[EMISSIONS TRADING

]Policy, Performance, and Implications

2015

Boston College Economics Department

Victor Houston

Abstract:

This paper will take an in depth look at the problem of externalities in the economy and why

they require government intervention to fix them. Regarding externalities, this paper will entail

the various methods of government regulation that can fix the problem of externalities.

Namely, I’ll be discussing the idea of taxes on pollution and, most of all, the cap-and-trade

policy model. This paper will look at the largest greenhouse gas emissions scheme in the world,

the European Union Emissions Trading Scheme, and assess its performance. It will additionally

entail the various controversies surrounding the design and implementation of the scheme and

the numerous ways in which it should be altered in order to ensure its future success.

Part 1: Externalities in the Economy

An externality is a side effect or consequence of commercial or industrial activity that affects

third parties not involved in the transaction. These externalities are not taken into consideration by the

producing firm, and due to the firm’s profit-maximizing nature will be exploited. Since some

externalities may affect people’s utility functions and production functions, the government must

intervene to ensure that the full benefits and costs of the market transaction are accounted for. Thus,

the government must determine which types of externalities are important enough for intervention,

which is not always an easy task. A look at the types and characteristics of externalities will make this

decision easier.

There are externalities referred to as pecuniary and those referred to as technological.

Pecuniary externalities are inherently fixable by market interactions such as supply and demand. An

example of a pecuniary externality is as follows:

“With gas prices above $3.00 a gallon, you decide that you want to buy a small, fuel efficient car.

Unfortunately, so do millions of other people, with the result that the average price of a small car rises by

a few hundred dollars. The other people’s decisions to buy a small car cause you harm because they

increase the price of the car you want to buy.”1

This type of example is referred to as a pecuniary externality because supply and demand will

work out the trade-off of paying less for gas but more for the car, and will eventually lead to a market

equilibrium. A technological externality is an externality that directly affects consumers and producers

and is not accounted for by the market system. Therefore, technological externalities will require

government intervention because they cannot be worked out by supply and demand factors and will not

1 Richard Tresch, Public Sector Economics, (Palgrave Macmillan, 2008), 100

reach optimal market equilibrium without intervention. An example of a negative technological

externality is as follows:

“Factories in the industrial Midwest spew pollutants from their smokestacks that damage the paint on

houses and cars and cause respiratory and other health problems. The pollutants may also harm other

businesses, such as commercial fishing in lakes whose fish populations have been affected by acid rain.

The damage from the pollutants affects people and firms independently of whether they choose to

purchase the products that these factories produce.”2

It can clearly be seen here that this type of externality will negatively affect people’s utility

functions and also third-party producer’s production functions. Without government intervention, the

industrial polluters would continue to pollute to maintain the lowest marginal costs and highest profits

possible. While there are positive externalities that occur as well, this paper will focus specifically on

negative technological externalities, also referred to as external diseconomies.

Negative externalities in the economy can be modeled to show the marginal damages to society.

Let’s use paper production as an example. The market supply curve for paper production can be

modeled as the marginal private cost, and the demand is what the market normally demands. At the

competitive market level, the price will be Pp and the quantity of paper produced will be Qp. In the

presence of externalities however, the marginal private cost does not account for the damages to

society from the pollution. Thus, the appropriate supply curve that the firm should use is the marginal

social cost, which incorporates the marginal damages from the pollutants suffered by all the people

affected by the pollutants (denoted as the marginal external cost). Thus, in order for the equilibrium to

be Pareto optimal, in which the output at which the marginal value of paper to consumers is equal to

the full marginal cost of producing the paper, the optimal quantity and price in the market for paper will

2 Ibid

be Qs and Ps. Any output of paper beyond Qs will have less value to consumers than the full social cost

of producing it. 3

Unfortunately, production firms don’t have much of an incentive to produce Qs at Ps because it is not

the competitive supply and demand equilibrium. A quick show of mathematics will prove why a firm

would not voluntarily produce at Qs and Ps:

To be on the total cost curve, producers should compute the ratio of the marginal product (MP) to the

price (P) of each factor that it uses in production and then equalize that ratio across all factors of

production. Thus a firm should do the following:

3 Ibid, 105

MPkPk

= MPLPL

= MPaPa

In this example, K denotes capital, L denotes labor, and A denotes air. The problem with this is that the

price of air is effectively zero, and thus the ratio of the marginal product of air to the price of air

becomes large without limit. The cost minimizing/profit-maximizing incentive is to substitute away from

capital and labor in favor of using more air until the marginal product of using more air is zero. This will

lead firms to maximize pollution and create massive negative externalities.

Part 2: Methods for Pollution Control

To fix this pricing problem and incentivize firms to produce at the social optimum, government

intervention must occur. Essentially, the government needs to levy a per-unit tax on the production of

paper which will increase the firm’s private marginal costs by the amount of the tax. If the tax is priced

adequately, then the new convergence of the supply and demand curves will be at the socially optimal

price and quantity that compensates for the marginal damages of the pollution. A tax of this nature, in

which it is equal to the aggregate marginal damages at the optimum is referred to as a Pigovian tax,

named after Arthur Cecil Pigou. This mathematical demonstration will illustrate how the tax affects the

firm’s profits:

Profit = pq – C(q) – tP(q), where p = price, q = quantity, C(q) =cost as a function of the firms output, t is

the price of the tax and P(q) is the amount of pollution as a function of the firm’s output

The firm maximizes profit by producing output at which marginal profit is zero:

dProfitdq

=p−dCdq

−t∗dPdq

=0

p=dCdq

+ t∗dPdq

Thus, this shows how the tax will implement into the firms pricing strategy and force them to internalize

the marginal damages of the pollution.

The problem with this type of tax is that pollution is not necessarily directly proportional to

output. This is because different firms may utilize different production technologies or factors of

production. For example, in countries where wages are low, production companies may shift away from

polluting capital and towards more labor. Thus, a per-unit tax on the output of the firm may not be

equitable for some companies. In order to fix this issue, the regulation should try to be levied as close to

the source of the pollution as possible. Thus, it would be more effective to try to monitor and tax the

actual amount of pollution produced by a company rather than pure output. Thus, placing a tax on the

use of air or water would be most effective, because it would cause the firms to substitute away from

using air and water and towards capital and labor to dispose of waste. By enacting this type of

regulation, firms carry the burden rather than society or the government and they have to prove their

reduction of pollution in order to pay less tax. Additionally, this type of tax allows the producer to

determine the most cost efficient way to reduce pollution, whether that ends up being actual

abatement or merely just paying the tax because it is cheaper than abating. By using this strategy, all

the government needs to do is continuously adjust the tax until the desired reduction of pollution is

attained.4

Another policy consideration for abatement of pollution is one that was put forth by Ronald

Coase. His mentality is that a Pigovian tax is not necessary because all the government would have to

4 Ibid, 116

do is assign property rights to the externality in order to allow the externality to be bought and sold in

the marketplace, which would naturally create an optimal equilibrium. Thus, as an example, property

rights could be assigned to clean air in a neighborhood next to a paper production mill. Therefore, in

order for the production firm to pollute, they would have to buy the property rights from people in the

neighborhood, thus internalizing the cost. In addition, individuals in the neighborhood could choose to

hold the property rights if they determine less pollution is more important than the benefits of selling

the property rights. Theoretically, this method would cause firms to produce at the optimal price and

quantity, but practically, it would be very difficult to implement. Due to the vast number of firms and

people affected by the pollution, it would be a logistical nightmare to assign the property rights in an

equitable manner. Additionally, there would be a large amount of people who don’t sell their property

rights, but free ride on the other people in the neighborhood that have. This would entice nobody to

sell their property rights and then no abatement would occur. Thus the Coase Theorem is not effective

when the externality is so widespread, and a Pigovian tax would be more applicable.

A problem with a Pigovian tax is that it is difficult to accurately price it to be equal to the

aggregate marginal damages at the social optimum. This is because when a government is determining

the marginal damages from pollution, they would look at the distance between the private marginal cost

curve and the social marginal cost curve at the competitive level. Thus, if the competitive level is much

higher than the optimal level, their tax would be grossly overestimated and would bring the equilibrium

below the optimal level. Once again, the government would measure the distance from the private

marginal cost curve to the social marginal cost curve, but at the new equilibrium which is below the

optimal equilibrium. Thus, their new tax will be less than needed, and the new equilibrium will be

somewhere in between the true optimal and the competitive equilibrium. In order for the government

to find the right tax that will equal the marginal external damages at the optimal level, they pick a level

in between these two levels and estimate it. Of course this isn’t a perfect way of determining the right

tax level, as there are varying degrees of accuracy, but this is the best that one can hope for.

Another method that seems to be the most effective is the command and control (CAC)

approach. In this approach, the government designates specific abatement technologies that firms are

required to use. In these types of approaches, the government designates that all firms must reduce

emissions by a certain percentage. Although this seems like an equitable method, it is not a cost-

efficient method because some firms may have steeper marginal abatement curves that makes it cost

much more for them to abate a certain amount than another company with a flatter marginal

abatement curve. Thus, the pollution target is not met with the most efficient use of resources. Some

firms may determine that it is least costly to pay the tax than to use a specific technology to abate, and

thus using the tax method is the least cost scenario.5

Another method that is essentially equivalent to a tax is the use of marketable permits, which

will be the focus of the rest of this paper. Under this type of system, the government will freely allocate

or auction permits to firms at a price Pp. The firm will only buy the amount of permits that they need,

and the price of the permits will act in the same way that the tax would:6

dProfitdq

=p−dCdq

−P p∗dPd q

=0

p=dCdq

+P p∗dPdq

5 Ibid, 1306 Ibid, 132

In this system, if a firm wants to pollute more than another firm, they may purchase permits

from the other firm at a price. The buying firm finds it less costly to purchase permits than to abate, and

the selling firm finds it less costly to abate than to own the permits. The benefits of this system are that

the government can set the cap of pollution that they desire in the environment, and then issue only

enough permits to equal that amount. Any desire to pollute more or less from certain firms will result in

trading of the permits which will, by the laws of supply and demand, automatically lead to an efficient

and optimal equilibrium. The benefits of permits over taxes are that the government would have to

readjust the tax periodically, while the permit trading adjusts automatically due to supply and demand.

While there are many drawbacks and systematic errors that can occur in a permit trading system, permit

trading still seems like the most effective and costless way to prevent excess pollution. The European

Union agrees that this is the best method, and launched a scheme to implement this across all EU

member-states plus Iceland, Norway, and Lichtenstein called the European Union Emissions Trading

Scheme (EU ETS). The EU ETS and its consequences will be the focus of the rest of this paper.

Part 3: The European Union Emissions Trading Scheme

The EU ETS is the largest greenhouse gas emissions scheme that exists and was started in 2005

to meet target reductions as posited by the Kyoto Protocol, which was an international treaty

committing participating parties to reduce greenhouse gas emissions by a certain amount. Although the

design and implementation of the EU ETS is independent of the Kyoto Protocol, it was surely motivated

and established as a result of it.7 The EU ETS is a major pillar of EU climate policy and covers 11,000

factories, power stations, and other installments with a net heat excess of 20 MW in 31 countries.8 The

EU ETS is based off of a cap-and-trade model in which the EU sets a desired pollution target and

7 Ellerman and Buchner, The European Union Emissions Trading Scheme: Origin, Allocations, and Early Results, Rev Environ Econ Policy (2007), 67 8 The EU Emissions Trading System (EU ETS), (European Commission,2013) 

allocates permits corresponding to that level of pollution. These permits can be traded by firms to

achieve least-cost efficiency. Each firm must hand in the amount of permits associated with their

pollutions at a determined time period and if they are short, they may purchase permits from others.

The converse situation occurs as well, where firms that have abated more than necessary relative to the

amount of permits they have may sell them to other firms. The EU ETS is structured in four phases that

began in 2005 and will end in 2028. Each phase has proposed a number of changes and in total they all

aim to cover about 40% of total EU emissions and to achieve a substantial reduction in emissions

throughout the scheme. While the EU ETS has played a major role in the reduction of greenhouse

gasses, various aspects must be considered to determine how successful the scheme has truly been.

Thus, the rest of this paper will entail a descriptive analysis of the achievements and challenges that the

EU ETS has faced by evaluating key details and performance indicators.

The key indicator of the performance of the EU ETS is reduction in greenhouse gas emissions,

but there are factors affecting the matter that make it difficult to truly determine the efficiency. The

most important factor here is the output of the economy, and thus should be compared to the

reductions in order to truly determine the efficiency of the scheme. The following graph compares the

GDP and output of industrials of the participating countries to emissions:

As it can be seen from the graph, the recession of 2008 caused a steep decline in GDP and

industrial output, and thus emissions naturally fell as well. An important takeaway from this graph is

that when the GDP and industrial output rebounded in 2010, emissions did not rebound with the same

force. A 3.4% rebound in emissions occurred compared to a 6.6% rebound in industrial output. Since

then, emissions have continued to decline while GDP and industrial output continued rising.9 One must

keep in mind that since this graph, the breadth of the scheme has increased by 13% with the addition of

new industries and countries.

The beneficial effects of the scheme have often been overshadowed by various realms of

criticism towards it. One of the largest origins of criticism derives from the over-allocation of allowances

in the scheme. Towards the end of the first phase, the price of the allowances fell to zero in 2007 due to

oversupply with an excess of 83 million allowances, or 1.3% of total emissions. This is a result of the

uncertainty regarding business as usual emissions and inaccuracy of cap setting. When the second

phase initiated, the EU reduced the number of allowances in each member state greatly in an attempt to

more accurately gauge the demand so that the price of the allowances wouldn’t be so volatile and end

up at zero. The following graph shows the change in the set emissions cap from phase one to phase two

for each member state:

9 Ellerman, Marcantonini, Zaklan, The EU ETS: Eight Years and Counting, (European University Institute, 2014), 8

As it can be seen, all member-states except for Romania and Slovakia decreased the cap by an

exceptional amount. It can be shown that the cap was clearly set too high and allowances were over-

allocated.

Another controversy is the ability for companies to bank allowances. The scheme allows firms

to bank their permit allowances to save for a later date. At the end of phase two, there were 1.8 billion

permits that were banked, which relates to 17% of total phase two emissions. The controversy arises

because the regulators are worried that excess banking will lead to the permit prices for phase three to

go down to zero. Interestingly, the price of allowances is still positive at about 5 euros. This indicates to

regulators that companies have demand for allowances in the future due to speculation that the prices

will rise greatly in later phases to keep up with the 1.74% annual reduction. The following graph shows

EU ETS sector emissions since 1990 and the eventual goal of reductions by 2050:10

Another controversial aspect regarding the EU ETS is the topic of price fluctuations of the

permits, known as EAU’s. During the first half of the trial period of the scheme, prices were egregiously

high, and then suffered a precipitous drop. Prices were expected to be in between 8 and 12 euros, but

in the first five months of the program, the prices ran up to 20 euros. The prices stayed at this level until

the first verified emissions data release came out. The explanation for these obscure prices were that

10 Ibid, 10

there was a cold, late winter in 2005, a dry summer in southern Europe, and high natural gas and oil

prices that made coal more attractive.11 When a more in depth analysis occurred, many economists

determined that the true cause of these high prices was an imbalance in the buyers and sellers in the

EUA market. Essentially, the companies that were short allowances and needed to cover their emissions

were more present than companies that held long positions that were not as active in the market.12

Additionally, the hedging demand of electric utilities companies was very strong and added more

pressure to the buying side with very few sellers in the market. The hesitation for sellers in the market

was due to uncertainty of their long term needs for the EUAs, and therefore many companies with a

patient attitude held their allowances for longer than may have been necessary. Eventually, when more

market information arose, these companies determined that they would not need their allowances for

phase one, and due to the inability to carry them over to phase two, they quickly sold their excess

allowances, driving the price to zero. Going forward, an aspect that has greatly facilitated more liquidity

in the EUA market is the creation of an exchange to trade on. Previously all EUAs were traded over the

counter, which led to a lack of organization. With the advent of an organized trading mechanism for the

EUAs and trading vehicles such as futures, options, and swaps on The London Exchange, about 75% of

EUA’s are now traded with great liquidity. This graph illustrates the increased trading volume that

occurred with the emergence of exchange traded EUAs:

11 Ellerman and Joskow, The European Union’s Emissions Trading System in Perspective, (Massachusetts Institute of Technology, 2008), 1512 Ibid, 15

Another incredibly controversial aspect of the EU ETS has to do with excess profits for

participating companies. The free allocation of allowances led to companies increasing their electricity

prices, and therefore increasing corporate profits. Critics argue that electricity prices would have been

lower if it were not for the freely allocated allowances. The controversy arises because there is

speculation that these companies were including the market value of the allowances in their marginal

cost function rather than what they actually paid for them ($0). In traditionally regulated electricity

markets, the market value of the allowances should not be passed on to consumers in the form of price

if they are freely allocated. The problem is that some of the electricity markets in the EU are more

liberalized, and the electricity producers took advantage of this matter and did consider the market

value of the freely allocated permits to add to their marginal costs. As a result of this, the EU ETS will

now auction off a larger percentage of the allowances rather than allocate them for free. Although the

auctioning method would not decrease the heightened prices of electricity for consumers, it would

ensure that the companies don’t accumulate excess profits by taking advantage of the regulatory

system. The argument from the side of the electricity producers is that the excess prices of electricity is

not reflecting true costs incurred, but rather the opportunity cost of the company forgoing the sale of

the used permits, which does equal the market value of the permits. The following graph shows how

the electricity prices moved with EUA price fluctuations, even though the electricity producers did not

have to pay the market value of the EUAs:13

By auctioning the EUAs rather than freely allocating them, it ensures that carbon prices will be

passed through to all consumers in retail prices, not just in liberally regulated markets, and it would

cause an increase in revenue to the government that would aid them in increasing efficiency and equity.

The EU determined that since the beginning of 2013, no power producers would receive any freely

13 Ibid, 28

allocated EUAs, and that the EUAs will be auctioned off by the member-state in which the companies

are a part of.

It seems evident that there were many kinks that needed to be sorted out during the first phase

of the EU ETS. While many criticize the system for these problems, one must consider that the first

phase of the system was only intended to be a trial period to determine what types of problems would

emerge so that they can establish solutions for them. Considering that, the trial period was a success

because it helped the government set the infrastructure and relevant regulation that must accompany

the scheme. This allowed them to be ready for phase two, which was the true commitment period of

the Kyoto Protocol (2008 -2012).

Overall, it is difficult to assess the effectiveness of the EU ETS due to these various issues and it

has been the topic of strenuous debate since it has initiated. The clear and most important issue is the

problem of over-allocation of EUAs. It seems that the EU has consistently done an inadequate job at

predicting the rate of emissions, and thus the over-allocation causes price fluctuations and firms to bank

their allowances for the next phase. After a look at the second phase of the scheme, many are

concerned that the outlook is grim for the scheme to meet its target by 2020. Critics argue that the

surplus allowances that were carried over from phase two to phase three will weaken the EU’s

commitment to further climate policy control, stating that they can rely on the ETS alone. Here is a

graph showing the reductions in emissions relative to the carryover emissions from phase two and the

2020 target goal:

Although the scheme has clearly aided in the reduction of emissions, the excess EUAs in the

market have served as somewhat of a safety net for companies to not cut reductions as much as they

could. Going into phase three, 2.8 billion tons of reductions were supposed to occur, but 3.5 billion

have thus far. This is primarily due to the recession in the economy and various other policies. Although

it is great that the reductions have surpassed the expected, it has now created a situation of

complacency where the excess allowances incentivize companies to not abate as much. Thus, going into

phase three, massive changes had to be made.

Phase three began in 2013, and the ETS was a completely different animal. The most important

change enacted for phase three is the change in the cap. They determined that the new cap would be a

declining trajectory starting from 5.22% below the phase two cap and then declining 1.74% each year.

Additionally, free allowances were issued to each sector based on their carbon efficiency as

benchmarked against the 10% best performers in their product category. Moreover, the EU established

a maximum amount of free allowances that could be given out, which was 43% of the annual cap.

Although these changes were enacted, they were still not enough to combat the allocation issues. Thus,

they eventually decided to postpone the auction of 900 million allowances that were supposed to be

released over 2014-2016 until 2019-2020 to create a temporary scarcity of allowances to illustrate the

more severe cap that is planned for phase four.14

Unfortunately, regardless of all the changes made to the ETS for phase four, there are seemingly

going to be lasting structural problems. It is undeniable that the ETS is causing a reduction in emissions

and that greenhouse gasses are slowly being reduced in the environment, but the problem of surplus

allowances in the market may prove to be the ultimate demise of the entire ETS. While, reductions are

continuing at about 1.74% a year, and are poised to be changed to 2.2% in 2030, if the EU does not

drastically modify the allocation problems in the scheme, there may be such an excess in future years

that the ETS will become obsolete. Regulatory proceedings do have the power to make sure this does

not happen, but it will require extensive research and accurate projections to slowly reduce the

oversupply in the market and establish the ETS as the pinnacle of a well-functioning emissions trading

system.

14 Damien Morris, Slaying the Dragon: Vanquish the Surplus and Rescue the ETS, (Sandbag, 2014)