Economic and Environmental Analysis of Tradable Permits

The following is an analysis comparing and contrasting the cases of tradable permits in theory and reality in terms of historical and theoretical backgrounds, geographical areas, distribution of permits, goals, the size of the project, involved players, the amount of financing in accordance with costs, effectiveness, efficiency and uncertainty.

The main idea of tradable permits is to create private and transferable property rights to pollute and to create an incentive to reduce emissions in a market system. Tradable permits were introduced to confront and deal with large scale environmental issues such as air or water pollution and CO2 emissions as a result of the greenhouse effect, mainly due to the economic activities of production and consumption, which is a world-wide scale environmental concern. Environmental issues are closely related to negative externalities that are the activities of one party make another worse off without paying the costs of doing the activities outside the market and price mechanism. It is based on the tragedy of commons which include extraction of natural resources such as over-fishing, over-grassing, logging of rain forests, and so on. Such open access natural resources are rivalry and non-excludable from using them which ultimately leads to depletion of those resources and furthermore, environmental damages. Hence, the fundamental goal of tradable permits, as a market mechanism, was to solve the environmental problems by firms or consumers, the polluters, receiving or buying permits from government.

The remarkable feature of tradable permits is that firms could transfer entitlement and right to pollute. Tradable permits are well-known for its effectiveness and efficiency. It is effective because the quantity of pollution is limited which is targeted and set by environmental policy so if one firm needed additional emissions, it would have to buy existing permits from another in the trading market and this another firm would have to decrease accordingly. Some firms can reduce their emissions at lower costs than others that cost much higher to reduce emissions. Thus, those with lower costs would sell permits to those with higher costs, and such practice of trading permits will ultimately lead to reallocation and reduction of emissions, having the total costs of emission reduction minimized. The graphs below show graphically that how optimal amount of pollution, abatement and costs are different among firms.

pollution abatement 1 pollution abatement 2

It is first initiated by government but this fact would not carry significant impacts because, once it has been initiated, it becomes a market instrument so its transfer and price highly depend on demand and supply in the tradable permit market. A government plays an important role when it comes to set a cap by determining the total amount of allowed emission which is based on the historical data or previous years. It seems that tradable permits have been developed in a relative short time and have become popular and pervasive across the world, being supported, recognized and encouraged to practice by economic/environmental organizations and many nations due to its effectiveness and efficiency.

Unlike the carbon/energy tax which easily invokes strong opponents and conflicts, tradable permits have become popular because it does not put much pressure on paying more taxes due to industrial emissions or require the exiting tax structure to change. According to Koutstaal and Nentjes (1995), tradable permits in environmental economic policy were developed by Dales in 1968 but the very fundamental concept has a longer history of trading coupons among consumers in the system of allotting production. It was already started throughout and after the Second World War because people suffered from famine and scarcity of resources and then first practiced for air pollutants through the Environmental Protection Agency (EPA) in the USA from 1975. Especially fisheries, which are known as open access resources have suffered from negative externalities for a long period of history. So, New Zealand which has one of the largest markets for fishing has established an individual transferable quota system to overcome the managerial problems under command and control regulations of season length, areas that are open to fishing, the size of vessels, etc. because such regulations failed to check all the details – administrative uncertainties, ultimately jeopardizing fish stocks. Again, the unique feature in the individual transferable quota system is that the involved firms are able to purchase, sell and trade quotas which are determined by the market to achieve efficiency.

The EU emission trading system is based on the idea that global warming and climate changes are due to human economic activities that causes emissions creating greenhouse gases so the system puts a limit on the quantity of emissions and allows companies to trade emissions allowances as needed, giving some flexibility to achieve the most cost-effectiveness. The extension of the system is quite large covering more than 11,000 power stations and manufacturing plant, including 28 EU member states, Iceland, Liechtenstein and Norway, limiting 45% of total EU emissions by the system, inspiring other parts of the world. The goal of the EU emission trading system is to lower the greenhouse gas emission by 21% in 2020 compared to 2005 by reducing 1.74% each year. Therefore, by 2050, it will be reduced by 80-95% compared to 1990 levels. Companies have cost-effective options in dealing with reduction in their emissions: investment in efficient technology; use of less carbon-intensive sources; purchase of extra allowances on the market – trading permit; any combination of the options to pursue the most efficient way.

The trading system covers the carbon-use and energy-intensive industries including oil refineries, steel words and production of iron, aluminum, metals, cement, glass, ceramic, paper, cardboard, acids and bulk organic chemicals that emit such as carbon dioxide, nitrous oxide or perfluorocarbons. There are mainly two options of distributing permits/allowances. One of them is known as grandfathering which is to provide permits to pollute for free based on the historical records to the existing firms from the government. So, the firms can save their costs and raise profit since they only have to pay for additional pollution.

This leads to the second option which is auctioning. For the additional amount of pollution, firms have to buy more allowances in accordance with the increasing amount at auction. Since it implements the concept that polluters should pay and puts new entrants at disadvantage because they have to bear a lot more emission costs, EU aims to abolish grandfathering by 2027.

The trading system also creates positive externalities in technology because companies have more incentives to invest and innovate related technologies such as carbon capture and storage, and innovative renewable energy technologies to reduce emissions, being financed by the sale of tradable permits to construct and operate such large-scale technological developments. However, the tendency differs by geographical areas. For example, the ability to invest in environmental-friendly technologies with sufficient amount of financing is not as high in eastern Europe and developing countries. Some of them are highly dependent on direct extraction of natural resources to sustain their life or their knowledge or concept to conserve the environment has not highly educated or developed although the trading market has grown up tremendously popular as shown in the graph provided in European Commission:

trading volumes in EU emission allowances

During the first phase of the European Union Emission Trading Scheme from 2005-2007, 2,100 million emission allowances were distributed for free to about 11,000 entities and they were allowed to trade on their own as needed within the EU. The distinctive feature of the phase two, which lasted from 2008 to 2012, was that firms were not allowed banking or borrowing. So, during the phase one and from the phase two, banking was allowed. The following graph shows allowance distribution and actual emissions by sector in 2006:

allowance allocation

As shown, power and heat sector is responsible for 72% of total emissions in EU and received 70% of the total allocation, resulting in a net shortage of allowances. The most of emissions were covered and below allocations but the gap between the allocation and emissions might be due to over-abatement or over-allocation. Also, the problem of uncertainty arose significantly in the phase one because the EU did not have reliable information about actual emissions when they started the market, so the allocations mostly depended on industry projections which contain incentives not to reveal their true costs, resulting in uncertain measurement problems. Besides disapproval of banking and borrowing during the phase two, another feature was that the EU ETS was encouraging and promoting the tradable permits through auctioning among the firms. The governments tried to increase the limit of 5% auctioning up to 10% in the second phase for a number of reasons: it increases efficiency; it reduces the distortions/uncertainties in free allocation; it increases predictability for investors by agreeing to target price ranges before, creating more stable EU ETS market. In the long-term, it provides carbon price signal by recycling revenue. Revenue is recycled to reduce other distortionary taxes on labour or capital in the economy, providing price certainty.

In the case of New Zealand emission scheme, since the launch in 2008, it has focused on transition measures to moderate the scheme’s impact, evolutionary practices to meet its 2030 target, and operational and technical improvements. The government has been supportive by funding in the supply management to meet the overall greenhouse gas reduction target which is %5 reduction from 1990 by 2020, 30% reduction from 2005 by 2030 and 50% reduction from 1990 by 2050. in 2013, the overall greenhouse gas emissions were 81 MtCO2e which was measured according to the measurement guidelines such as the Good Practice Guidance and Uncertainty Management in National Greenhouse Gas Inventories, Good Practice Guidance for Land Use, Land-Use Change and Forestry, the Climate Change Convention guidelines on reporting and review and the Kyoto Protocol guidelines on reporting and review. That number covered a number of sectors by order of the largest emissions: agriculture, energy, transport, industrial processes and other product use and waste . They were gradually phased into the system over time and it was enforced to be mandatory for some parts with voluntary opt-in for other parts in the sectors. 2,536 entities are registered and covered in the system and 2,468 of them have obligations to surrender permits – surrender obligations – reported in June 2015.

So how have they implemented the system in terms of allocation is intensity-based allocation for the industrial sector?

The government allotted 90% of free allocation for highly emissions-intensive activities whereas 60% of the permits were allocated for moderately emissions-intensive activities. The government discriminated the permits according to the intensity of emissions by sector. In the New Zealand Emission Trading system, it has no fixed cap in forestry to accommodate carbon sequestration but in non-forestry sectors, it has introduced auctioning in 2012 within the overall cap .In terms of enforcement, it imposes a penalty of NZD 30 for each unit of failing to surrender emission units. Furthermore, if entities failed to collect/submit data, they would be fined up to NZD 24,000.

However, in implementing the New Zealand Emission Trading system, it caused whole lot of social and cultural debates due to different subjectivities and perspectives between farming practices and the environmental governance in terms of mitigating greenhouse gas emission activities through political and economic justifications for market-based instrument – trading permits. In theory, the state would distribute tradable permits that require polluters to surrender the number of permits approved, based on a reference year to achieve economic efficiency but, in reality, strong opposition arose from the financial liabilities when the farmers comply with the environmental targets of the state, based on their identities, interests and institutional contexts. Also, there were disparities between farmers’ prevailing subjectivities and environmental subjectivities because some thought that the permit system limited farming practices to some extent although agriculture is a big portion in the economy in New Zealand and others resisted the idea of buying permits to continue to pollute. As stated, it involved a variety of complex aspects surrounding the permit system.

Switzerland also addresses a range of environmental issues associated with pollution of air, water and soil, reduction of biodiversity degradation and mitigation of climate change. In order to deal with the environmental concerns, they also adopted the “polluter pays” principle since January 2008, commencing the Swiss ETS, which covers 400 involved companies with permits to 3 million tonnes of CO2. The overall reduction target was to reduce the emissions more than 20% by 2020 compared to 1990 with the sub-target of 25% reduction for heating and process fuels amounts by 2020 The Swiss ETS has attempted to promote more efficient use of natural sources by investing more in energy-efficient technologies and the use of low-carbon energy sources. The Swiss ETS has been reaching cost-efficiency and flexibility of compliance through more access to a bigger and more liquid market in relation with the EU as well as the continuous support from the Swiss government for energy-intensive companies to connect with the ETS.

In deciding which one of tradable permits or carbon tax is better, it considers a number of factors. In the context of small trading countries like New Zealand, if the country was the first-mover to implement tradable permits or carbon tax before other countries, that country would have some advantages with the carbon tax policy because the producers of export and import substitution products bear most of the costs, capturing carbon leakage and reducing unnecessary industry structural adjustments.

Also, in terms of cost increment, the carbon tax system seems to be more appealing because it shows a greater stability and certainty. Also, with regard to the long term view of greenhouse gas emissions, the carbon tax system also shows a greater price stability. Another article stated that in Central and Easter Europe, the tax system is a more prevalent and popular system but it is too low to meet the environmental target but only builds barriers for more efficient policies.

However, it seems to be constrained to a geographical area and a small open countries and the tendency gradually turns to impose tradable permits which lead to a net gain in economic efficiency by equating marginal social benefits and costs stability. For instance, New Zealand switched to a tradable permit scheme in 2005, and 27 European Unions countries and Australia introduced the trading system as well after New Zealand. One reason could be that carbon charges create political resistance and conflicts between the state and certain involved industries having the disadvantage of increased tax which is the additional financial burden or changing the existing tax structure. Charging tax would require the involved industries considerable efforts to readjust their tax structure and even re-construct their internal system to avoid tax.

Also, certain geographical areas such as Southern EU member states strongly resisted the carbon tax scheme because the system only favours those with more developed economies with more financing to invest and support to initiate and operate the program more efficiently. Moreover, tradable permits deliver political expediency because it initially allows to efficiently and conveniently distribute the allowances free for those that fall under the eligible category.

So, it also has a feature of political convenience in the initial assignment of allowances. Under changing Economic environment, carbon tax is more vulnerable because in times of inflation, the tax would be decreased in the real value that the firms could relatively increase their emission whereas the total amount of carbon emission is fixed under the tradable permit system. Also, the trading system is feasible and practical to implement through grandfathering and auctioning as mentioned above. Hence, tradable permits are more politically desirable.

Another equally important case of tradable permits is the U.S. Acid Rain Program. According to the United States Environmental Protection Agency (EPA), the Acid Rain Program (ARP) is a market-based program aimed at reducing the overall emission of sulfur dioxide and nitrogen oxides, which cause acid rain. This emissions trading program predominantly targets coal-burning power plants, allowing them to buy and sell emission permits based on each firm’s own cost-benefit analysis.

In the 1980s, the United States began to have issues with acid rain. In 1990, the Clean Air Act declared that the government of United States aimed to reduce overall SO2 emissions by 10 million tons. There are two phases in this Act. In Phase I, by January 1, 1995, the program targeted on 110 electric power plants to reduce their sulfur dioxide emission rates to 2.5 lbs/mmbtu.Each of these power plants was classified by name and location, and a quantity of emissions quota was specified in tons of SO2 emissions annually. Moreover, new power plants built after 1978 were required to minimize sulfur dioxide to a lowest emissions rate of which is 0.6 lbs/mmBtu. In order to reduce emissions, for each ton of sulfur dioxide reduced below the emissions limit, a power plant received an emissions allowance they could use at another unit, keep for future use, or sell to other firms. The freedom to buy and sell emission allowances created a market of tradable permits.

In Phase II, all coal-fired power plants were needed to limit emissions of sulfur dioxide to 1.2 lbs/mmBtu by January 1, 2000. Phase II covers more firms and it also increased the penalties for firms who did not want to participate in emissions permit trading. Moreover, total emissions were limited each year based upon U.S. EPA regulations. Currently, only 8.95 million tons of SO2 emissions are permitted annually in U.S.

The 1990 Clear Air Act also aimed to reduce nitrogen oxide (NOxx) emissions. The key factors in NOxx formation are flame temperature and combustion (Chestnut and Mills, pg.254. 2005). Installing the low-NOx burners are the most common methods to emissions up to 50%. Therefore, many firms installed low-NOxx burners, which demonstrates Low-NOx burner technology was ready to use.

As part of U.S Acid Rain Program, the tradable permits of SO2 emission are proposed to motivate firms to adopt the most efficient strategy to reduce the emission. Every ARP operating permit highlights specific requirements and options that firms select based upon their specific needs. These requirements often require investment and upgrades in equipment in order to monitor emissions and pollution. For example, monitoring systems must be installed in smoke stacks that transmit daily emissions data on SO2, NOx, and other pollutants to the Environmental Protection Agency in order to monitor progress and provide credibility to the trading section of the U.S Acid Rain program.

There are several uncertainties that affect the efficiency and effectiveness in executing this program, which include the cost of fuels, the value of emissions permits, and the operation of markets. For example, firms renegotiated contracts with a goal to be risk averse and more flexible in choices.

The U.S Acid Rain Program has successfully decreased the annual emissions of sulfur dioxide by 8 million tons, nitrogen oxides by 2.7 million tons from 1995 to 2009. Moreover, in U.S, SO2 emissions have decreased 40%, and acid rain levels have declined 65% since 1991.

However, the US Acid Rain Program has not reduced SO2 emissions as much as the EU emission trading system, which reduced SO2 emissions by more than 70%. Therefore, the effectiveness of the Acid Rain Program has been criticized. A significant issue with this Acid Rain Cap and Trade Programs is that the cap is high enough that some firms do not need to reduce their emissions. Despite these recent positive outcomes, the ARP still remains less effective than EU pollution regulations. Thus, it is clear that the tradable permits of U.S Acid Rain Program need to be re-evaluated in terms of their economic distribution and regulations. Also the cap of emission and pollution need to be set lower to achieve more efficiency and effectiveness in this U.S Acid Rain Program.

In operating the tradable permit system, countries run into difficulties, limitations and critiques. For example, the EU ETS at an international scale, companies that emit more based on the historical records would receive more permits, conveying the issue of fairness among the involved firms in the industry. Also, the system also invokes the issue of significant amount of transaction costs because: companies cannot monitor and record their emissions; there is a possibility to contain measurement errors in data; the permit price could be expensive on high demand or not available. For the fisheries in New Zealand whose trading mechanism is individual transferrable quotas, it is distributed, again, based on the historical records not by the sustainable yields and the trading market boom in New Zealand abolished small firms out of the market.

Also, industries like fisheries are seasonally sensitive so when the stock is full for high demand, the market prices are high, resulting in price volatility. Transaction costs take quite a portion across the participating countries because in the process involves traders and brokers who match buyers and sellers in the commission range of 3% – 25% which varies by locations or sector. Moreover, the volunteer opt-in provision has its structural problem because the practical problem of setting a baseline for permits arises by discouraging low cost firms from joining the tradable permit system which only have to bear uncompensated costs. Also, for those who do not comply with the tradable permit system, high penalties are applied in all the European systems along with hard caps. However, the involved firms would pay the low penalties rather than paying the high marginal costs to comply with the cap. In principle, regardless of the initial assignment of allotting permits, the trading system will achieve goals of equity and cost/effectiveness but in practice, initial allocations may have some impacts on improving feasibility of the system or proving inadequately addressed equity concerns in the system of trading permits. So, there seem to be some disparities between implementing the tradable system in principle and practice.


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