Chapter 13
Policies, Instruments and Co-operative Arrangements
Box 13.4 The EU Emission Trading System The EU Emissions Trading System (EU ETS) is the world’s largest tradable permits programme. The programme was initiated on January 1, 2005, and it applies to approximately 11,500 installations across the EU’s 25 Member States. The system covers about 45% of the EU’s total CO2 emissions and includes facilities from the electric power sector and other major industrial sectors. The first phase of the EU ETS runs from 2005 until 2007. The second phase will begin in 2008 and continue through to 2012, coinciding with the 5-year Kyoto compliance period. Member States develop National Allocation Plans, which describe in detail how allowances will be distributed to different sectors and installations. During the first phase, Member States may auction off up to 5% of their allowances; during the second phase, up to 10% of allowances may be auctioned off. Market development and prices: A number of factors affect allowance prices in the EU ETS, including the overall size of the allocation, relative fuel prices, weather and the availability of certified emission reductions (CERs) from the Clean Development Mechanism (CDM) (Christiansen et al., 2005). The EU ETS experienced significant price volatility during its start-up period, and for a brief period in April 2006 prices rose to nearly 30 per tonne; however, prices subsequently dropped dramatically when the first plant-level emissions data from Member States were released. The sharp decline in prices focused attention on the size of the initial Phase I allocation. Analysts have concluded that this initial allocation was a small reduction from business as usual emissions (Grubb et al., 2005; Betz et al., 2004). Consistency in national allocation plans: Several studies have documented differences in the allocation plans and methodologies of Member States (Betz et al., 2004; Zetterberg et al. 2004; Baron and Philibert, 2005; DEHSt, 2005). Researchers have looked at the impact on innovation and investment incentives of different aspects of allocation rules (Matthes et al., 2005; Schleich and Betz, 2005) and have found that these rules can affect technology choices and investment decisions. Ahman et al. (2006), Neuhoff et al. (2006) and Betz et al., (2004) find that when Member States’ policies require the confiscation of allowances following the closure of facilities, this creates a subsidy for continued operation of older facilities and a disincentive to build new facilities. They further find that different formulas for new entrants can impact on the market. Implications of free allocation on electricity prices: Sijm et al. (2006) report that a significant percentage of the value of allowances allocated to the power sector was passed on to consumers in the price of electricity and that this pass-through of costs could result in substantially increased profits by some companies. The authors suggest that auctioning a larger share of allowances could address these distributional issues. In a report for the UK government, IPA Energy Consulting found a similar cost pass-through for the UK and other EU Member States (IPA Energy Consulting, 2005).
and the EU ETS. (Babiker et al., 2003; Betz et al., 2004; Klepper and Peterson, 2004; Bohringer and Löschel, 2005). Not only the coverage of sectors may vary in a tradable permits programme, but also the point of obligation. The responsibility for holding permits may be assigned directly to emitters, such as energy-using industrial facilities (downstream), to producers or processors of fuels (upstream) or to some combination of the two (a ‘hybrid system’).11 The upstream system would require permits to be held at the level of fossil fuel wholesalers and importers (Cramton and Kerr, 2002).12 There are two basic options for the initial distribution of permits: (1) free distribution of permits to existing polluters
or (2) auctions. Cramton and Kerr (2002) describe a number of equity benefits of auctions, including providing a source of revenue that could potentially address inequities brought about by a carbon policy, creating equal opportunity for new entrants and avoiding the potential for “windfall profits” that might accrue to emissions sources if allowances are allocated at no charge.13 (See Box 13.4 for a discussion of this issue). Goulder et al. (1999) and Dinan and Rogers (2002) find that recycling revenues from auctioned allowances can have economy-wide efficiency benefits if they are used to reduce certain types of taxes. Dinan and Rogers (2002) and Parry (2004) argue that free allocation of tradable permits may be regressive because this type of allowance distribution leads to income
10 However, they also find that the exclusion of certain sectors, such as residential and commercial direct use of fossil fuels, does not noticeably affect the cost of an otherwise economy-wide tradable permit system covering electricity production, industry and transportation. 11 See IPCC (2001b), Baron and Bygrave (2002), UNEP/UNCTAD (2002), and Baron and Philibert (2005) for a discussion of the advantages and disadvantages of these different approaches. 12 As the discussion below notes, the point of obligation is not necessarily the point at which all permits need be allocated. 13 A hybrid of free allocation and auctioning or emissions taxes is also possible (Pezzey 2003). Bovenburg and Goulder (2001) and Burtraw et al. (2002) find that allocating only a small portion of permits at no cost while auctioning the remainder can compensate industry for losses due to a carbon policy.
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