Permit Trading in Different Applications

Bernd Hansjürgens, Ralf Antes, Marianne Strunz

• Publisher: Routledge
• Year: 2011
• Print ISBN: 9781138241312
• eBook ISBN: 9781136710438
• Topic: Business
• Subtopic: Business General
• Index: Business

Permit trading is an environmental policy instrument that has received increasing levels of attention over recent years. Coming from the field of air quality management, with the European CO2 emissions trading system being the most prominent example, it enters new fields of application, such as land use policy and biodiversity protection, water quality and water quantity trading. This book gives an overview of these recent developments and discusses the possibilities and limits of permit trading in environmental policies.

The advantages of permit trading are not only seen with respect to economic efficiency, which leads to achieving the environmental target at minimum cost, but also with respect to the instrument's environmental effectiveness. By setting a cap for the overall emissions, a given environmental target can be met. This makes permit trading an interesting case for many environmental fields where safeguarding the environmental target plays a dominant role. Against this background, permit trading is discussed in environmental policy fields, where it has not been considered before, for example, land use management, biodiversity protection and water trading.

Permit Trading in Different Applications analyses the properties of permit trading: its possibilities and limitations, its design options and its restrictions on a more general level. It demonstrates how lessons learnt in established policy fields like air quality management can be transferred to new and emerging fields of application. This collection will provide students and practitioners in environmental sciences and policy with valuable research into instrument choice and design with respect to permit trading.

1 Introduction

Permit Trading: A Market-Based Instrument Enters New Fields of Application

Bernd Hansjürgens and Ralf Antes

1.1 Problem Statement and Aims of the Book

Emissions trading or, more generally, permit trading has received increased attention over recent years. Based on the seminal paper by Coase (1960), the instrument was “invented” in the late 1960s by Herman Dales (1968) for air quality policies and Thomas Crocker (1966) for water management. Since then it has left the ivory tower of economic theory and entered into environmental policy. While the first flexibility measures of US air quality policy in the late 1970s (bubble, netting, offset and banking policy) were still in a strong command-and-control tradition (because binding standards were still the dominant element of regulation) (Hahn 1989; Hahn and Hester 1989a, b), it was the US Clean Air Act Amendment of 1990 that put emissions trading into practice in the form of a cap-and-trade system (Ellerman et al. 2000). This system – the “grand policy experiment” (Stavins 1998) – was introduced to combat SO₂ as the main cause of acid rain and came into force in 1995. Even earlier, in 1994, the Regional Clean Air Incentives Market (RECLAIM) was implemented in southern California. This programme built on the design options of the US domestic SO₂ emissions trading, but focused on regional ozone by reducing the precursor substances SO₂ and NO_x (Fromm and Hansjürgens 1996; Harrison 2004). Another milestone of emissions trading in US air quality management was the introduction of the north-eastern states' NO_x Budget Program in 1994 (Farrell 2000).

Since then, emissions trading has been widely discussed for air quality management, in particular for reducing greenhouse gas emissions. The most famous emissions trading scheme today – the “new grand policy experiment” (Kruger and Pizer 2004; Zapfel 2005; Hansjürgens 2005) – is the European Union Emissions Trading System (EU ETS) for CO₂. Based on the Kyoto Protocol, in which emissions trading was proposed for climate policy, it came into force within the then 15 member states of the European Union in 2005. After a “testing phase” from 2005 to 2007 it entered its first “official” phase, which started in 2008 and will run through to 2012. The design of the second Kyoto phase (starting in 2013) – in fact the third phase if the testing phase is included – is already under way. Similarly, several greenhouse gas (GHG) emissions trading schemes are being discussed in the United States and many other parts of the world.

It is thus obvious that much research has already been conducted and is currently under way with respect to emissions trading in general and the EU ETS in particular. In addition, a lot of practical experience has been gained in designing concrete trading systems worldwide (for an overview, see Antes et al. 2008). However, most of the ongoing research activities in the literature as well as the practical experience focus on air quality management, CO₂ trading and climate policy. Thus, one could say that the instrument of “emissions trading” is in a “mature state” in these fields of application.

On the basis of these experiences the advantages of permit trading have become more prominent in public discussion about the choice of instrument in environmental policy. The advantages were (and are) not only seen with respect to economic efficiency, thus leading to the achievement of the environmental target at least cost. (The same is true for other market-based instruments, such as environmental taxation). More importantly, a great advantage is seen with respect to the instrument's environmental effectiveness: setting a cap for the overall emissions makes it possible for a given environmental target to be met. This makes permit trading an interesting instrument for many other environmental policy fields where safeguarding the environmental target and preserving environmental stocks play a dominant role.

Against this background, permit trading is increasingly being discussed in environmental policy fields where it had not been considered before, such as land use management, biodiversity protection and water trading. There are already some analyses in the literature as well as first experiences with permit trading in these emerging fields. The analyses in the literature cover research questions ranging from more theoretical considerations to concrete design options and deepened analysis of implementation issues.

Nevertheless, both the literature and experience in applying tradable permits to new and emerging environmental policy fields where they have not yet been applied are still in their infancy. So far, there are only a few papers in academic journals that solely focus on selective aspects of instrument design. Often, very specific elements are picked out and analysed. Because of the preliminary state of the discussion, numerous research gaps remain. Additionally, lessons learned from emissions trading in the fields of air quality management and climate policy could deliver fruitful insights for the now emerging fields. Thus, there is a lack of analyses that compare the possibilities and limits of permit trading in different fields of application.

Against this background, the aims of this book are:

• To analyse the properties of permit trading comprehensively: its possibilities and limitations, successful design options, restrictions, etc. This will be done in both “traditional” fields of application (air quality and climate policy) and new and emerging fields of application (e.g. biodiversity policy and nature conservation, land use policy, water policy).
• To demonstrate whether lessons learned in “traditional” policy fields can be transferred to new fields of application, and if so, how.
• To fill specific research gaps in instrument choice and (in particular) instrument design.
• To contribute to instrument choice in environmental policy by delivering a comparative analysis of market-based instrument permit trading.

There are two types of arguments that can be developed to find answers to the above questions: First, economic literature deals comprehensively with instrument choice in environmental policy and thus delivers arguments on the possibilities and limits of permit trading. However, textbook analyses are often characterised by comparisons of “ideal” policy instruments, such as command-and-control regulation, environmental taxes or tradable permits, without explicitly considering the characteristics of the policy field for which they are proposed, existing and overlapping policies, or their concrete design. Notwithstanding that there are a few authors who also include such concrete aspects in their analysis when dealing with permit trading (Tietenberg 2006), most of the existing work neglects these considerations in spite of the fact that the implementation of permit trading schemes strongly depends on such factors. Second, insights can be gained from analysing concrete real-world applications of permit trading schemes. In particular, ex-post analysis of existing permit trading schemes may help to derive lessons and improve the design of this instrument in environmental policies. However, this kind of analysis is also very challenging. Very often it is hard to identify whether a certain effect (e.g. an environmental improvement) can be traced back to the instrument of permit trading or whether it has been brought about by other factors (e.g. changing framework conditions resulting from technological change; or other instruments that are also applied in the respective policy field). While the focus of this book is clearly on the second type of argument (the analyses of first experiences with existing permit trading schemes in different fields of application), the theoretical aspects will also be touched on in some of the chapters of the book.

In the remaining sections of this introductory chapter, after providing the necessary definitions (section 1.2), we will recall the economic arguments put forward in favour of emissions trading (section 1.3). We will then derive research questions and practical problems addressed to permit trading when this instrument enters new fields of application (section 1.4). Finally, we will give an overview of the remaining chapters of this book (section 1.5).

1.2 Command-and-Control Regulation and Types of Permit Trading

The background against which economists have developed (and are still developing) arguments in favour of market-based instruments (i.e. environmental taxes or emissions trading) is the existing regulatory framework. Therefore, a brief characterisation of this regulatory framework may be deemed necessary. For regulatory prescriptions in environmental policy, economists often use the term “command-and-control policy”, under which they subsume many kinds of legal prescriptions (ambient standards, emissions standards, technical standards, etc.). The term “command and control” is widespread not only in the economics literature but also in environmental policy. “If ever economists have managed a semantic triumph, it is with command and control, for it is hard to imagine a less appealing term” (Ellerman 2007: 49). However, the term does not cover the essential difference between regulatory instruments on the one hand and emissions trading on the other. Emissions trading rules are also legally binding and incorporate a certain “command”; the instrument also requires “control”. Instead, the decisive difference is that in a regulatory framework it is the regulatory authority that prescribes certain emissions standards and/or technologies which have to be adopted by private entities (companies or households), while in the case of market-based instruments the abatement decision lies with the private actors, and is connected with a considerable degree of freedom as to how, when and where to abate.

Command-and-control policies are criticised by economists mainly because they are not cost-effective. The regulator does not have the necessary information about the cheapest way to abate emissions, nor do the addressees of regulatory prescriptions face adequate incentives to search for innovative least-cost abatement strategies. The result is that environmental policy is a field that is primarily characterised by technical and legal solutions, thus leading to an alliance between engineers and lawyers. Environmental decisions are not dealt with in the companies' strategic departments, nor do they lead to a bundling of companies' competences with respect to discovering new and innovative solutions. Therefore, the assumption made by economists is that environmental policies based on such command-and-control policies are unnecessarily expensive.

The idea behind permit trading is to assign permits (similar to property rights) governing the limited use of the environment, with the sources subject to the trading scheme being required to surrender an allowance for every unit of pollutants they use. The total number of permits issued guarantees that the overall environmental target will be met. The permits are allocated to polluters, who can either use them to cover their own emissions or exchange them with other polluters. The permits are allocated to firms or private households either by selling them, i.e. by auctions, or free of charge, i.e. by a “grandfathering mechanism”. Polluters who have excess permits can sell emissions rights on the permit market, whereas polluters who need additional permits can purchase them on the market. Participants in a permit market make their abatement decision by comparing the cost of additional abatement measures and the price of emissions rights on the permit market. Polluters with higher marginal abatement costs purchase permits, while polluters with lower marginal abatement costs carry out abatement measures and sell their surplus permits on the market (Antes 2006).

There are two distinct types of permit trading: credit-based systems and cap-and-trade systems (Ellerman et al. 2003; Tietenberg 2003). The differences relate to the role of regulation within these schemes. A credit-based system is still characterised by the dominance of regulatory elements: higher than required emissions reductions (“over-compliance”) beyond a certain threshold at one source can be used to “compensate” less than required emissions reductions (“non-compliance” or “under-compliance”) at another source. The threshold that determines over- and under-compliance is normally characterised by a legislative prescription, for example a certain concentration ratio at a source or a specific technical standard (e.g. Best Available Control Technology, BACT). A second aspect that points to the still decisive role of regulators in a credit-based system is the fact that each “trade” has to be pre-certified by the environmental regulator on a one-by-one basis. This leaves great discretionary powers with the regulator – and not with the company – and leads to high transaction costs.¹ In contrast, cap-and-trade systems change the participants' role: While environmental regulators have to design and monitor the trading system and then, if it is successfully implemented, resist detailed intervention, it is in the responsibility of the addressees to develop adequate abatement strategies.

When drawing attention to the advantages of emissions trading (often implicitly), economic textbooks refer primarily to the ideal type of cap-and-trade emissions trading systems, rather than to credit-based systems, and focus on the advantages of these “mature” types of trading. However, the properties of credit-based systems should not be neglected, for two reasons. First, many real-world emissions trading systems have developed gradually, from regulatory prescriptions to credit-based systems and then to cap-and-trade systems. Second, and closely related, many environmental policy fields are based on a strong existing regulatory framework (Burtraw 1996; Hansjürgens 2000). Thus, the path from “command and control” to trading systems may lead through credit-based schemes.

1.3 Arguments Put Forward in Favour of Emissions Trading

1.3.1 Cost Savings

The main advantage of permit trading schemes compared to command-and-control is that permit schemes lead to more environmental protection at less cost. If the addressees of environmental policy are given the discretionary freedom to search for flexible abatement strategies, they will look to discover and realise the least-cost options. This could also result in one source abating more than required (owing to low abatement cost), while other sources could abate less than required (Ellerman et al. 2003; Sterner 2003). As long as the overall environmental target (the “cap”) is met, it is not important who abates by how much. Thus, giving more flexibility and freedom to the companies also means that some companies may not abate. It is important to note that the regulator will not be able to bring about these cost-effective options, owing to information asymmetries: it is the company that knows best how, when and where to abate cost-effectively, while the regula...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright
• Contents
• List of Figures and tables
• List of Contributors
• Preface and acknowledgements
• List of Abbreviations
• 1. Introduction: Permit Trading – A Market-Based Instrument Enters New Fields of Application
• Part I: Emerging Emissions Trading Schemes in Air Quality Management and Climate Policy
• Part II: Permit Trading in Land Use Management and Biodiversity
• Part III: Water Trading and Water Quality Trading
• Part IV: Overarching Design Options and Conclusions
• Index