Conclusion
In economic terms, tradable emission rights originate from the property rights school and attach a price to environmental pollution. In legal terms, an emission right is not a permanent, private property right, but rather an authorization, or hybrid property right, which can be terminated or limited by the government.
A tradable emission rights system can be designed on the basis of permit trading or credit trading. Permit trading is superior according to neoclassical economic theory. Credit trading, also referred to as performance standard rate trading, is inefficient and its effectiveness is uncertain. The environmental scarcity is not reflected in a price for each unit of emissions: when the economy grows, the supply of credits increases as well, because polluters do not have an emission ceiling. Under permit trading, also called allowance trading or cap and trade, polluters do have an emission ceiling. This design option is both efficient and effective: when the economy grows, the demand for emission rights increases, but the supply of such rights remains constant because of the emission ceiling. The US gained experience with both design options: their SO2 allowance trading scheme is well known. After years of scepticism, the EU agreed upon a directive that allows CO2 permit trading, to start in 2005, for various segments of industry.However, some companies and policy makers in the EU still try to steer the national allocation of emission rights in the inefficient direction of credit trading, for instance by linking the height of ceilings for individual companies, within the ceiling for an industry as a whole, to the size of their production. An institutional economics perspective can explain such attempts. Credit trading is politically attractive, not only for firms, which do not have to purchase new emission rights when they expand, but also for policy makers: the set-up costs (or political transaction costs) of permit trading are relatively high, since it comes to replace existing environmental policy, while credit trading builds incrementally on extant policy by using it as a baseline to calculate the transferable emission reductions.
In addition, some have argued that is it not problematic to start with (elements of) credit trading, assuming that such a scheme can later evolve into a permit trading system. A pathdependence approach, however, suggests that this comes at a risk, because starting with a suboptimal type of emissions trading can result in an institutional lock-in from which it may be difficult to escape in the future. Sunk costs, coordination benefits, learning effects and vested interests are some of the primary self-reinforcing mechanisms that contribute to such a lock-in.Under the aforementioned EU directive, every member state is required to allocate its allowances free of charge to avoid competitive distortions and state aid under EC Article 87. The desirability of such harmonization depends, however, on what law and economics perspective one takes. Often overlooked is that not only the alternative of auctioning, but also allocation free of charge involves costs for firms: emission rights allocated for free have opportunity costs when they are used to cover the emissions of the allowance owner. A firm with gratis emission rights has to include these costs (equal to the allowance price) in the product price if it does not want to go bankrupt in the longer term. This means that it cannot ask lower product prices than its competitor with auctioned rights. According to this efficiency approach, therefore, allowance allocation differences do not lead to competitive distortions or state aid, making harmonization unnecessary. By choosing in favour of harmonization in the directive, however, the EU stresses the legal relevance of the equity approach concerning EC Article 87: a company with gratis allowances has more financial resources than a comparable foreign firm with auctioned allowances, because allocation free of charge implies a capital gift.
It would be inconsistent if this equity aspect were suddenly to cease to play a role in other legal matters related to the same allocation of emission allowances.
An example is the question whether gratis allocation is compatible with the polluter-pays principle established under EC Article 174. According to the efficiency approach, a polluter also pays when allowances are allocated for free, because he/she does have costs, namely the opportunity costs of employing (and thus not selling) the emission rights in producing output. However, according to the equity approach (which does not focus on the efficiency similarities between auctioning and free allocation, but on their financial differences), it is not the polluter who pays, but the public, because gratis allocation can be interpreted as a welfare transfer from the public to the polluters. A consistent application of the equity approach therefore leads to a potential legal conflict with the polluter-pays principle in the EU. Politics, however, is not always consistent from a law and economics point of view: it seems that the political will of the European institutions to allocate emission rights for free carries more weight than the conceptual consistency of the emissions trading system.Notes
1. Some authors argue that more or less similar ideas can be traced back to as far as John Stuart Mill, who wrote in 1848 about the possibility of giving air a market price, or Aristotle, who wrote more than 2000 years ago that which is common to the greatest number has the least care bestowed upon it (see Yandle, 1999: 17; Cole, 1999: 105).
2. Project-based credit trading, like joint implementation (JI) and the clean development mechanism (CDM) as defined under Articles 6 and 12 of the Kyoto Protocol, respectively, is a different story. In that case, an investor receives credits for achieved emission reductions in a (usually foreign) host country. These emission reductions are measured from a baseline that estimates future emissions at the project location if the project had not taken place. These baselines have to be approved before the transaction is allowed, which increases market transaction costs.
3. To clarify the concept of opportunity (or alternative) costs it may be useful to compare (a) the difference between a firm with gratis allowances and a firm with auctioned allowances to (b) a young farmer who has inherited land from his father and a young farmer who has no family in the agrarian sector and thus has to buy land. The first farmer must pass on the opportunity cost of the land in the price of, say, the milk or corn he produces if he does not want to end up bankrupt: he could have sold the land instead of using it. He does have a financial advantage over his young competitor who had to buy the land from someone else, but as a result of the opportunity cost of the land he cannot ask lower prices for his products than his competitor, so that competition is not distorted.
4. In an imperfect market, competition is only distorted in a number of exceptional cases. An example is a price war in which the company with gratis emission rights can survive longer, financially, than a company with auctioned rights. A price war is risky, however, not only from an economic, but also from a legal perspective: the price fighter can be prosecuted by the authorities that enforce antitrust law.
References
Arthur, W.B. (1994), Increasing Returns and Path Dependence in the Economy, Ann Arbor, MI: University of Michigan Press.
Cini, M. and L. McGowan (1998), Competition Policy in the European Union, London: Macmillan.
Cole, D.H. (1999), ‘Clearing the air: four propositions about property rights and environmental protection’, Duke Environmental Law and Policy Forum 10 (103), 103-30.
COM (2000a), Green Paper on Greenhouse Gas Emissions Trading Within the European Union, Green Paper presented by the Commission, 8 March, Brussels: European Commission.
COM (2000b), XXIXth Report on Competition Policy 1999, document SEC(2000)720 final, 5 May, Brussels/Luxembourg: European Commission.
COM (2000c), State Aid No. N 653/99 — CO2 Quotas (Statsstottesag nr.
N 653/99 — CO2 kvoter), Letter by Mario Monti to the Danish government, English version (draft), 12 April, Brussels/ Luxembourg: European Commission.COM (2001), State Aid No. N 416/2001 — United Kingdom Emission Trading Scheme, Letter by Mario Monti to the UK government, C(2001)3739fin, 28 April, Brussels/Luxembourg: European Commission.
Convery, F.J., L. Redmond, Louise Dunne and L.B. Ryan (2003), ‘Assessing the European Union Emissions Trading Directive’, Paper presented at the 12th Annual Conference of the European Association of Environmental and Resource Economists (EAERE), 28-30 June, Bilbao, Spain.
Cozijnsen, J. (2002), ‘Internationale handel in emissierechten: handhavingsinstrument ten behoeve van het Kyoto Protocol en de Europese en nationale uitwerking’ [International trade in emission rights: enforcement instruments under the Kyoto Protocol and the European and national implentation], Milieu & Recht 7/8, 197-201.
Dales, J.H. (1968), Pollution, Property and Prices: An Essay in Policy-Making and Economics, Toronto: Toronto University Press.
Demsetz, H. (1967), ‘Toward a theory of property rights’, American Economic Review 57, 34759.
Dijkstra, B.R. (1999), The Political Economy of Environmental Policy: A Public Chtoice Approach to Market Instruments, Cheltenham, UK and Northampton, MA, USA: Edward Elgar.
Grafton, R.Q. and R.A. Devlin (1996), ‘Paying for pollution: permits and charges’, Scandinavian Journal of Economics 98 (2), 275-88.
Groenenberg, H. and K. Blok (2002), ‘Benchmark-based emission allocation in a cap-and-trade system’, Climate Policy 2, 105-09.
Hildebrand, D. (1998), The Role of Economic Analysis in the EC Competition Rules, The Hague: Kluwer Law International.
Lefevere, J. and F. Yamin (1999), EC Trade and Competition Law Issues Raised by the Design of an EC Emissions Trading System, Scoping Paper No.1, Study for the European Commission DG XI, Designing Options for Implementing an Emissions Trading Regime for Greenhouse Gases in the EC, London: Foundation for International Environmental Law and Development (FIELD).
Montgomery, W.D. (1972), ‘Markets in licences and efficient pollution control programs’, Journal of Economic Theory 5 (3), 395-418.
Nash, J.R. (2000), ‘Too much market? Conflict between tradable pollution allowances and the “polluter pays” principle’, Harvard Environmental Law Review 465, 1-59.
Nentjes, A., P. Koutstaal and G. Klaassen (1995), Tradeable Carbon Permits: Feasibility, Experiences, Bottlenecks, Dutch National Research Programme on Global Air Pollution and Climate Change (NRP), NRP Report no. 410 100 114, Groningen/Bilthoven: RuG/NRP.
North, D.C. (1990), Institutions, Institutional Change and Economic Performance, Cambridge: Cambridge University Press.
Peeters, M. (2002), ‘Een EU-markt voor broeikasgasemissierechten’ [An EU market for greenhouse gas emission rights], Milieu & Recht 7/8, 189-96.
Peeters, M. (2003), ‘Emissions trading as a new dimension to European environmental law: the political agreement of the European Council on greenhouse gas allowance trading’, European Environmental Law Review (March), 82-92.
Pierson, P. (2000), ‘Increasing returns, path dependence, and the study of politics’, American Political Science Review 94 (2), 251-67.
Rose, C.M. (1999), ‘Expanding the choices for the global commons: comparing newfangled tradable allowance schemes to old-fashioned common property regimes’, Duke Environmental Law and Policy Forum 10 (45), 45-72.
Tietenberg, T. (1980), ‘Transferable discharge permits and the control of stationary source air pollution: a survey and synthesis’, Land Economics 56 (4), 391-416.
Tietenberg, T., M. Grubb, A. Michaelowa, B. Swift and Z.X. Zhang (1999), International Rules for Greenhouse Gas Emissions Trading: Defining the Principles, Modalities, Rules and Guidelines for Verification, Reporting and Accountability, UNCTAD/GDS/GFSB/Misc.6, Geneva: United Nations Conference on Trade and Development (UNCTAD).
Tietenberg, T. and D.G. Victor (1994), ‘Possible administrative structures and procedures for implementing a tradeable entitlement approach to controlling global warming’, in Combating Global Warming: Possible Rules, Regulations and Administrative Arrangements for a Global Market in CO2 Emission Entitlements, Geneva: United Nations Conference on Trade and Development (UNCTAD).
Van der Laan, R. and A. Nentjes (2001), ‘Competitive distortions in EU environmental legislation: inefficiency versus inequity’, European Journal of Law and Economics 11 (2), 131-52.
Welch, W.P. (1983), ‘The political feasibility of full ownership property rights: the cases of pollution and fisheries’, Policy Sciences 16, 165-80.
Woerdman, E. (2004), The Institutional Economics of Market-based Climate Policy, Amsterdam: Elsevier.
Woerdman, E., J.T. Boom and A. Nentjes (2002), ‘Economy versus environment? design alternatives for emissions trading from a lock-in perspective’, in M.T.J. Kok, W.J.V. Vermeulen, A.P.C. Faaij and D. de Jager (eds), Global Warming and Social Innovation: The Challenge of a Climate-Neutral Society, London: Earthscan, pp. 160-78.
Worsley, R. and R. Freedman (2003), Europarl Daily Notebook: 02-07-2003, Brussels: European Parliament.
Yandle, B. (1999), ‘Grasping for the heavens: 3-D property rights and the global commons’, Duke Environmental Law and Policy Forum 10 (13), 13-44.
25