The European union as first mover in the market for greenhouse gas emissions permits

Abstract

This study aims to analyse the potential market for emissions permits that the European Union (EU) established in 2005, in a first-mover attitude with regard to the frame of the Kyoto Protocol. To this end the integrated assessment Regional Integrated Climate and the Economy (RICE) model is employed, adapted to the specific objectives intended. A referential paretian-optimum price of US$25.63 tCO₂ is obtained around the year 2007, which duplicates the hypothetical harmonized carbon tax. The ratio between the willingness to pay and the net environmental damages as a result of adverse climate change point to the high degree of commitment and the leadership initiative that seem to be assumed by the EU-15, the extended EU including Eastern European countries and the European OECD as a whole, with the hinterland geo-strategic referent represented by Russia and the Ukraine.

Notes

1 Cf. Coase (1960) for a seminal concept of social cost and Solomon (1999) for a compilation of application systems for transferable emissions rights, as well as the incidence of the paradigm in the New International Economics from the viewpoint of efficiency as a valid objective for an economic policy.

2 Cf. inter alii, Chichilnisky et al. (1993 2000), Bohm & Larsen (1994), McCann (1994), Nentjes et al. (1995), Stavins (1995), Hanley et al. (1997), Koutstaal (1997), McKibbin (1998), Zhang (1998), Bohm (1999), Casella (1999), Hahn & Stavins (1999), Kruse & Cronshaw (1999), Woerdman (2000), Schneider & Wagner (2002).

3 With the British as frontrunner a trial was initiated in 2002, which despite its differentiated characteristics, will be inserted at the right time in a harmonized way in the intra-communitary market, in the same way as will happen with the latter in 2008 in the emissions permits market within the scope of the countries in Kyoto Annex B.

4 We take the year 2007 because it is the end of the first period for the application of the European Trading Scheme.

5 The externalities derived from global over-warming, caused by adverse climate change, are incorporated by means of the willingness to pay on the sum of the damages among the different regions, evaluated at regionalized discount rates. In the hypothesis of the implementation of a harmonized global carbon tax, each region will improve its carbon emissions with regard to the value of the assumed impositive charge (which will be equivalent to the efficient first – best price in a supposed global emissions permits market).

6 Fearnside (2002) proposes a pondered index that takes four latent generations into consideration: children, adults, grandchildren and great-grandchildren. This provides greater flexibility for short-term assignation as compared to medium and long term.

7 Cf. Khanna (2001) for an empirically founded critique on the inconsistency of the technological Hicksian-neutral change premise.

8 See Appendix for model specifications.

9 These countries currently play an important geo-strategic role and will continue to do so in the future, in the scope of a common European economic space.

10 Cf. Bodansky (2004) for a survey of approaches beyond 2012.

11 With the acquiescence of Russia, which occurred on 11 November 2004 and the previous ratification by the Ukraine, which occurred on 12 April 2004, the reduction of real aggregate emissions by the EU, Eastern European countries, Japan, Russia and the Ukraine reached 62.57%. However, as the Ukraine's emissions have not been officially communicated to the UNFCCC, they must be discounted, leaving a reduction of 57.67%, which is still sufficient and viable. With the incorporation of Canada, which occurred on 17 December 2002, the statutory percentage rose to 61.01%, while the real one soared to 65.91%. In conclusion, a reduction of two-thirds was reached in 1997 compared to the reference year of 1990, although the USA and Australia opted out of the agreement.

12 Three collateral characteristics of global climate change can be specified: (i) past emissions of GHG and the inertia of global development have conditioned intervention measures at present and in the near future; (ii) the efficacy of a measure adopted unilaterally within the EU aimed at a favourable alteration of the climate change is very little; and (iii) the impacts of climate change on the economy and the environment of the EU differ greatly between Northern countries and Southern countries (Rothmans et al., 1994).

13 Cf. inter alii Grubb et al. (2005), Böhringer & Lange (2004), Böhringer et al. (2004), Kruger & Pizer (2004), Christiansen & Wettestad (2003).

14 By the end of 2005, the exchange's cumulative total of tonnes traded grew to 94 million—on average 900 000 a day. About 60% of volume came from the exchange-for-physical facility, which boomed by mid-summer. The EU ETS covers companies of all sizes—not just utilities and large financial institutions, but industrial and smaller companies as well. These companies typically approached the market via intermediaries such as banks and brokers. At first, the active traders were concentrated in north-western Europe—in particular the UK, Germany and the Netherlands. As the year went on, growing interest emerged from central and eastern European companies. Farther afield, 2005 saw the development of several parallel cap-and-trade initiatives from non-EU regions including Canada, Japan, South Korea, and nine states, as California, and 200 cities in the US.

All 25 EU Member States' National Allocation Plans (NAPs), were approved by the EU, totalling 2.2 billion allowances for 2005. The price was volatile but generally trended up as the year went on. At the beginning of 2005, carbon was trading around [euro]6.00 a tonne of carbon dioxide equivalent (tCO₂-eq.). When European Climate Exchange (ECX), launched carbon contracts in April, the price had risen to [euro]16/tCO₂-eq. The most dramatic moment of the year was the drop from [euro]30 to [euro]18 over a period of two weeks in July. During 2005 the sample price average was [euro]21.58 with a sample standard deviation of [euro]2.61. By the close of 2005, the price hovered around [euro]21. Going forward, if the EU carbon market were to trade three times its underlying asset value, current prices would make it worth close to [euro]150 billion. By any count, the carbon market grew impressively throughout 2005 (ECX, 2006).

15 International Emissions Trading was introduced into the Kyoto Protocol to allow more flexibility for the parties in reaching their targets and to increase its overall cost-efficiency. International Emissions Trading is defined as trading the ‘assigned amount units’, mainly at state level. In contrast to this, the EU Emissions Trading Scheme takes place at the level of installations, thus targeting the emitters themselves. Both systems will be operated independently of each other, at least in their initial phases (Butzengeiger et al., 2003).

16 It is foreseeable that during the second period new regional clusters will have formed that will exchange emissions permits, so the system would tend to a gradual globalization.

17 Allocation is governed by Articles 9 to 11 and Annex III of Directive 2003/87/EC.

18 The quantification of the sanctions indicates the ranking order of market prices considered to be viable. Obviously, the emissions marginal depression costs should be substantially lower than the sanction, so that it will not be worthwhile paying the fine and continuing to pollute.

19 Actually, the ECX is a wholly owned subsidiary of the Chicago Climate Exchange, which manages sales and marketing for European environmental products.

20 The estimate of the impact on permit prices and revenues to the International Emissions Trading, as a function of the amount of their surplus allowances relative to the ‘business-as-usual’ emissions is more colloquially known as ‘hot air’ (Böhringer & Löschel, 2003; Grubb, 2003).

21 First it would be convenient to recall the lack of political-fiscal viability of the establishment of a harmonized global tax on carbon and/or energy, as mentioned previously in this work. Although this may never become a reality on a worldwide scale, regions may be established where a carbon-tax is implemented in the medium or long term, with the necessary precautions in order to safeguard international competitiveness. However, it is true that its quantification constitutes a plausible referent compared to the dilemma of price control versus quantity control.

22 In 2002, the UK was probably one of the first countries to set in motion an instrument of carbon emissions permits market, the ETS, which can be used as a model for similar regimes in other countries, while at the same time the UK benefits from the experience accumulated as first-mover within the EU. It is estimated that a successful ETS can represent a saving of at least 2 Mt C (7.3 Mt CO₂-eq.) annually until 2010, which for the 2002 – 2010 period means 18 Mt C (66 Mt CO₂-eq.).

23 Australia has also refused to ratify the Kyoto Protocol, but its participation share is not relevant for modelling.

24 Data for the Ukraine, estimated by extrapolation, have been incorporated in the term Russia (RU) as it is understood that it will follow the same path as Russia given the significant volume of its emissions contingent, including ‘hot air’.

25 Alternatively it is representative of the opportunity cost for the initial grandfathering allocation and an indicator of the starting price in the auction of 10% of the allowable permits planned for 2008.

26 In this case the USA is also included as a calibrating referent.

27 There is the possibility that appropriate damage signals will not be perceived, either because it is not known how to transmit them or value them or because the political class prefers to maintain dialectic twilight to support its short-term electoral interests.

28 See Appendix.

29 Cf. Azar & Schneider (2002) for a more hopeful alternative analysis.

30 Because the value of the ratio is inversely proportional to net economic damages values at equal willingness to pay values, when small values of the ratio coincide with large net economic damages values, as in the case of the OECD countries, this denotes an attitude which is at the very least passive with regard to assuming the risks derived from adverse climate change.

31 India is included among the low income countries.

32 Although their quantitative results have been reviled by the ecology sector which favours strict criteria in the area of energy efficiency (cf. inter alii von Weizsäcker et al., 1997).

33 Tol (2003) argues that estimates of the marginal damage costs are particularly sensitive to uncertainties in the carbon cycle. A large part of the uncertainty about the marginal costs is due to the choice of utility discount rate. He states ‘the bottom line is that a government should use the same discount rate for all its projects and that the government discount rate should not deviate too much from the preferred social discount rate of its citizens’ (p. 3). It precludes low utility discount rates.

34 The existence of a threshold in the damage function, i.e. D_J (t)= θ_1J · T(t)^θ_2J , is critical to precautionary action. Optimal paths are much less sensitive to uncertainty on the scale of the damages than on the threshold values. The sensitivity analysis on the threshold function parameters shows that the abruptness of the kink does matter: in this model a sharper kink means less effort. Regarding the threshold damage function, it seems comparatively harder to avoid subjective assessments when the uncertain parameters are the scale θ _1j or the exponent θ _2j . With this representation of non-linearity and uncertainty, a kind of precautionary behaviour is revealed by the cost – benefit analysis of optimal reduction paths (Dumas & Ha-Duong, 2004). Moreover, there is a caveat: admittedly, both θ _1j and θ _2j are highly speculative parameters. With different numerical values, one can obtain alternative estimates of the ‘prescriptive willingness to pay’ to avoid non-market damages. Although the numerical values are questionable, the general principle seems plausible. All nations might be willing to pay something to avoid climate change, but poor nations cannot afford to pay a great deal in the near future. Their more immediate priorities will be overcoming domestic poverty and disease (Manne, 2004).

35 For this prospective analysis the willingness to pay methodology is used as a proxy estimator of the prevention, mitigation and adaptation value of future climate change.

36 With damage being a function of the stock rather than the flow (Pearce, 2003).