how to regulate carbon emissions

HOW to regulate carbon emissions

Mads Nørgaard Jørgensen & Tobias Rune Caspersen, Institut for Statskundskab, Københavns Universitet

Analysing the principles of THE EU EMISSION TRADING SCHEME AND THE CARBON REDUCTION LABEL

List of Contents

1. Introduction 3

2. Analytical approach 4

2.1 Defining regulation 4

2.2 Case selections 4

2.3 Defining the mind of companies 6

2.4 Structure 7

3. Regulating in theory 8

3.1 Standards 8

3.1.1 High or low standards? 8

3.1.3 Process standards 9

3.1.4 Uncertainty 9

3.2 Sanctions 10

3.3 Marketing potential 10

4. Carbon Reduction Label 12

4.1 Presentation 12

4.1.1 PAS 2050 12

4.1.2 Carbon Reduction Label 13

4.2 CRL analysis 15

4.2.1 Logic of rationality 16

5. EU Emission Trading Scheme 20

5.1 The system in action 20

5.2 Analysing the European approach 21

6. How to regulate carbon emissions 25

6.1 Perspectives on regulating carbon emissions 25

7. Conclusion 28

8. References 30

How to regulate carbon emissions December 2009 2

Mads Nørgaard Jørgensen & Tobias Rune Caspersen

1. Introduction

The concept of climate change is a relatively new problem faced by global policymakers,

business leaders, and NGOs, and consequently, the proposed regulative solutions diverge

greatly. How to cope with climate change is perhaps one of the most relevant questions today

as the time of the Kyoto Protocol is running out and an heir is sought.

Climate is something widely different from most other political problems in the sense that for

once, it is actually a necessity to reach agreement internationally if the notion of the nation-

state as the effective political unit is to be maintained with some creditability. It is an

international problem and national public solutions are simply not enough (Reinicke, 1998;

Kaul, 1999: 464). Even though the severe limits of the Kyoto treaty and the difficulties of

obtaining a new one might suggest that public regulation by nation-states is ineffective on

global issues, the European Union does show that international binding public regulations can

be accepted and implemented by the countries involved through the EU Emission Trading

Scheme.

On the other hand, academia and the private sector suggest that this might not be the most

efficient way to deal with the problem (Reinicke, 1998: Chapter 2; Cutler et al., 1999: 3). Private

regulation is a radically different approach to achieve the goal of cutting carbon emissions, but

the economical incentives of good public relations might just let the market forces do the trick;

an approach such as the Carbon Reduction Label has its own advantages and disadvantages

vis-á-vis intergovernmental regulation. To acquire knowledge of how to regulate carbon emissions,

we analyse the problem case wise through the following question:

What are the advantages and disadvantages of regulating carbon emissions through the

European Union’s Emission Trading Scheme and the Carbon Reduction Label?

The arguments for this approach are outlined in the next chapter. In answering the problem

three preliminary questions stand before us: first, how do we define regulation; second, to what

extent can our findings of the two cases be used in general; and third, how do we define the

mind of companies, which the regulation seeks to influence. These questions will be answered

consecutively followed by a structuring of the paper.



2. Analytical approach

2.1 Defining regulation

It is our understanding that for a regulation to be effective it has to exercise power. Robert Dahl

describes power as: “A has power over B to the extent that he can get B to do something that B would

not otherwise do” (Dahl, 1957: 203). We therefore define regulation as containing both a specific

goal or rule and influencive means to make companies comply with it.

Furthermore we focus on regulation approaches that are general in scope, even though we see

a tendency for sector-specific regulation as more common (Gunningham, 2007: 223. The

distinction is important because the general approaches are faced with somewhat more

complex interaction of their policy content, while the sector-specific assumable can specialise

their approach, due to a more thorough following of the sector stakeholders and companies.

Further, as we want to shed light on some of the differences in advantages and disadvantages

of intergovernmental and private regulation approaches, sector-specific cases simply would be

less possible to compare.

2.2 Case selections

The main focus of this chapter is to consider how well the selected cases are representative of

the present landscape for regulating carbon emissions, which is important to be able to

generalise our findings. In doing so it is necessary to clarify the selection process of the Carbon

Reduction Label and the EU Emission Trading Scheme as our cases.

The selection is carried out according to three criteria, derived from our definitions:

- Significant elements of either private or intergovernmental climate regulation.

- The ability of the regulation approach to enforce the policies chosen.

- General and not sector-specific in scope.

Starting with the first of the criteria, it stems from a consensus in the literature on the subject

that these are the only types of regulation capable of handling global problems (Kaul, 1999,



464). According to Reinicke, national regulations would lead to a race to the bottom (Reinicke,

1998). Even though it is said that neither intergovernmental nor private regulation are pro-

active by nature, they stand out as the solutions since climate change is upon us now.

Purely private or intergovernmental climate regulation is of course ideal types, and we cannot

hope to find real world examples hereof. As a consequence, the criterion is merely used to

focus on significant elements of each type and strive for cases as close to the ideal types as

possible. Excluded are therefore national climate regulation approaches, private-public

partnerships and similar hybrids on the grounds that to use our conclusions outside the specific

cases at all, we will need to be as close to the ideal types as we can.

The second criterion is a necessity based on our definition of regulation from Dahl’s

description of power. Hence, regulation approaches that do not contain an ability to enforce its

decision either directly or indirectly have no real power and would be meaningless to include in

the analysis.

The third and final criterion directly follows our choice of analysing general regulation

approaches. Even though general and sector-specific approaches differ in scope, we find it

reasonable that many of the methods of general regulation approaches can be used on sector-

specific regulation approaches, as least more so, than the other way.

As a consequence of these criteria, other regulation approaches have been left out. These

include as an example the UN Global Compact, which is a private/intergovernmental hybrid

with no real power to enforce itself (UN Global Compact, 2009), and the solemnly vision-

declaring Nairobi-declaration of the African Union (African Union, 2009: 9).

By these criterions, the European Union’s Emission Trading Scheme and the originally British

private initiative of Carbon Reduction Label stood out as prime examples. They are both

general in their scope and the two cases with the least mix of public and private regulation

within the same approach even though the Carbon Reduction Label were originally initiated

by the British government. Hence, the cases are not ideal types but they are as close as we can

get in a complex real world and the advantages and disadvantages of each can within reason,

following the arguments above, be used outside this context as estimates of intergovernmental

and private types of regulation.



2.3 Defining the mind of companies

Companies are assumed to be rational actors. We find this choice to be reasonable based on

the very short timeframe available if we are to successfully react to climate change as pointed

out by the IPCC (IPCC, 2007: 775). Norm and sociologically determined acts requires a longer

learning process to influence patterns of actions significantly (Cutler et al., 1999: 9). As stated

before, according to the UN climate council, there is not enough time to wait for these

processes to effect incentive structures and thus emissions. If we were to include norm and

sociologically determined acts, we would have to moderate and restrain our conclusions even

further. Such additional precautions lower the validity of the analysis. Even though reliability

in principle would suffer by looking at the problem from only a single theoretical perspective,

the relatively short timeframe provide some leverage to our choice of focussing on rationality.

Through the lenses of rationality, regulation is an attempt to correct the failures of the free

market. Being a non-excludable public good the environment is a collective action problem,

because the cost of polluting is not paid by the polluters (Prakash & Potoski, 2006: 43). The

invisible hand of Adam Smith simply does not take these externalities into account (Smith,

2003: section 2.3). This market failure needs to be corrected by the public to maintain correct

market terms where the huge cost to the environment caused by pollution is somehow

minimised through less pollution, or strictly economically speaking, through sanctions that

makes up for the cost to the environment.

Because we assume companies to be rational, the otherwise fairly distinct types of regulation

become much more blurry. Regulation can be seen as either hard or soft regulation; determined

by whether the policies punishes companies if they are not acting as desired (in this case

polluting excessively), or if the policies try to change the direct incentive structures by making

it profitable to act as desired; the stick (hard regulation) and the carrot (soft regulation),

respectively. However, the assumption of rational actors and the focus on economic incentive

structures make these ideal types to a graduation of no real practical importance. If everything

is seen in terms of economic incentives then both direct sanctions (fines, confiscations etc.) and

indirect ones (image amongst clients, experts, competitors, industry organisations etc.) work in

exactly the same way.



2.4 Structure

First, we cannot measure the exact outcome of each approach by how much reduction of

carbon emissions it produces. Second, we cannot obtain valid quantitative data concerning the

economic implications on each identified parameter, singling out what is caused by each

approach. As a consequence, the analysis will position itself on a purely theoretical platform,

the only empirics being the cases themselves. In answering the question we therefore look at

advantages and disadvantages of the regulation approaches through their economical

implications for the companies, their rational incentive structures, on a qualitative level.

Doing so the next chapter will clarify which parameters to be looked at and the precise

theorems for what these parameters mean for the differences in economical incentives.

Through our assumptions we will deduce three main parameters which arguably contain the

essential elements for an objective, qualitative evaluation of the regulation approaches.

The Carbon Reduction Label and the EU Emission Trading Scheme is analysed in chapter 4

and 5, respectively. Before the actual analysis and assessment of advantages and disadvantages

of each regulation approach, each chapter briefly outlines the current policies and mechanisms

of the case in question. The analyses is concluded by recapitulating the advantages and

disadvantages to deduce some general perspectives on how to regulate carbon emissions.



3. Regulating in theory

To be able to creditably analyse and compare the two regulation approaches, addressed later,

this chapter presents the advantages and disadvantages of varying regulatory methods. The

presentation is divided into three distinct parameters: Standards, sanctions and marketing

potential. Following our definition of regulation, drawn on Dahl’s idea of power, regulation

includes some sort of rule or goal, here called standards. Furthermore, the definition requires

the regulation to influence the companies to comply with the standards. Our assumption that

companies act rationally according to economic incentives, opens two ways to compliance:

Punishment or reward. The punishment is presented as sanctions and reward as marketing

potential. To cover both intergovernmental and private types of regulation the presentation is

sought to be general in scope.

3.1 Standards

3.1.1 HIGH OR LOW STANDARDS?

First of all, the regulator needs to consider the degree of regulation: Should it have high or low

standards? Of course the regulator would prefer as high a standard as possible, but the

consideration is important since the degree of regulation is negatively correlated with the

degree of compliance. If the standards are two high the compliance will tend to be low,

because of the associated high costs of complying (Prakash & Potoski, 2006: 56).

3.1.2 SPECIFICATION OR PERFORMANCE STANDARDS?

Roughly speaking, there are two types of standards: Specification or performance standards. A

specification standard is a standard that tells the companies exactly what to do. It defines one

specific method and therefore requires virtually no interpretation. It does however include

some disadvantages; to be effective the guidelines need to be extremely detailed, which makes

it difficult for companies to comprehend and difficult for the regulator to keep up to date.

Furthermore it inhibits innovation and does not encourage individual best practice

(Gunningham, 2007: 212).

A performance standard, on the other hand, sets a general goal and lets the company decide

how to comply. The backside here is first of all the additional administrative cost associated



with the necessity of control by the regulator. Secondly, it may be burdensome for small and

medium-sized enterprises to develop their own methods for compliance. In such cases it is

preferable that the regulator provides technical advice (Gunningham, 2007: 214).

3.1.3 PROCESS STANDARDS

The central element in process standards is an encouragement to go beyond the minimal

standards by providing incentives for companies to make continuous improvement

(Gunningham, 2007: 214). This is achievable by making different standard-levels and thereby

different levels of compliance. Process standards are therefore a way to include both low and

high performers and can be used with both specification- and performance standards.

3.1.4 UNCERTAINTY

When evaluating the use of standards, it is also important to consider the uncertainty that rests

about future regulations. If this uncertainty is too high companies will be reluctant to lead the

way and invest time and money in complying.

Being the first in a new market means the possibility of a price premium as you receive a short-

term monopoly status, as well as the longer-term profitability of learning the new techniques

and accumulating experience here within before your competitors. The latter means that the

competitors would have to pay a higher price at any given time for a comparable product since

the experience curve makes it continuously cheaper to produce any particular good, including

non-polluting goods (Johnson et al., 2008: 336). However, within the sphere of politically

controversial matters, such as the environment, first mover’s advantage is somewhat reduced as

regulation can change very fast making expensive investments less certain and thus less

worthwhile. In such cases, the literature on microeconomics tend to favour a fast second

approach instead, meaning that the rational solution would be not to take the risk of being the

first to invest in something uncertain but always be ready for fast investments when regulation

seems to be relatively certain (Johnson et al., 2008: 338). In that way one tries to maximise the

benefits of learning new techniques fast making it cheaper to produce these new goods faster,

but without taking the potentially very unprofitable investments in completely new and

politically uncertain territory.



3.2 Sanctions

One way to encourage companies to meet the regulation standard is to threaten with sanctions

in the case of non-compliance. For this to be effective third party monitoring is of vital

importance, due to a general lack of public scrutiny in companies and consequent information

asymmetries (Prakash & Potoski, 2006: 58).

3.2.1 COMMAND AND CONTROL OR INFORMATION REGULATION

The type of sanctions can be divided between command and control- or information

regulation. Command and control regulation is the classical type, with clear guidelines for

compliance, which if not met, are followed up by economic or legal sanctions. For private

regulations, carrying out these sanctions requires a mandate given by the regulator. The state

has a monopoly on the use of legitimate violence, which means that all intergovernmental

regulation besides the EU needs states’ acceptances in all cases of sanctions (Cutler et al.,

1999: 359).

In information regulation there is not necessarily any direct demand for change. Instead the

approach relies upon the public opinion and the economic market as the mechanisms to bring

about cuts in carbon emissions. The logic is that firms care about their reputation: By naming

and shaming the laggards will lose reputation and consequently be punished in the market

(Prakash & Potoski, 2006: 62). This logic is further examined below.

3.3 Marketing potential

Marketing potential is a reward to compliers. By marketing that the company is socially

responsible it enables itself to differentiate its products, which attract costumers and/or allows

it to charge a price premium.

The reason for this marketing potential is related to the fact that regulation of carbon emissions

induces companies to undertake costs to produce a public good. In return for cutting carbon

emissions, companies receive goodwill from external stakeholders, such as consumers, interest

organisations and the government (Prakash & Potoski, 2006; 49).



Marketing potential however, requires that the design of standards makes it possible for firms

to differentiate themselves from each other. In general, this could be accomplished by using

process standards, as discussed above. For voluntary regulations it would be possible to

differentiate between members and non-members.

Taking the same action unilaterally would be less credible, because it is non-institutionalised

(Prakash & Potoski, 2006: 53). Moreover achieving good reputation is less costly when

affiliated with a credible regulative program due to economies of scale, a dynamic akin to

network effects: one company’s progressive environmental activities generates positive

reputational and goodwill externalities for other companies within the regulative program

(Prakash & Potoski, 50-51).



4. Carbon Reduction Label

After having defined the parameters necessary for an assessment of regulation policies, we turn

to the actual analysis of our two cases; beginning with the Carbon Reduction Label. Initially,

we will present a brief introduction to the concrete nature and regulation mechanisms before

proceeding with the assessment.

4.1 Presentation

The Carbon Reduction Label is a regulation approach that labels product’s carbon emissions. It

is managed by the Carbon Label Company, which is a subsidiary of the Carbon Trust. The

Carbon Trust is a private organisation tasked with creating practical business-focused solutions

and advising organisations on how to reduce their carbon emissions (The Carbon Trust, 2008:

10). The organisation is funded by the UK Government and is therefore providing its services

to businesses free of charge (The Carbon Trust, 2007: 7). The organisation is however not

limited to the UK but targets companies around the world.

4.1.1 PAS 2050

The Carbon Reduction Label builds on the Public Available Specification (PAS) 2050, which is

an approach to assessing carbon emissions developed by the Carbon Trust among others (The

Carbon Trust, 2008: 8). The PAS 2050 differs from other standards in view of the fact that it is

aimed at measuring products and not entire companies (The Carbon Trust, 2008: 1). The

advantage hereof is the ability to label products according to their carbon emissions.

To develop the PAS 2050 it was important to consider the balance between consistency, to

ensure the measurement reliability, and practicality, to ensure business support. To make the

assessment consistent it is essential that the whole life cycle of the product is included in the

calculation. The distinct stages identified are listed in the figure below.



Figure 1: Product life cycle

There is however some practical difficulties involved. First, companies producing more than

one product need to divide up their emissions. Secondly, the producer of the end product

might not be in control of the whole life cycle. It is, as an example, very common that the

manufacturing company is not involved in the procurement of raw materials. The solution

provided by the PAS 2050 is for the companies to provide the information up to their point in

the chain (The Carbon Trust, 2008: 12). Thirdly, the ‘use phase’ is difficult to measure, because

there is no certainty over how any product will be used, and lastly how to grasp with recycled

materials. With the last two issues, PAS 2050 draws on existing standards, like the ISO 14044

(International Organisation for Standardization) and the Greenhouse Gas (GHG) Protocol

(The Carbon Trust, 2008: 12-13).

Furthermore, for the PAS 2050 to be practicable, it has set a de minimis limit. According to

their publication it ‘allows any one source contributing less than 1% of the total footprint to be excluded,

provided the total exclusions do not exceed 5% of the overall product carbon footprint’ (The Carbon

Trust, 2008: 12).

Because the PAS 2050 has tried to find a middle ground between consistency and practicality,

it is, as shown, not possible to be completely prescriptive. The Carbon Trust has therefore

written a Code of Good Practice, which, however, will not be discussed here.

4.1.2 CARBON REDUCTION LABEL

Building on the PAS 2050, the Carbon Reduction Label ‘offers companies a way to display their

products’ carbon footprint information consistently, credibly and with a commitment to reduce the

footprint over time’ (The Carbon Trust, 2008: 7). It is set up to meet the market needs for carbon

emission visibility demanded by both producers and consumers. With their own words it



“addresses businesses’ need to better understand how their products and supply chains impact carbon

emissions and to respond to growing consumer demand for carbon information and low-carbon

products” (The Carbon Trust, 2008: 2).

For companies to use the label they have to be certified by the Carbon Label Company.

Furthermore, the Carbon Label Company requires that companies reduce their carbon

emissions over a two year timeline. If not, the companies will loose their certification (The

Carbon Label Company, 2009)

The graphics of the Carbon Reduction Label includes at least the carbon emissions per unit

and the statement “We have committed to reduce this carbon footprint”. Apart from this there are

three optional elements:

“An educational element explaining how the footprint is created. This could explain whether the

measurement includes GHG emissions associated with food preparation or the washing of a

garment, for instance.

Product comparison information between different items produced by the same company and

within the same category.

Customer action tips on appropriate products, empowering consumers by showing them how they

can reduce emissions when using, preparing or washing the product, for instance.”

(The Carbon Label Company, 2009)

At the moment there are a only 21 companies publicly displaying their carbon footprint (The

Carbon Trust, 2008: 19). The figure below shows an example of a Carbon Reduction Label.



Figure 2: Continental Clothing (The Carbon Trust, 2008: 27)

4.2 CRL analysis

Looking at the description above, with the presented theory in mind, it is clear that the Carbon

Label Company puts to use the logic of information regulation to influence companies to

reduce their carbon emissions. The Carbon Reduction Label makes it possible for the

consumer to make an informed choice based on products’ carbon emissions. Assuming

consumers prefer low carbon products, it will affect companies towards reduction of carbon

emissions.

This logic, however, presupposes almost universal use of the label, which is at present not the

case. It is therefore pivotal to deduce the rationale for companies to join the Carbon Reduction

Label. First, calculating carbon emissions specific to every stage of the products enables

companies to locate ways to reduce their carbon emissions, and thereby also reduce their costs

of production. Second, the Carbon Reduction Label provides the means for companies to

credibly display their efforts to reduce their product’s carbon emissions. The carbon Reduction



Label serves as a symbol of the company’s commitment to reduction. Third, and most

importantly, the label makes it possible for companies to differentiate themselves form each

other, and thereby produces a race to the top, where companies strive to lower their carbon

emissions as much as possible, to have the product with the lowest carbon footprint.

These marketing benefits necessitate high credibility of the Carbon Reduction Label. The

Carbon Label Company has therefore set a standard requiring companies to reduce their

products’ carbon emissions. Companies not complying is sanctioned though expulsion, which

ensures credibility.

Contrary to the marketing benefits the method for measuring, the PAS 2050, causes

administrative costs conflicting the rationale for joining. Measuring product carbon emissions,

as described by the PAS 2050, is a challenging task, compared to measuring a company’s

overall carbon emissions, as used in the EU ETS. In the overall measure you simply sum up the

onsite fuel and electricity consumption and the use of transport and convert the figures to CO2.

On the other hand, to calculate the carbon emissions of a single product, as described above,

you need to divide your emissions between your products and include indirect emissions

discharged by your suppliers and the consumer. This is not only difficult and costly, it might

also be unattainable, because it requires the willingness from all parts in the supply chain to

cooperate, which might not be in their individual rational interest. Even though the PAS 2050

in some instances draws on existing codes, ISO and GHG, the conclusion stands that the PAS

2050 is very comprehensive and costly for companies to adopt.

Following this, it is essential to determine the uncertainty of the associated costs. If the label

does not become prevalent the marketing potential will be lost and the only use of calculation

is an internal search for carbon efficiency.

4.2.1 LOGIC OF RATIONALITY

In summery, joining the Carbon Reduction Label rests on a cost-benefit analysis of the costs of

measuring compared to the marketing potential it might bring. The cost-benefit analysis,

however, differs in accordance to the phase of the label: Start-up phase compared to complete



phase. Furthermore, the cost-benefit analysis is influenced by the specific product’s level of

public attention (high or low) and its degree of measurement complexity (high or low).

In the start up phase, characterized by few members, simply using the label is a marketing

benefit, because it symbolises a company’s good intentions. Another benefit the ‘first movers’

receive is valuable knowledge of measuring. However, with only a few members it is difficult

for the consumer to analyse whether the specific amount of carbon emissions is high or low,

because of the relatively few opponents to compare with. This reduces the overall marketing

potential. Furthermore, if the label does not succeed, the costs of being a first mover will be

lost. Being a ‘fast second mover’, on the other hand, you still receive a great share of the initial

benefits, but greatly lower the uncertainty of loss.

In the complete phase, characterised by many members, it would be rational either to lower

your carbon emissions as much as possible, or not at all and thereby exit the Carbon Reduction

Label. If you undertake costs to reduce your carbon emissions, the highest payoff in marketing

potential will be obtained by being the lowest polluter. Looking at the opposite logic, if you are

at the bottom of the list in your specific category, you would be better off not displaying your

carbon emissions at all. In the long run the Carbon Reduction Label will therefore not be

efficient in regulating the low performers; they are better off outside the label.

Looking at different products, it is irrefutable that high complexity of the product greatly

increases the costs of measuring its carbon emissions. The figures below show the life cycle of

a complex and a simple product, respectively. For some sectors of products, the costs of

measuring might greatly exceed the marketing potential the label brings. It is therefore not

evident that the Carbon Reduction Label is suitable for regulating all sectors.



Figure 3: Boots Botanics shampoo (The Carbon Trust, 2008: 11)

Figure 4: Innocent’s smoothie (The Carbon Trust, 2008: 11)



Lastly, the public attention, determining the marketing potential, is not a fixed size. There may

be sectors with low public attention such as raw material extraction. In such cases it would be

irrational to undertake the costs of measuring and reducing carbon emissions; at least if based

only on the Carbon Reduction Label.

In conclusion, the Carbon Reduction Label is best suited at regulating companies, whose

products are of low complexity and high public attention. Furthermore its great force lies in

providing incentives for the high performers, but, because the label is voluntary, there are on

the contrary little incentives for low performers to join the label in the long run.

It is therefore obvious that the Carbon Reduction Label is not able on its own to regulate all

possible polluters.



5. EU Emission Trading Scheme

As with the Carbon Reduction Label above, we will start with a short presentation of the

characteristics of the Emission Trading Scheme before moving on to the analysis.

5.1 The system in action

The European Union’s Emission Trading Scheme (ETS) is a regulation approach that allows

companies to trade emission allowances with each other and thus provide an attempt towards

an efficient allocation of emissions to the industries where change would be most costly. It is

by far the largest emission trading scheme in the world and currently covers more than 10,000

installations in the energy and industrial sectors1 which are collectively responsible for close to

half of the EU's carbon emissions and 40% of its total greenhouse gas emissions (Wagner,

2004: 12; European Commission, 2008).

To compensate for emission variances from year to year caused by changes in weather, the

emission allowances under the ETS are given as part of a series of years at a time; the so-called

trading period. The first part of the scheme, the very first trading period, took place from

January 2005 to December 2007, the second from January 2008 to December 2012. Within

each of these trading periods, the affected companies can also bank and borrow, meaning that

a unit of allowance in 2009 can be saved (banked) and used in 2010 or borrowed and used in

2008. In general, interperiod borrowing is not allowed, but it is accepted to save allowance

units from one period to be used in the next (Stauffer, 2009).

5.1.1 ALLOWANCES

The actual granting of allowances to the specific operators is done by the national governments

of the EU, but the overall emission cap and the proposed national allocation plans (NAP) on

an industry level do need to be approved by the commission (European Commission 2009).

The governments are also responsible for the tracking and validating of the actual emissions

against the assigned amounts. The companies may reassign or trade their granted allowances



1 As per part I of the scheme the following are covered: combustion installations with a thermal input above 20MW, mineral oil refineries, coke ovens, production and processing of ferrous metals, mineral industry (cement clinker, glass and ceramic bricks) and pulp, paper and board activities.

in a number of ways: First, they can move them between operators still within the same parent

company (this includes cross-border reassignments). Second, they can trade privately using a

broker as mediator, or third, they can use one of the climate exchanges in Europe. The latter

works in much the same way as a stock exchange; buyers and sellers are matched by the

current market price. Further, the regulation allows companies to trade projects that reduce

carbon emissions in completely the same way as the actual emissions; this includes projects in

developing countries. As the EU ETS is designed to be more or less compatible with the Kyoto

Treaty, this means that if a project reducing 1 tonne of CO2 is certified by the UNFCCC

(supervisors of the Kyoto Treaty) it will count as a EU Allowance Unit of 1 tonne of CO2 and

can be traded as such on a one-to-one basis (Carbon Finance, 2008; COP7, 2001).

The aforementioned allocations have changed somewhat as the ETS regulation has matured.

The phase 1 allocations were higher than the actual emissions in 2005 (Parker, 2008: 6).

However, the objectives here were quite modest in terms of reduction (only 1-2% in the EU) as

the main goal was implementation (Ellerman & Joskow, 2008: 7). Further, even with over-

allocation of allowances the emissions were lower than forecasts by 3-4%, which at least

partially was caused by the ETS’s putting an additional price on carbon although it was still

very little (Buchner & Ellerman, 2007). By phase II, the general emission cap was 6% lower

than 2005 levels (European Commission, 2006).

5.2 Analysing the European approach

The Union’s Emission Trading Scheme provides a regulation scheme based on distinct

command-and-control sanctions. By demanding that the companies of the sectors included do

not pollute more than the emission allowances allocated to them or acquired through purchase

or emission-reducing initiatives, the scheme face problems very much different from the private

scheme of Carbon Reduction Label introduced in the previous chapter.

Two major critical concerns have been raised about the ETS; volatile prices and windfall

profits. The first of these emerges from the fact that the price of emission permits rose by a

factor of three within half a year of phase I, and declined to almost zero a year later (Cozijsen,

2009). This is very problematic as the system was unable to deliver stable incentives to the

companies involved (Ellerman & Joskow, 2008: 15). However, the energy sector has always



been fairly volatile and it is expected that minimum prices on emission permits and a more

widely used system of banking and options for future emissions will moderate some of the

volatility (European Commission 2009).

The concern of windfall profits is to some extent related to the price volatility. As electricity

prices skyrocketed in 2005, some consumers found it unfair that even though companies

received permits for free, the consumers were charged extra, the windfall profit (European

Commission 2009). Studies have shown that companies actually were able to pass on a

significant part of the market cost of their free permits to the consumers (Sijm et al., 2006; The

Carbon Trust, 2006), and consequently it has been much debated whether the permits should

be auctioned off instead of given out for free. To further push some of the costs on to the

producers, thus giving them incentives to cut emissions, it has been suggested to advance

deregulation of the European electrical market to let market forces push the fraction of costs

passed on to consumers towards the efficient market equilibrium (Ellerman & Joskow, 2008:

25, National Bank of Belgium, 2006).

The main point from these two critical reviews of the ETS is the fact that the regulation is very

much uncertain on future changes. This is extremely problematic for the possibility of a

successful cut in emissions since the strict command-and-control scheme with its specification

standards already limits the degree to which companies can outperform the market on

reducing pollution. Of course they do have the option of investing in greener technology to

reduce their spending on carbon allocations, but with highly volatile prices and very low prices

on carbon allocation, the incentives to do this have been more or less not-existing. This was

shown very vividly when, Ecofys, an independent consultancy, in an assessment of the NAPs

waiting to be approved for phase II found that the majority were not sufficiently strict as the

suggested caps were higher than independently estimated business-as-usual emissions and only

really cut emissions compared to the higher official business-as-usual projection (Rathman et

al, 2006). After this report, eleven of the first 12 NAPs were rejected. Further, the commission

started infringement proceedings against six countries2 for not submitting their NAPs within

deadline; an example of a market with too many carbon allocations and too volatile and low

prices on carbon to really induce companies investing in green technology.



2 Austria, Czech Republic, Denmark, Hungary, Italy and Spain.

Further, as the scheme has an inclusion of every single company within the chosen sectors, the

possibility to get a price premium through differentiating the company from its competitors in

the sector is very little. Again, the option of investing in greener technology and carbon

reducing projects other places is present but without a reassurance from the regulators on how

the scheme is to develop, such investment is simply not rational for companies; the risk of

investing in expensive technology that will put you worse off than your competitors who

simply buys cheap allocations permits, is to high.

Another point of interest in an assessment of the ETS from our parameters is the choice of

reference for reducing emissions. As the ETS is designed at least partially as the European

response to the Kyoto Protocol the base year of 1990 is predominant. This does bias the

country allocation slightly towards punishing the countries initially not polluting very much in

1990, but the Kyoto Protocol does incorporate most of these issues and the alternatives with

continues new reference year would have been far more biased (The Carbon Trust, 2006: 8).

However, the actual allocation of carbon permits still needs to be based on individual plants,

which is a very bureaucratic process. Several countries uses benchmarking in the sense that

allocation of permits are done according to the least polluting plant of that particular sector.

This does provide an ability to intervene for the regulators to include special characteristics of

all sectors, but as mentioned it is a very tiresome and intrusive process that renders the

companies at the mercy of bureaucrats who might not have sector experience. The result in the

Netherlands was an abandonment of the benchmarking attempt after 125 different benchmarks

had been developed (Wagner, 2004). The workload was simply not cost-effective and the

scheme has yet to show such a thing as an efficient and objectively fair carbon allocation to

individual plants. So far member countries of the EU are still protecting their own economies

where possible (Buchner & Ellerman, 2007: 18).

As mentioned above, the commission has proposed a number of changes to the regulation.

Among these are centralised allocation of permits by the EU and a higher proportion of these

to be auctioned instead of given away for free. The objective is to minimise intra-union

differences and price volatility as well as pushing for even higher economic incentives for

complying with the policy of non-pollution investments (Kanter, 2008; European Commission,

2007). However, the changes have not been passed as legislature and the effects can take place



from January 2013 at the earliest. More recently three non-EU members have joined the ETS3

and the airline industry has been included which is expected to be in effect from 2012

(European Commission, 2005; EU Business, 2007). The long-term goal is to include all

industries and all greenhouse gases (Dimas, 2005).

This last notion might not be consistent with the desire to create an objectively and efficient

trading scheme without unnecessary uncertainty about future changes and interventions. In

general, the more the commission interferes and changes the regulatory framework the more

uncertainty it creates within the companies and the fewer long-term green investments will be

rational. But several of the sectors involved are absolutely critical for the functioning of states.

So even though market efficiency would make it most profitable to reduce emissions in the

sectors where it is cheapest to do so, some sectors simply need to be of a certain size no matter

the polluting effects. It is a strong statement, but sectors such as energy are vital for the

infrastructure and security of modern states. The point here is that sectors need to be

differentiated by the commission and member states to exclude the risk of jeopardizing security

even though it does limits the perfect allocation of emission permits on a purely environmental

and economic basis.

The main conclusion here is that the huge number of emission permits available during the

first trading periods, the uncertainty of which sectors faces intervention by commission

regulators, which sectors in which countries can pollute how much and the extreme volatility

in prices (even for a normally volatile product) make it very difficult for companies to plan and

profit from the expensive long-term green investments (Ellerman & Joskow, 2008: 42).

However, the ability to trade permits does provide for some room for innovation and product

differentiation if the aforementioned problems are solved.



3 Norway, Iceland and Liechtenstein.

6. How to regulate carbon emissions

Following the two analyses we find it important to reassess the key challenges in order to

deduce some general guidelines for how to regulate carbon emissions, which is the topic of the last

section.

The analysis of the Carbon Reduction Label clearly showed the great potential of information

regulation. The label is however still to show its capabilities. The race to the top, where

companies strive to outperform each other on low carbon products require a high company

participation. To achieve this, it is important to further lower the costs of compliance or

increase the benefits of participation, in view of our assumption of rationality. Further the

analysis concluded that the label would not be able to restrain all carbon dischargers, because

of different circumstances.

On the contrary, the ETS draws on the principles of command-and-control regulation and is

therefore in a position to demand reduction of carbon emissions. However, as the analysis has

showed the ETS faces other problems, the greatest being how to distribute the carbon

allowances to provide incentives to lower the carbon emissions instead of buying cheap

permits. To do so the Commission has declared that more allowances will be auctioned instead

of given away for free. The most important, as far as our argument goes, is however to provide

a stable platform for the companies to act upon. If the uncertainty about future regulation is

too high, the companies will be reluctant to invest in low carbon technology.

6.1 Perspectives on regulating carbon emissions

Looking on from the conclusions of the two separate cases, we still need to be mindful of the

assumptions forming the foundation of the theories and our causal claims. Based on the

theoretical background and the concrete rational incentives for companies involved in the

Carbon Reduction Label, public support for first movers is a necessity if technological

breakthroughs and green investments are to be profitable. And if a certain type of action is not

profitable, either by direct income or a more valuable image, these investments simply will not

come. As the theoretical basis for this is fairly general in scope and the Carbon Reduction

Label exemplifies this lack in a concrete private regulation scheme, we feel confident that this is



in fact a general tendency for private approaches within climate regulation. Whether such

public support should be in the form of direct economic incentives or a very long-term legal

framework is not a question to be answered by this analysis; both approaches fulfil the

requirements, and both would be a step in the direction of a more hybrid regulatory framework

taking in elements from the other side of the private/public continuum of regulation power.

If we turn to the ETS there are some conclusions, which seem to be somewhat more general in

scope than just an application on the European continent. Even though it is primarily a public

regulation scheme, and an intergovernmental one of those, it does possess trends towards

setting up the framework for companies to make their own decisions on whether it is profitable

to cut emissions or buy redemption through allowances from elsewhere. However, as the ETS

seems to be the only comprehensive command-and-control scheme within intergovernmental

climate regulation and it still bases itself on setting up rational incentives for companies,

certain lessons are apparent for ETS as well as other intergovernmental schemes trying to

commit members on different levels. The market functions of such schemes are clever in the

sense that too much bureaucratic morass is expensive, inefficient, straining on inter-members

relations and simply unnecessary. As we have seen, the problems of the ETS are mostly in the

form of balancing market versus government interference. It is a dilemma and as concluded

above, some sectors are so critical that market regulations are not good enough. Further, even

though some of the slow diplomacy is removed, we still see fierce arguments over allocations.

Fixing these problems in intergovernmental regulation in general will, based on theory and the

ETS case, result in a trade-off with market efficiency. Elaborate specifications as regulation

standards are not necessarily the answer to this trade-off; the quest is for consistency so the

market knows what to expect from regulators and thus can invest accordingly. Looking only at

the effectiveness of regulation, deciding whether to allocate centrally or maintaining it at

member state level is not that important; the critical point is to make a decision, doing it fast

and sticking to it.

To sum up, intergovernmental regulation probably will need the use of incentives to regulate

private action since no intergovernmental body so far has been capable of merely trying to

solve the climate regulation problem in any other way. Learning from the private schemes,

market incentives are critical for the success and a part from the aforementioned public support

for first movers in climate investments, the best thing the intergovernmental regulatory body



can do to create the efficient framework they aim for is to agree on long-term policies and stick

to them. Security for green investments above all else.

In this way publicly induced frameworks for private initiatives can take the form of either the

all-including type, as the ETS, covering everything and regulating the big picture, while the

same basic thinking also is behind the Carbon Reduction Label type of regulation. In the latter,

there is just the opportunity to differentiate even more by much looser standards and thus

bigger room for innovation; a greater reduction and a marketing potential not available at the

ETS type regulation. The two types can learn from one another as mentioned above, but they

still serve different purposes; one based on clear standards in production and one based on the

informed consumer choice. They do seem fairly complimentary with regards to climate

regulation (Reinicke, 1998: 219; Prakash & Potoski, 2006, 74; Gunningham, 2007: 207).



7. Conclusion

To answer the question of how to regulate carbon emissions our analysis has studied two

contrasting regulative approaches. The first being a private regulation and the second an

intergovernmental one. The reason for this follows our argument that the nature of climate

change as a world wide problem, which delimits the regulative approaches to either private or

intergovernmental regulation.

The analysis builds on a theoretical platform of advantages and disadvantages of regulative

methods, derived from our assumptions that companies are rational, and therefore act

according to economic incentive structures, and that a regulation, to be effective, needs to

enforce its strategy. The theoretical parameters deduced are: standards, sanctions and

marketing potential. With these in mind the advantages and disadvantages of the two

regulative approaches have been assessed.

Our analysis has clearly showed that climate change is a relatively new field of policy. Both

regulative approaches show signs of being in a start up phase, and therefore have some critical

aspects to improve.

The Carbon Reduction Label, representing a private approach, labels product’s carbon

emissions and thereby puts to use the logic of information regulation to influence companies

to reduce their carbon emissions. The biggest force of the label is its possibility of producing a

race to the top, where companies strive to outperform each other by lowering their carbon

emissions. This requires high participation, which is not the case at the moment, due to three

obstacles. First, high costs of measuring a products carbon emissions; second, high uncertainty

about future public regulation; and third, some sectors may not benefit enough from the

marketing potential.

The EU Emission Trading Scheme, representing an intergovernmental approach, is based on

command-and-control regulation. It demands companies not to pollute more than their

allowances for carbon emissions allocated to them or acquired through purchase or emission-

reducing initiatives. In theory this opens possibilities for the market forces to find the most

efficient ways of cutting carbon emissions, but with too high uncertainty about future

regulation the reductions have been relatively modest. This is very problematic as the system is



unable to deliver stable incentives to the companies involved making them reluctant to invest

long-term.

Owing to the fact that the cases in question are both general in scope and not sector-specific

regulations, we have argued, that our finding within reason can be used outside their own

specific context. The last chapter has therefore put forth some general lessons. However, we do

not argue that the two cases are the only suitable regulative approaches, but together they cover

many of the basic elements of regulating a policy field such as climate change.

We recommend that public support for first movers in climate investments are needed to cover

their disproportionate costs. Other than this, the best thing the intergovernmental as well as the

private regulatory body can do to create the efficient framework they aim for is to agree on

long-term policies and stick to them; certainty for investments are by far the most pressing

issue given our focus on companies’ rationality and the power of regulation.



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