Editing Emissions trading (section)

==Economics ==
{{See also|Carbon emission trading#Economics}}
It is possible for a country to reduce emissions using a [[Command and control (management)|command-and-control]] approach, such as regulation, [[direct tax|direct]] and [[indirect tax]]es. The cost of that approach differs between countries because the [[Marginal Abatement Cost Curve]] (MAC)—the cost of eliminating an additional unit of pollution—differs by country.

===Coase model===

[[The Problem of Social Cost|Coase (1960)]]<ref>{{Cite web
 |year            = 2001
 |title           = 10.4.5 Who Should Pay for the Response? Mitigation by Countries and Sectors: Equity and Cost-effectiveness Considerations. In (book chapter): Decision-making Frameworks. In: Climate Change 2001: Mitigation. Contribution of Working Group III to the Third Assessment Report of the Intergovernmental Panel on Climate Change (B. Metz ''et al''. Eds.)
 |publisher       = Print version: Cambridge University Press, Cambridge, UK, and New York, N.Y., U.S.A.. This version: GRID-Arendal website
 |author          = Toth, F.L.
 |url             = http://www.grida.no/climate/ipcc_tar/wg3/445.htm
 |access-date      = 2010-01-10
 |display-authors = etal
 |archive-url     = https://web.archive.org/web/20090805205830/http://www.grida.no/climate/ipcc_tar///wg3/445.htm
 |archive-date    = 2009-08-05
 |url-status        = dead
}}</ref><ref>{{Cite journal
 |year=2005 
 |author=Helm, D. 
 |title=Economic Instruments and Environmental Policy 
 |journal=The Economic and Social Review 
 |volume=36 
 |issue=3 
 |url=http://www.dieterhelm.co.uk/node/631
 |page=4 
 |access-date=2010-04-26 
 |url-status=dead 
 |archive-url=https://web.archive.org/web/20110501072425/http://www.dieterhelm.co.uk/node/631 
 |archive-date=2011-05-01 
}}</ref> argued that social costs could be accounted for by negotiating property rights according to a particular objective. Coase's model assumes perfectly operating [[Market (economics)|market]]s and equal [[bargaining power]] among those arguing for property rights. 
In Coase's model, efficiency, i.e., achieving a given reduction in emissions at lowest cost, is promoted by the market system. This can also be looked at from the perspective of having the greatest flexibility to reduce emissions. Flexibility is desirable because the [[margin (economics)|marginal]] costs, that is to say, the incremental costs of reducing emissions, varies among countries. Emissions trading allows emission reductions to be first made in locations where the marginal costs of abatement are lowest (Bashmakov ''et al''., 2001).<ref>{{Cite web
 |year            = 2001
 |title           = 6.3.1 International Emissions Trading. In (book chapter): 6. Policies, Measures, and Instruments. In: Climate Change 2001: Mitigation. Contribution of Working Group III to the Third Assessment Report of the Intergovernmental Panel on Climate Change (B. Metz ''et al''. Eds.)
 |publisher       = Print version: Cambridge University Press, Cambridge, UK, and New York, N.Y., U.S.A.. This version: GRID-Arendal website
 |author          = Bashmakov, I.
 |url             = http://www.grida.no/climate/ipcc_tar/wg3/246.htm#631
 |access-date      = 2010-04-26
 |display-authors = etal
 |archive-url     = https://web.archive.org/web/20090805204450/http://www.grida.no/climate/ipcc_tar///wg3/246.htm#631
 |archive-date    = 2009-08-05
 |url-status        = dead
}}</ref> Over time, efficiency can also be promoted by allowing "banking" of permits (Goldemberg ''et al''., 1996, p.&nbsp;30). This allows polluters to reduce emissions at a time when it is most efficient to do so.

===Equity===
One of the advantages of Coase's model is that it suggests that fairness (equity) can be addressed in the distribution of property rights, and that regardless of how these property rights are assigned, the market will produce the most efficient outcome.<ref name="goldemberg">{{cite book |author=Goldemberg, J. |url=https://archive.org/details/climatechange1990000unse_h1m9/page/29 |title=Climate Change 1995: Economic and Social Dimensions of Climate Change. Contribution of Working Group III to the Second Assessment Report of the Intergovernmental Panel on Climate Change |publisher=Cambridge University Press, Cambridge, U.K., and New York, N.Y., U.S.A. |year=1996 |isbn=978-0-521-56854-8 |editor=J.P. Bruce |page=[https://archive.org/details/climatechange1990000unse_h1m9/page/29 29] |contribution=Introduction: scope of the assessment. |display-authors=etal |display-editors=etal}}</ref> In reality, according to the held view, markets are not perfect, and it is therefore possible that a trade-off will occur between equity and efficiency (Halsnæs ''et al''., 2007).<ref>{{Cite web
|year=2007
|title=2.6.5 Economic efficiency and eventual trade-offs with equity. In (book chapter): Framing issues. In: Climate Change 2007: Mitigation. Contribution of Working Group III to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change (B. Metz ''et al''. Eds.)
|publisher=Cambridge University Press, Cambridge, UK, and New York, N.Y., U.S.A.
|author=Halsnæs, K.
|url=http://www.ipcc.ch/publications_and_data/ar4/wg3/en/ch2s2-6-5.html
|access-date=2010-04-26
|display-authors=etal
|archive-url=https://web.archive.org/web/20100502211617/http://www.ipcc.ch/publications_and_data/ar4/wg3/en/ch2s2-6-5.html
|archive-date=May 2, 2010
|url-status=dead
}}</ref>

===Trading===
In an emissions trading system, permits may be traded by emitters who are liable to hold a sufficient number of permits in system. Some analysts argue that allowing others to participate in trading, e.g., private [[broker]]age firms, can allow for better [[risk management|management of risk]] in the system, e.g., to variations in permit prices (Bashmakov ''et al.'', 2001).<ref>{{Cite book
 |year            = 2001
 |contribution    = 6.2.2.3 Tradable Permits. In (book chapter): 6. Policies, Measures, and Instruments.
 |title           = Climate Change 2001: Mitigation. Contribution of Working Group III to the Third Assessment Report of the Intergovernmental Panel on Climate Change
 |editor          = B. Metz
 |publisher       = Print version: Cambridge University Press, Cambridge, UK, and New York, N.Y., U.S.A.. This version: GRID-Arendal website
 |author          = Bashmakov, I.
 |url             = http://www.grida.no/climate/ipcc_tar/wg3/237.htm
 |access-date      = 2010-04-26
 |display-authors = etal
 |display-editors = etal
 |archive-url     = https://web.archive.org/web/20090805204427/http://www.grida.no/climate/ipcc_tar///wg3/237.htm
 |archive-date    = 2009-08-05
 |url-status        = dead
}}</ref> It may also improve the efficiency of system. According to Bashmakov ''et al''. (2001), regulation of these other entities may be necessary, as is done in other [[financial market]]s, e.g., to prevent abuses of the system, such as [[insider trading]].

===Incentives and allocation===
Emissions trading gives polluters an incentive to reduce their emissions. However, there are possible [[perverse incentive]]s that can exist in emissions trading. Allocating permits on the basis of past emissions ("grandfathering") can result in firms having an incentive to maintain emissions. For example, a firm that reduced its emissions would receive fewer permits in the future (IMF, 2008, pp.&nbsp;25–26).<ref name=imf>{{Cite web
|url=http://www.imf.org/external/np/pp/eng/2008/022208.pdf
|date=March 2008
|author=IMF
|title=Fiscal Implications of Climate Change
|publisher=International Monetary Fund, Fiscal Affairs Department
|access-date=2010-04-26
|archive-date=2010-08-06
|archive-url=https://web.archive.org/web/20100806180316/http://www.imf.org/external/np/pp/eng/2008/022208.pdf
|url-status=live
}}</ref> There are costs that emitters do face, e.g., the costs of the fuel being used, but there are other costs that are not necessarily included in the price of a good or service. These other costs are called [[external cost]]s (Halsnæs ''et al.'', 2007).<ref>{{Cite book
|year=2007
|contribution=2.4 Cost and benefit concepts, including private and social cost perspectives and relationships to other decision-making frameworks
|title=Framing issues.
|series=Climate Change 2007: Mitigation. Contribution of Working Group III to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change
|editor=B. Metz
|publisher=Cambridge University Press, Cambridge, UK, and New York, N.Y., U.S.A.
|author=Halsnæs, K.
|page=6
|url=http://www.ipcc.ch/publications_and_data/ar4/wg3/en/ch2s2-4.html
|access-date=2010-04-26
|display-authors=etal
|display-editors=etal
|archive-url=https://web.archive.org/web/20100502210408/http://www.ipcc.ch/publications_and_data/ar4/wg3/en/ch2s2-4.html
|archive-date=May 2, 2010
|url-status=dead
}}</ref> This problem can also be criticized on ethical grounds, since the polluter is being paid to reduce emissions (Goldemberg ''et al''., 1996, p.&nbsp;38).<ref name=goldemberg/> On the other hand, a permit system where permits are auctioned rather than given away, provides the government with revenues. These revenues might be used to improve the efficiency of overall climate policy, e.g., by funding [[Efficient energy use|energy efficiency]] programs (ACEEE 2019)<ref>{{Cite web|url=https://aceee.org/white-paper/carbon-tax-010319|title=State and Provincial Efforts to Put a Price on Greenhouse Gas Emissions, with Implications for Energy Efficiency|last=eschwass|date=2019-01-02|website=ACEEE|access-date=2019-01-08|archive-date=2019-01-09|archive-url=https://web.archive.org/web/20190109012007/https://aceee.org/white-paper/carbon-tax-010319|url-status=live}}</ref> or reductions in [[distortion (economics)|distortionary]] taxes (Fisher ''et al''., 1996, p.&nbsp;417).<ref>{{Cite book
|year=1996
|author=Fisher, B.S.
|contribution=An Economic Assessment of Policy Instruments for Combating Climate Change
|title=Climate Change 1995: Economic and Social Dimensions of Climate Change
|series=Contribution of Working Group III to the Second Assessment Report of the Intergovernmental Panel on Climate Change
|editor=J.P. Bruce
|publisher=This version: Printed by Cambridge University Press, Cambridge, UK, and New York, N.Y., U.S.A.. PDF version: IPCC website
|url=https://archive.org/details/climatechange1990000unse_h1m9
|isbn=978-0-521-56854-8
|display-authors=etal
|display-editors=etal
|url-access=registration
}}</ref>

In Coase's model of social costs, either choice (grandfathering or auctioning) leads to efficiency. In reality, grandfathering subsidizes polluters, meaning that polluting industries may be kept in business longer than would otherwise occur.<ref>{{Cite web |title=Air Pollution Regulation and Grandfathering |url=https://www.cato.org/blog/air-pollution-regulation-grandfathering |url-status=live |archive-url=https://web.archive.org/web/20240308203107/https://www.cato.org/blog/air-pollution-regulation-grandfathering |archive-date=March 8, 2024 |access-date=2025-02-28 |website=www.cato.org}}</ref> Grandfathering may also reduce the rate of technological improvement towards less polluting technologies (Fisher ''et al.'', 1996, p.&nbsp;417).

William Nordhaus argues that allocations cost the economy as they cause the under utilization an efficient form of taxation.<ref name="nordhaus_taxorno">{{Cite web
 |url=http://www.er.uqam.ca/nobel/r25314/cours/ECO8071/Articles/NordhausToTaxOrNotRevEnvEcAndPol07.pdf 
 |last=Nordhaus 
 |first=William 
 |title=To Tax or Not to Tax: Alternative Approaches to Slowing Global Warming 
 |year=2007 
 |publisher=Oxford University Press 
 |access-date=2010-04-28 
 |url-status=dead 
 |archive-url=https://web.archive.org/web/20110725175014/http://www.er.uqam.ca/nobel/r25314/cours/ECO8071/Articles/NordhausToTaxOrNotRevEnvEcAndPol07.pdf 
 |archive-date=2011-07-25 
}}</ref> Nordhaus argues that normal income, goods or service taxes distort efficient investment and consumption, so by using pollution taxes to generate revenue an emissions scheme can increase the efficiency of the economy.<ref name="nordhaus_taxorno"/>

'''Form of allocation'''

The economist [[Ross Garnaut]] states that permits allocated to existing emitters by 'grandfathering' are not 'free'. As the permits are scarce they have value and the benefit of that value is acquired in full by the emitter. The cost is imposed elsewhere in the economy, typically on consumers who cannot pass on the costs.<ref name="garnaut">{{cite book |last=Garnaut |first=Ross |url=http://www.garnautreview.org.au/chp14.htm#14_3 |title=The Garnaut Climate Change Review |publisher=Cambridge University Press |year=2008 |isbn=978-0-521-74444-7 |contribution=Releasing permits into the market |access-date=28 April 2010}}</ref>

===Market and least-cost===

Some economists have urged the use of market-based instruments such as emissions trading to address environmental problems instead of prescriptive "command-and-control" regulation.<ref name="stavins98">{{cite journal|last=Stavins|first=Robert N|year=1998|title=What Can We Learn from the Grand Policy Experiment? Lessons from {{chem|SO|2}} Allowance Trading|journal=The Journal of Economic Perspectives|series=3|publisher=American Economic Association|volume=12|issue=3|pages=69–88|doi=10.1257/jep.12.3.69|jstor=2647033|doi-access=free}}</ref> [[Command and control regulation]] is criticized for being insensitive to geographical and technological differences, and therefore inefficient;<ref>Bryner, Gary C. Blue Skies, Green Politics: the Clean Air Act of 1990. Washington, D.C.:Congressional Quarterly Inc., 1951</ref> however, this is not always so, as shown by the WWII rationing program in the U.S. in which local and regional boards made adjustments for these differences.<ref>Cox, Stan (2013). [https://thenewpress.com/books/any-way-you-slice-it "Any way you slice it: The past, present and future of rationing"] {{Webarchive|url=https://web.archive.org/web/20190815204318/https://thenewpress.com/books/any-way-you-slice-it |date=2019-08-15 }}. New Press Books.</ref>

After an emissions limit has been set by a government political process, individual companies are free to choose how or whether to reduce their emissions. Failure to report emissions and surrender emission permits is often punishable by a further government regulatory mechanism, such as a fine that increases costs of production. Firms will choose the least-cost way to comply with the pollution regulation, which will lead to reductions where the least expensive solutions exist, while allowing emissions that are more expensive to reduce.

Under an emissions trading system, each regulated polluter has flexibility to use the most cost-effective combination of buying or selling emission permits, reducing its emissions by installing cleaner technology, or reducing its emissions by reducing production. The most cost-effective strategy depends on the polluter's marginal abatement cost and the market price of permits. In theory, a polluter's decisions should lead to an economically efficient allocation of reductions among polluters, and lower compliance costs for individual firms and for the economy overall, compared to command-and-control mechanisms.<ref>Hall, JV and Walton, AL, "A case study in pollution markets: dismal science US. Dismal reality" (1996) XIV Contemporary Economic Policy 67.</ref><ref name="boswall" />

===Measuring, reporting, verification and enforcement===
{{More citations needed section|date=September 2009}}
In some industrial processes, emissions can be physically measured by inserting sensors and flowmeters in chimneys and stacks, but many types of activity rely on theoretical calculations instead of measurement. Depending on local legislation, measurements may require additional checks and verification by government or third party [[auditor]]s, prior or post submission to the local regulator.

Enforcement methods include [[fine (penalty)|fines]] and [[sanctions (law)|sanctions]] for polluters that have exceeded their allowances. Concerns include the cost of MRV and enforcement, and the risk that facilities may lie about actual emissions.

==== Pollution markets ====
An emission license directly confers a right to emit pollutants up to a certain rate.
In contrast, a '''pollution license''' for a given location confers the right to emit pollutants at a rate which will cause no more than a specified increase at the pollution-level. For concreteness, consider the following model.<ref name="Montgomery1972" />

* There are <math>n</math> agents each of which emits <math>e_i</math> pollutants.
* There are <math>m</math> locations each of which suffers pollution <math>q_i</math>.
* The pollution is a linear combination of the emissions. The relation between <math>e</math> and <math>q</math> is given by a ''diffusion matrix'' <math>H</math>, such that: <math>q = H\cdot e</math>.

As an example, consider three countries along a river (as in the [[fair river sharing]] setting).

* Pollution in the upstream country is determined only by the emission of the upstream country: <math>q_1 = e_1</math>.
* Pollution in the middle country is determined by its own emission and by the emission of country 1: <math>q_2 = e_1 + e_2</math>.
* Pollution in the downstream country is the sum of all emissions: <math>q_3 = e_1 + e_2 + e_3</math>.

So the matrix <math>H</math> in this case is a triangular matrix of ones.

Each pollution-license for location <math>i</math> permits its holder to emit pollutants that will cause at most this level of pollution at location <math>i</math>. Therefore, a polluter that affects water quality at a number of points has to hold a portfolio of licenses covering all relevant monitoring-points. In the above example, if country 2 wants to emit a unit of pollutant, it should purchase two permits: one for location 2 and one for location 3.

Montgomery shows that, while both markets lead to efficient license allocation, the market in pollution-licenses is more widely applicable than the market in emission-licenses.<ref name="Montgomery1972" />

===International emissions trading===
{{trade bloc}}

The nature of the pollutant plays a very important role when policy-makers decide which framework should be used to control pollution. CO<sub>2</sub> acts globally, thus its impact on the environment is generally similar wherever in the globe it is released. So the location of the originator of the emissions does not matter from an environmental standpoint.<ref name=EO_1>{{cite web|title=Estimating Offset Supply in a Cap-and-Trade Program|url=http://www.nationalaglawcenter.org/wp-content/uploads/assets/crs/RL34705.pdf|date=16 April 2010| first=Jonathan L.|last=Ramseur| publisher=[[Congressional Research Service]]|access-date=2 January 2024|archive-date=27 September 2013|archive-url=https://web.archive.org/web/20130927185455/http://www.nationalaglawcenter.org/wp-content/uploads/assets/crs/RL34705.pdf|url-status=live}}</ref>

The policy framework is different for regional pollutants<ref name=":3" /><ref>[http://news.bbc.co.uk/2/hi/science/nature/4083331.stm Map: Pollution hotspots] {{Webarchive|url=https://web.archive.org/web/20101116232241/http://news.bbc.co.uk/2/hi/science/nature/4083331.stm |date=2010-11-16 }}, BBC map of areas that suffer from intense local pollution, BBC News, 2004-12-13. Retrieved 2009-10-19.</ref> (e.g. [[Sulfur dioxide|SO<sub>2</sub>]] and [[NOx|NO<sub>x</sub>]], and also [[mercury (element)|mercury]]) because the impact of these pollutants may differ by location. The same amount of a regional pollutant can exert a very high impact in some locations and a low impact in other locations, so it matters where the pollutant is released. This is known as the ''Hot Spot'' problem.

A [[Euler–Lagrange equation|Lagrange framework]] is commonly used to determine the least cost of achieving an objective, in this case the total reduction in emissions required in a year. In some cases, it is possible to use the Lagrange optimization framework to determine the required reductions for each country (based on their MAC) so that the total cost of reduction is minimized. In such a scenario, the [[Lagrange multiplier]] represents the market allowance price (P) of a pollutant, such as the current market price of emission permits in Europe and the US.<ref>{{cite web |url=http://www.chicagoclimatex.com/ |title=Chicago Climate Exchange prices |publisher=Chicagoclimatex.com |date=2009-08-04 |access-date=2009-11-03 |url-status=dead |archive-url=https://web.archive.org/web/20091105001705/http://www.chicagoclimatex.com/ |archive-date=2009-11-05 }}</ref>

Countries face the permit market price that exists in the market that day, so they are able to make individual decisions that would minimize their costs while at the same time achieving regulatory compliance. This is also another version of the [[Ordinal utility|Equi-Marginal Principle]], commonly used in economics to choose the most economically efficient decision.

=== Prices versus quantities, and the safety valve ===
[[File:Regional Greenhouse Gase Initiative (REGI) allowance clearing price in September 2008 through December 2021 (51840469964).png|thumb|upright=1.5|Quarterly clearing price of an allowance to emit a ton of carbon dioxide in the US [[Regional Greenhouse Gas Initiative]], 2008–2021. The price of carbon emission has increased as the number of allowances issued has decreased.]]
There has been longstanding debate on the relative merits of ''price'' versus ''quantity'' instruments to achieve emission reductions.<ref>{{cite journal |doi=10.2307/2296698 |last=Weitzman |first=M. L. |title=Prices vs. Quantities |journal=Review of Economic Studies | volume =41 |issue= 4 |date=October 1974 |pages=477–491 |jstor=2296698 |citeseerx=10.1.1.1031.4819 }}</ref>

An emission cap and permit trading system is a ''quantity'' instrument because it fixes the overall emission level (quantity) and allows the price to vary. Uncertainty in future supply and demand conditions (market [[volatility (finance)|volatility]]) coupled with a fixed number of pollution permits creates an uncertainty in the future price of pollution permits, and the industry must accordingly bear the cost of adapting to these volatile market conditions. The burden of a volatile market thus lies with the industry rather than the controlling agency, which is generally more efficient. However, under volatile market conditions, the ability of the controlling agency to alter the caps will translate into an ability to pick "winners and losers" and thus presents an opportunity for corruption.

In contrast, an [[Carbon tax|emission tax]] is a ''price'' instrument because it fixes the price while the emission level is allowed to vary according to economic activity. A major drawback of an emission tax is that the environmental outcome (e.g. a limit on the amount of emissions) is not guaranteed. On one hand, a tax will remove capital from the industry, suppressing possibly useful economic activity, but conversely, the polluter will not need to hedge as much against future uncertainty since the amount of tax will track with profits. The burden of a volatile market will be borne by the controlling (taxing) agency rather than the industry itself, which is generally less efficient. An advantage is that, given a uniform tax rate and a volatile market, the taxing entity will not be in a position to pick "winners and losers" and the opportunity for corruption will be less.

Assuming no corruption and assuming that the controlling agency and the industry are equally efficient at adapting to volatile market conditions, the best choice depends on the sensitivity of the costs of emission reduction, compared to the sensitivity of the benefits (i.e., climate damage avoided by a reduction) when the level of emission control is varied.

A third option, known as a ''safety valve'', is a hybrid of the price and quantity instruments. The system is essentially an emission cap and permit trading system but the maximum (or minimum) permit price is capped. Emitters have the choice of either obtaining permits in the marketplace or buying them from the government at a specified trigger price (which could be adjusted over time). The system is sometimes recommended as a way of overcoming the fundamental disadvantages of both systems by giving governments the flexibility to adjust the system as new information comes to light. It can be shown that by setting the trigger price high enough, or the number of permits low enough, the safety valve can be used to mimic either a pure quantity or pure price mechanism.<ref>{{cite journal |last1=Jacoby |first1=D.H. |last2=Ellerman |first2=A.D. |title=The safety valve and climate policy |journal=Energy Policy |volume=32 |issue=4 |pages=481–49 |date=March 2004 |doi=10.1016/S0301-4215(03)00150-2 |bibcode=2004EnPol..32..481J |hdl=1721.1/3561 |url=https://dspace.mit.edu/bitstream/1721.1/3561/1/MITJPSPGC_Rpt83.pdf |hdl-access=free |access-date=2019-09-23 |archive-date=2007-06-28 |archive-url=https://web.archive.org/web/20070628142224/http://dspace.mit.edu/bitstream/1721.1/3561/1/MITJPSPGC_Rpt83.pdf |url-status=live }}</ref>