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a blog from young economists at Nova SBE

European Union Emissions Trade System

The European Union Emissions Trade System (EU ETS) is the world’s first cap-and-trade program for carbon dioxide. It is market-based approach used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants. The Kyoto Protocol inspired it, but they are independent.

The EU ETS was launch in 2005 to combat climate change and was design to be implemented in phases, following a pilot phase, now it is in the third one. This system covers more than 11000 power stations in 30 countries and 41% of the EU’s CO2 emissions. It is expected that by 2020 emission will be 21% lower, and by 2030, 43% lower.

How this program works? It is fix an amount of greenhouse gases that can be emitted by the installations cover by the system. Over time, this amount is reduced, so that emissions progressively decrease. Within the program, companies receive or buy emission allowances, which they can trade between them. Each allowance represents the right to emit one tonne of CO2. Also, it is necessary to pay for the right to emit one tonne of CO2 in the atmosphere, and it is given a financial value to each tonne saved, therefore, companies have a new goal: low-carbon technologies.

I have already described the EU ETS, now I will examine an implication of the Coase Theorem, which has an impact on environmental economics and on public policy in the environmental domain, based on “The Effect of Allowance Allocations on Cap-and-Trade System Performance paper.

The Coase Theorem describes the economic efficiency (more services without using more resources) of an allocation in the presence of externalities (external benefits or damage), which means that private transactions are efficient as long as property rights exist, only a small number of parties are involved, and transactions costs are low.

Under certain conditions, the equilibrium of all the markets in a cap-and-trade program will be cost-effective (possible without spend lots of money) and independent of the initial allocation of tradable rights. Hence, the independence property will be verified: the overall cost of achieving a given aggregate emission reduction will be minimized and the final allocation of permits will become independent of the initial one. This property allows equity and efficiency, thus the government can establish emission reduction goal by setting the cap.

Market imperfections are present in most real-world markets, therefore, there are also present in the European Union Allowances (EUA) market of the EU ETS. Will these imperfections violate the independence property?

The EUA was allocated based on a system that rewards certain cleaner sources. Its initial allocation did not have an effect on firms’ production decisions, suggesting that there have been only a few distortions in the market. With this program, firms are not capable of exercising market power, thus firms are not able to maintain market shares.

The EU ETS involves different nations. As the costs of making an economic change, transaction costs, have been low and due to the presence of intermediaries in the EUA market, trading between different countries has become very frequent.

Provisions that grant allowances freely to new entrants to the market introduced distortions – a departure from the state in each agent maximizes his welfare. This requires that unused allowances be forfeited by any facility that shuts down. These provisions subsidize production violate the independence property.

Solutions are needed. One of the major changes that the European Parliament approved was an increase in the degree of centralization, with only one European Community registry. Therefore, members will have less discretion to determine how many allowances will be distributed within their borders; hence, it will drop the uncertainty regarding the overall level of the cap. Also, if members distribute approximately two-thirds of their allowances through auction, it may provide a useful price signal.

Another positive change was the expansion to new sectors, which had an effect on the decrease of the transaction costs. With all this modification, the EU ETS became more efficient. Thus, the independence property has been particularly important in gaining support for the use of cap-and-trade programs to address environmental issues.

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Author: studentnovasbe

Master student in Nova Sbe

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