Sanjay Patnaik and Jorge Rivera
In recent years, emissions trading schemes (ETS) have become the preferred regulatory tool for many governments for reducing greenhouse gas emissions. While ETS have several potential advantages vis-à-vis other policies, their proponents rarely acknowledge the complex public administrative structures required to implement them. The European Union Emissions Trading Scheme (EU ETS), launched in 2005, is currently the most established and largest multi-national ETS for greenhouse gases in the world. Covering more than 11,000 plants in a variety of industries across the EU, it has provided important lessons and a template for other active and planned ETS by numerous sub-national and national governments around the world (including China, California and South Korea).
Based on insights generated from our multi-year research projects on the EU ETS, we identify three best practices for the design and implementation of ETS: (1) the elimination of free emissions permit allocation to the regulated firms and plants, (2) the harmonization of cross-country administrative structures and rules when linking different ETS, and (3) the provision of more stringent market oversight by regulators.
Who Gets The Allowances?
The first and most essential element of an ETS is setting an overall emissions limit for regulated entities and then allocating the “rights to emit” (i.e., emissions allowances) to them. Since emissions allowances are valuable assets (i.e., they give the owner a property right to pollute and are priced by the market), the allocation of emissions allowances by regulators can become a hotly contested political process.
Similar to the EU ETS, regulators often allocate these allowances for free to existing polluters. The idea is to use free permits to get “buy-in” from firms and reduce their incentives to oppose the new scheme. However, free allocation is a complex administrative task because there are several different ways to allocate these allowances such as, using historic emissions or industry benchmarking on plant efficiency. With a limited number of allowances, regulated firms and industries have an incentive to lobby for a larger share of allowances for themselves.
To avoid this allocation problem, regulators could auction allowances off instead of allocating them for free, an approach that is increasingly being implemented by regulators (including in Phase 3 of the EU ETS and in the Californian ETS). The auctioning approach might be particularly attractive for countries whose political systems lack transparency. Although the design of auctions can be subject to inequitable corporate influence as well, allocation by auction can improve the legitimacy of the system.
Linking Emissions Trading Schemes Across Countries
The second issue worth highlighting relates to the linkage of different ETS and permit markets across countries such as the planned integration of ETS across California, Ontario and Quebec, and the connection of the EU ETS with emissions offset credits generated outside the EU. A linkage implies that, for instance, firms in California can then use permits from Québec and vice versa. Our research suggests that allowing companies to use different types of emissions permits from distinct markets leads to obvious problems. For one, the cost of acquiring a permit to emit a ton of carbon dioxide can differ between California and Ontario (depending on how many permits were allocated in that jurisdiction in the first place). These price differentials can help companies that have the resources to closely follow multiple emission markets, specifically multinational companies. To alleviate this potential issue, we propose that the administrative structures and regulatory rules for linked ETS need to be rapidly harmonized to provide the affected firms with the same rules across markets.
Trust But Verify
A well-functioning ETS requires an oversight system that ensures accurate measurement and verification of emissions levels of the regulated firms, permit traders have the proper credentials and emissions permits in circulation are not fraudulent. This is similar to the stock market where oversight mechanisms such as the Securities and Exchange Commission have been used for a long time. As the experience with the EU ETS shows, a new ETS can be vulnerable to criminal activities and fraud. We therefore suggest that public administrators provide more stringent market oversight and institute government-led verification procedures when implementing an ETS. This could be challenging in developing countries with weak administrative capacities.
In sum, market-based mechanisms might function best in high capacity states; essentially more market, more state. This is an important lesson for the study and practice of public administration.
Sanjay Patnaik is an Assistant Professor of Strategic Management and Public Policy at the George Washington University School of Business.
Jorge Rivera is a Professor of Strategic Management and Public Policy, and Tucker-Endowed Fellow at the George Washington University School of Business.