Different types of tradable emission rights

On a domestic level, there are two general options to shape a tradable emis­sion rights system, namely, on the basis of (a) permit trading or (b) credit trading. Under permit trading, a government allocates emission ceilings to private parties, allowing them to trade with each other.

Permit trading, which incorporates emission ceilings, is efficient and effec­tive. Newcomers and growing firms have to buy permits, also referred to as ‘allowances’, from other firms (or from a government reserve) to cover the additional polluting activities. Those who leave the industry keep their allow­ances, which they can sell. The system is efficient, because every emission allowance that is used to cover the emissions has a price: either the purchase price of new allowances or the revenues that the polluter forgoes by not selling the allowances it already possesses (which are opportunity costs as we shall explain in more detail later on). Each unit of emissions therefore has a price, since each unit could be sold. Moreover, if the economy grows, the demand for allowances increases, but the supply remains constant as a result of the emission ceiling.

Credit trading, which does not incorporate emission ceilings, is less effic­ient and its effectiveness is uncertain. A firm can create credits voluntarily by reducing its emissions below the emission level required by the applicable voluntary or regulatory policies and measures. For instance, if the policy is a performance (or: relative) standard which requires a certain quantity of CO₂ per unit of output or energy, a firm should multiply this standard with its production volume to obtain its total emission figure. If this firm emits less CO₂ than this baseline (or: benchmark) figure by initiating a certain abate­ment project, it can sell these credits to another firm.

Although companies can achieve cost savings by selling credits, the environmental scarcity under credit trading is not reflected in a price for each unit of emissions. If the economy grows, the supply of credits also increases because companies do not have an emission ceiling but have to observe an energy-efficiency standard. If an energy-intensive company wants to expand production, or if a newcomer enters the industry, it thus has a right to new emissions. These do not have to be purchased from existing polluters, or from a government reserve, within an environmental consump­tion space as in the permit trading system. Instead, the company receives its emission credits above and beyond the existing quantity. The consequence is that the social costs of the extra emissions are not fully reflected in the costs per unit of product and thus not in the product price. Carbon-intensive products are therefore priced too cheaply, leading to an inefficient restruc­turing of production.

The market transaction costs of credit trading would not differ much from permit trading, because both types make use of the information advantages of the private sector and do not require advance approval of every entitlement transfer. Nevertheless, the determination of the allowed emissions for a given year is more difficult under credit trading, because these are not given (as under permit trading), but have to be calculated on the basis of existing climate policy, for example by multiplying the performance standard with the energy use in that year, which can be done accurately only ex post.²