COMMENTARY
Should the rules of allocating emissions permits be
harmonised?
Zhong Xiang Zhang *
Faculties of Law and Economics,Uni6ersity of Groningen,P.O.Box716,9700AS Groningen,The Netherlands Received 13 July 1998; received in revised form 26 February 1999; accepted 12 March 1999
Abstract
The Kyoto Protocol is the first international environmental agreement that sets legally binding greenhouse gas emissions targets and timetables for Annex I countries. Its Article 17 authorizes emissions trading among Annex B countries. If properly designed, emissions trading can effectively reduce their abatement costs, while assisting Annex I countries in achieving their Kyoto obligations. If Annex B governments elect to allocate the assigned amounts to their individual sub-national legal entities and authorize them to trade on the international emissions permits market, I argue that individual governments should be left free to devise their own ways of allocating emissions permits. © 1999 Elsevier Science B.V. All rights reserved.
Keywords:Carbon tax; Emissions trading; Greenhouse gases; International competitiveness
www.elsevier.com/locate/ecolecon
1. Introduction
In the face of a potentially serious global cli-mate change problem, 160 countries eventually reached an historical agreement on limiting green-house gas emissions in December 1997, Kyoto. While the United Nations Framework
Conven-tion on Climate Change (UNFCCC) at the Earth
Summit in June 1992 committed Annex I
countries1to ‘aim’ to stabilize emissions of carbon
dioxide (CO2) and other greenhouse gases at their
1990 levels by 2000, the so-called Kyoto Protocol goes further. It sets legally binding emissions targets and timetables for these countries. To-gether, Annex I countries must reduce their emis-sions of six greenhouse gases by 5.2% below 1990 levels over the commitment period 2008 – 2012, with the European Union, the United States (US) and Japan required to reduce their emissions of such gases by 8, 7 and 6%, respectively (UN-FCCC, 1997). This Protocol will become effective
* Tel.: +31-50-3636882; fax:+31-50-3637101. E-mail address:z.x.zhang@rechten.rug.nl (Z.X. Zhang) 1Annex I countries refer to the Organisation for Economic Co-operation and Development (OECD) countries and countries with economies in transition. These countries have committed themselves to legally binding greenhouse gas emissions targets.
once it is ratified by at least 55 countries whose
CO2 emissions represent at least 55% of the total
from Annex I countries in the year 1990.
The Kyoto Protocol also accepts the concept of emissions trading, under which one Annex B
country2 or its sub-national entities would be
allowed to purchase the rights to emit greenhouse gases from other Annex B countries or their regu-lated entities that are able to cut greenhouse gas emissions below their assigned amounts or their targets. Structured effectively, the market-based emissions trading approach, pioneered in the US
SO2 allowance trading program (Ellerman et al.,
1997), can provide an economic incentive to cut greenhouse gas emissions while also allowing flex-ibility for taking cost-effective actions. It is gener-ally acknowledged that the inclusion of emissions trading in the Protocol is in line with the underly-ing principles in Article 3.3 of the UNFCCC, which states ‘‘policies and measures to deal with climate change should be cost-effective so as to ensure global benefits at the lowest possible cost’’, and reflects an important decision to address cli-mate change issues through flexible market mechanisms.
The decision on whether and how to allocate the assigned amounts to sub-national entities is the first step towards trading among emissions sources as well as trading among countries. This raises the competitiveness concern in the initial allocation of permits. Against this background, this article examines whether there is the need for the harmonisation of allocation of permits.
2. Competitiveness concern in the allocation of permits
In principle, an emissions trading scheme could include all the greenhouse gases under Annex A to the Kyoto Protocol. The so-called
comprehen-sive approach would provide maximum opportu-nity for trading to find those sources where the costs of abating greenhouse gases are lowest, thus maximizing the cost savings. In practice, a work-able emissions trading scheme requires that emis-sions of whatever a pollutant to be included have to be measured with reasonable accuracy. This requirement implicitly precludes including all gases in the initial trading scheme (Victor, 1991). However, limiting trading to a subset of gases is not likely to be effective unless the Protocol is
further amended to partition the assigned
amounts into two categories: tradable and non-tradable gases with separate goals being assigned for each (Grubb et al., 1998). Without a separa-tion of categories, it lacks a legal basis to reject the legitimate claim from those countries that use the flexibility inherent in the equivalence process to substitute freely among the gases, because Arti-cle 5.3 of the Protocol (UNFCCC, 1997) has authorized that the global warming potentials are
used to translate on-CO2 greenhouse gases into
carbon equivalent units in determining each An-nex I Party’s compliance with its assigned amounts.
Once the coverage issue is set, emissions trading could take place either on an inter-governmental basis or on an inter-source basis. Under inter-gov-ernmental trading, governments elect not to allo-cate the assigned amounts to sub-national entities, and retain the sole right to trade. As such, inter-governmental emissions trading takes place on a government-to-government basis.
Under inter-source trading, governments elect to allocate the assigned amounts to individual sub-national entities, and authorize them to trade on the international emissions permits market. Its great advantage over inter-governmental trading is that it limits the governments to setting the rules rather than undertaking emissions trading themselves, and leaves individual companies the freedom to choose how to comply with their limits. By incorporating sub-national entities into an international emissions trading scheme, the companies that actually have control over sions would be able to profit directly from emis-sions reduction activities, thus providing them with strong incentives to exploit cost-effective
abatement opportunities. This would potentially increase the total amount of transactions in the international scheme, meaning greater capital flows to selling participants and greater cost re-ductions for buying participants. By increasing the number of trades, it would also improve mar-ket liquidity and reduce the potential for abuse of market power. The latter might occur under inter-governmental trading if one country or bloc holds a significant proportion of the total number of permits. Moreover, in comparison with national governments, individual companies are in the best position to possess information about their emis-sions reduction options and the corresponding marginal cost and thus to determine their efficient emissions level.3
If emissions trading among sub-national entities is authorized, the next issue is how Annex B governments allocate the assigned amounts to sub-national entities within their countries. This decision is the first step towards trading among emissions sources.
The allocation of permits to emissions sources is a politically contentious issue because, given economic value of the permits, the choice has distributional implications and, in the presence of transaction costs, has efficiency implications as well (Hausker, 1992; ELI, 1997; Cramton and Kerr, 1998; Grubb et al., 1998; Joskow and Schmalensee, 1998; Stavins, 1998). Individual emissions sources can benefit greatly depending on the allocation methods chosen.
One often-discussed allocation method is a form of grandfathering, whereby the permits are given out freely to existing regulated entities in proportion to their historical emissions or fossil
fuel sales. For example, in the US SO2allowance
trading program mandated in Title IV of the Clean Air Act Amendments of 1990, the basic allocation formula has been free distribution of
available allowances among generating units within the regulated plants in proportion to their average fossil fuel consumption during the base-line period 1985 – 1987 multiplied by 2.5 pounds
of SO2 emissions per million British thermal unit
(BTU) for Phase I and by 1.2 pounds of SO2
emissions per million BTU for Phase II (Ellerman et al., 1997). Grandfathering would have the ad-vantage of minimizing the disruption of current production of the regulated entities (Zhang, 1997). With grandfathering, emissions sources could also save considerable expenditures because they only have to pay for additional permits as needed. Therefore, it increases the political accept-ability of an emissions trading scheme (Baumol and Oates, 1988). However, like stringent com-mand-and-control standards for new sources, grandfathering gives rise to entry barriers for new sources to enter the market because they must buy their emissions permits while existing sources ob-tain theirs for free (Grubb et al., 1998; Stavins, 1998).
The alternative to grandfathering is that the government would require prospective permits buyers to bid for permits in an auction. The
adopted annual auction of SO2 allowances in the
US SO2 allowance trading program, which
repre-sents less than 2% of the total allowance alloca-tion and thus is a trivial part of the overall program (Ellerman et al., 1997), is structured as a sealed-bid auction with pay-your-bid-pricing. Po-tential buyers are required to simultaneously send bids in sealed orders, stating the number of the permits they are willing to buy at a stated maxi-mum price. The auctioneer then supplies permits beginning with the highest bidder until the excess supply is zero. Unlike in a stock market where there is one single price at any time, this form of auction creates many different settlement prices. Alternatively, a sealed-bid auction could be de-signed in such a manner that all winners pay the price of the marginal buyer, that is, the clearing price for each permit. Unlike in a sealed-bid auc-tion with pay-your-bid-pricing where the bidders attempt to guess where the clearing price is likely to be, predicting the clearing price is less impor-tant in an auction with uniform pricing, since every winner pays the same price no matter how
high it bids. This form of auction also encourages participation by small bidders, since it is strategi-cally simple.4
Auctioning permits is aimed to serve two pur-poses. One is to ensure that permits are available for small and new sources. The second purpose is to deliver signals on permit prices. Many analysts often argue that auctioning is superior to grandfa-thering in the initial allocation of permits on the following grounds. First, as further discussed in the next section, auctioning generates revenues that could be used to reduce pre-existing distor-tionary taxes, thus generating overall efficiency gains (Parry et al., 1997). Second, it provides a stronger incentive for technical innovation (Milli-man and Prince, 1989). Third, auctioning elimi-nates the need to establish historical baselines for the regulated entities and helps to ease political contention in the allocation of scarcity rents, which occurs if the permits are grandfathered (Hausker, 1992; ELI, 1997). Fourth, revenues raised from auctioning could be used to directly compensate those affected workers and con-sumers, and thus the equity goal could be better achieved under auctioning than under grandfa-thering. Despite all these advantages of auction-ing, however, all the existing trading programs have initially allocated the permits through grand-fathering, partly because it provides greater politi-cal control over the distributional effects of regulation (Stavins, 1998).
The initial allocation process itself represents the establishment and distribution of private property rights over emissions, and itself lies out-side the mandate of the World Trade Organiza-tion (WTO) (Vaughan, 1997). Given the great
concern about international competitiveness,
however, the allocation of permits does have the potential to bring parties into conflict with the
WTO provisions. Some fear, for example, that governments could allocate the permits in such a manner to favour domestic firms against foreign rivals. For example, a government of country X might allocate a generous amount of permits to a domestic firm, while a similar foreign firm also operating in the same industry of country X might get a tight emissions budget. This form of allocation will violate the WTO principle of non-discrimination. The allocation of permits could also be designed in such a manner to advantage certain sectors over others and further enhance their existing imperfect market competition. For example, a government might, to the extent possi-ble, allow certain sectors to emit, while imposing additional pressure on other emissions sources. The above ways to allocate permits make explicit an unequal treatment, a practice which can be much easier hidden from the general public under the conventional command-and-control regula-tions than under the above incentive-based policy instrument (Stavins, 1998). This treatment in turn will have a similar price distortion effect as a subsidy, and would be in conflict with the WTO rules that prohibit the use of export subsidies for such a purpose. All this clearly indicates that the manner in which countries allocate their assigned amounts should be compatible with these WTO principles and should not constitute a means of arbitrary or unjustifiable discrimination or a dis-guised restriction on international trade (Zhang, 1998).
However, it should be pointed out that, al-though grandfathering is al-thought of as giving implicit subsidies to some sectors, grandfathering is less trade-distorted than the exemptions from carbon taxes. To understand their difference, it is important to bear in mind that grandfathering itself also implies an opportunity cost for firms receiving permits: what matters here is not how you get your permits, but what you can sell them for — that is, what determines opportunity cost. Thus, even if permits are awarded gratis, firms will value them at their market price. Accord-ingly, the prices of energy will adjust to reflect the increased scarcity of fossil fuels. This means that, regardless of whether emissions permits are given out freely or are auctioned by the government, the
effects on energy prices are expected to be the same, although the initial ownership of emissions permits differs among different allocation methods. As a result, relative prices of products will not be dis-torted relative to their pre-existing levels and switch-ing of demands towards products of those firms whose permits are awarded gratis (the so-called substitution effect) will not be induced by grandfa-thering. This makes grandfathering different from the exemptions from carbon taxes. In the latter case, there exist substitution effects. For example, the Commission of the European Com- munities (CEC)
proposal for a mixed carbon and energy tax5
provides for exemptions for the six energy-intensive industries (i.e. iron and steel, non-ferrous metals, chemicals, cement, glass, and pulp and paper) from coverage of the CEC tax on grounds of competitive-ness. This not only reduces the effectiveness of the
CEC tax in achieving its objective of reducing CO2
emissions, but also makes the industries, which are exempt from paying the CEC tax, improve their competitive position in relation to those industries which are not. Therefore, there will be some switch-ing of demand towards the products of these energy-intensive industries, which is precisely the reaction that such a tax should avoid (Zhang, 1997).
3. The harmonisation of allocation of permits?
With the great concern that a government that grandfathers permits to a domestic firm could give it a competitive advantage over a similar firm in another country where permits are not awarded gratis, some believe that there is the need for the harmonisation of allocation of permits. According to Article 17 of the Kyoto Protocol, the rules governing greenhouse gas emissions trading will be defined by the Conference of the Parties (COP) to the UNFCCC. This Article clearly indicates that the
COP to the UNFCCC will determine all the rules relating to emissions trading, including decisions on whether to harmonise the allocation of permits, and if so on what basis.
Indeed, in order to facilitate trading and increase the environmental performance of an international emissions trading scheme, certain elements of do-mestic trading schemes operating within an interna-tional trading framework need to be comparable across countries, in particular with respect to mon-itoring and enforcement, although harmonisation poses difficult coordination. However, the alloca-tion of permits does not fall into the category of harmonisation. I think that individual governments should be left free to devise their own ways of allocating permits on the following grounds (Zhang, 1998).
First, I think that a firm that has to buy emissions permits is not necessarily at a competitive disadvan-tage, because even if it obtains permits by auction, if necessary, its government still can protect its international competitiveness by means of recycling the revenues raised through auctioned permits to lower other pre-existing distortionary taxes, such as taxes on labour and capital.
Second, although auctioning at least part of the assigned amounts to sub-national legal entities alleviates to some extent the concern about interna-tional competitiveness, any attempts to produce an agreement on a common rate are likely to run into concerns about national sovereignty and thus would encounter significant political difficulties. Take the
above CEC proposal for a carbon/energy tax as an
example. National sovereignty considerations to some extent explain why the CEC proposal for a
carbon/energy tax failed to gain the unanimous
support of its member states, partly because some member states opposed an increase in the fiscal competence of the Community and thus opposed the introduction at a European level of a new tax on grounds of fiscal sovereignty (Bill, 1997). Besides, many existing national policies, including environ-mental policies,6differ widely among countries and 5As part of its comprehensive strategy to control CO
2 emissions and increase energy efficiency, a carbon/energy tax has been proposed by the CEC. The CEC proposal is that member states introduce a carbon/energy tax of US$ 3 per barrel oil equivalent in 1993, rising in real terms by US$ 1 a year to US$ 10 per barrel in 2000. After the year 2000 the tax rate will remain at US$ 10 per barrel at 1993 prices. The tax rates are allocated across fuels, with 50% based on carbon content and 50% on energy content (Zhang, 1997).
constantly affect trade patterns, and firms already compete internationally under very differing cir-cumstances of corporate income tax rates, labour costs and energy prices.7 Even if existing policies
that have already had competitiveness implica-tions are not harmonised across countries, thus an argument for special treatment in the allocation of permits on grounds of competitiveness is not com-pelling (OECD, 1997).
Third, given great differences in national cir-cumstances, setting a uniform rule of allocation will restrict the rights of individual governments to select the option which is best suited to their own national circumstances. Indeed, the failure of
the above CEC carbon/energy tax is to some
extent because some member states are loath to restrict themselves to the common CEC-specified policy. With second-best considerations, it is con-ceivable that some countries whose economies are heavily distorted would decide to auction permits, and that the revenues generated through auc-tioned permits can then be used to reduce pre-ex-isting distortionary taxes, thus generating overall efficiency gains. Parry et al. (1997), for example, show that the costs of reducing US carbon emis-sions by 10% in a second-best setting with pre-ex-isting labour taxes are five times higher under a grandfathered carbon permits case than under an auctioned case. This is because the policy where the permits are auctioned raises revenues for the government that can be used to reduce pre-exist-ing distortionary taxes. By contrast, in the former case, no revenue-recycling effect occurs since no revenues are raised for the government. However, the policy produces the same tax-interaction effect as under the latter case, which tends to reduce employment and investment and thus exacerbates the distortionary effects of pre-existing taxes.8
Be-cause the policy where the permits are given out freely under a grandfathered case does not pro-duce the revenue-recycling effect to counteract the tax-interaction effect, it has a higher economic cost than a policy where the permits are auctioned under an auctioned case. The study of Parry et al. (1997) clearly indicates that if the harmonisation of allocation of permits is in the form of imposing a uniform percentage limitation on the use of auctioning, this will restrict the US potential of exploiting the revenue-recycling effect to counter-act the tax-intercounter-action effect, thus leading to a higher economic cost than would otherwise have been the case.
Fourth, and importantly, leaving individual governments the freedom to devise their own ways of allocating assigned amounts to sub-na-tional entities would ensure that any individual government maintains its right to determine the domestic policies and measures that would be taken to meet its Kyoto obligations. For example, a government that wants to use taxes or regula-tions for domestic emissions control could retain the sole right to trade. As such, any effectuated trades take place on a government-to-government basis. Alternatively, a government could allocate its assigned amounts to private entities, and au-thorize them to trade on the international emis-sions permits market.
4. Concluding remarks
The Kyoto Protocol is the first international environmental agreement that sets legally binding greenhouse gas emissions targets and timetables for Annex I countries. Its Article 17 authorizes emissions trading among Annex B countries. If properly designed, emissions trading can effec-tively reduce their abatement costs while assisting Annex I countries in achieving their Kyoto obli-gations. Past experience has shown that compa-nies are the best entities to trade emissions permits. Allocating permits to individual sub-na-tional legal entities will facilitate private participa-tion in emissions trading. However, the ways to allocate emissions permits promote the concern about international competitiveness. With this
concern in mind, I argue that individual govern-ments should be left free to devise their own ways of allocating emissions permits. This would ensure that individual governments maintain their right to determine the domestic policies and measures that would be taken to meet their Kyoto obligations.
Acknowledgements
This article was part of the presentations at the United Nations Conference on Trade and Development Workshop on International Green-house Gas Emissions Trading, a Side-Event of the Eighth Session of the Subsidiary Bodies of the UNFCCC, 8 June 1998, Bonn; the World
Congress of Environmental and Resource
Economists, 25 – 27 June 1998, Venice; the Eu-ropean Union Workshop on Domestic Trade-able Quotas, 1 – 2 July 1998, Brussels; and the IX Pacific Science Inter-Congress, S-III-2
Eco-nomics of Sustainable Development, 16 – 18
November 1998, Taipei; as well as at a seminar at Renmin University of China, 9 December 1998, Beijing. I would like to thank participants in the above Workshops and Congress, three anonymous referees and Tom Tietenberg for useful discussions and comments on an earlier version of the article. Financial support from the Netherlands Organization for Scientific Re-search is gratefully acknowledged. The usual caveat applies.
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