of carbondioxide, which is the main greenhouse gas. Taking as a starting point the assumption that a CO2 emission reduction target has been set, the objective of these studies is to determine the optimal way of reducing these emissions.
From the start, it has been pointed out by environmental economists that economic instruments are suitable for implementing a policy of reducing emissions of greenhouse gases. With economic instruments, emissions will be reduced in an efficient manner, according to the theory. This has been argued and illustrated in a large number of studies which deal with economic instruments like taxes or charges and tradeable emission permits (see e.g. Barrett 1992, UNCTAD 1992, OECD 1992a and 1992b, Smith 1992). In this study, the instrument of tradeable carbon emission permits (TCP’s) is studied in more detail. The central issue is: the design of a feasible system of TCP’s and the study of the consequences of implementing such a system. Up till now, the focus of research in this area has been predominantly on the efficiency of reducing CO2 emissions by means of tradeable emission permits or taxes. Less attention has been paid to the design of such a system, which is the subject of chapter 2. In this chapter the outlines are sketched of a feasible system of tradeable emission permits for the European Union. The proposed system is in essence a system of (carbon in) fuel rationing with tradeability of quota between citizens. Points under consideration are a.o. the characteristics of the fuel permit, the distribution of the permits (either the government sells them or gives them away for free), the market allocation of the permits, the time path by which the number of permits available is reduced, monitoring and enforcement of the system and the consequences which a system of tradeable emission permits might have for business location choice. Moreover it is studied whether a system of TCP’s can operate on a national base in one member state of the European Union or if it should be implemented at the European level. Last, the requirements of a EU-wide system are sketched. A study of the implications of reducing CO2 emissions by means of TCP’s (or any other instrument) can not be complete without studying the economic consequences of such a system. To predict some of the consequences of introducing an instrument like TCP’s in an industry a micro-economic approach is necessary in which the influence on one or more facets of economic behaviour is studied in detail. For example, attention has been given to the potential misuse of market power in the permit market (see Tietenberg 1985 and Hahn 1984). On the other hand hardly any attention has been paid up till now to the possible effects of tradeable emission permits on entry into industries. This is especially interesting because it has been practice to grandfather permits to existing sources while new sources, potential entrants, have to buy them. Many people, and even economists have the intuition that in particular such a system of grandfathering will erect barriers to potential entrants, whereas a system of auctioning permits to all firms, established ones and entrants, would not have such an impact, or at least a much weaker negative effect on entry. In chapter 3 and 4 it is analyzed how far this idea is true. The question is addressed whether, how and to what extent a system of tradeable permits might create barriers to entry in the product market. Several forms of entry barriers which might be caused or increased by tradeable permits are identified and analyzed. Subsequently, it is studied whether these forms of entry barriers are likely to occur in the system of TCP’s which is outlined in chapter 2. An effort is made to determine to what extent entry will be affected when entry barriers are raised due to the TCP system.
The above questions are important, not only from a static point of view, but also if a dynamic view is taken. If a TCP-system for reducing CO2 emissions raises entry barriers, it will affect the whole economy, affecting long-term industry dynamics. This in turn might reduce the efforts on research and development and reduce economic activity and efficiency in the longer run in the whole economy. The approach taken here is to study the micro-economic consequences of a system of tradeable carbon permits with respect to entry barriers, both with grandfathering and with auctioning of CO2 emission permits. The results will be compared with the results achieved under two other instruments, taxes and standards. The possible occurrence of entry barriers is analyzed both theoretically and empirically.