RIETI Report June 2010

# Proposal for a Desirable Domestic Emissions Trading System

The issue of climate change has been on countless agendas for nearly two decades and although progress has been slow, it is clear that world leaders are now treating the issue seriously. The immediate focus for many nations is on how best to reduce greenhouse gas emissions to achieve their proposed target levels by 2020. Several major economies have created carbon trading systems but there is controversy about which system will be most effective and equitable in achieving long term reductions in global emissions.

In this month's RIETI Report, Shunsuke MANAGI, who is a Faculty Fellow at RIETI and Associate Professor of the Graduate School of Environmental Studies at Tohoku University, discusses the problems and factors associated with existing emissions trading systems; explains why uniform price auctions are preferable to double price auctions; and offers policy suggestions toward creating a global low-carbon society.

## This month's featured article

### Proposal for a Desirable Domestic Emissions Trading System

MANAGI ShunsukeFaculty Fellow, RIETI

The global environment is a public good that moves beyond national boundaries and impacts us on a global level. If protection of the global environment was left to voluntary efforts by individuals and businesses without any government intervention, it would result in a level of protection that is considered socially insufficient. The need to reach an international consensus on the issue of climate change has been recognized, and indeed, gradual progress has been made in discussions toward achieving that goal. This is evidenced by the adoption of the Kyoto Protocol at the Third Conference of the Parties to the United Nations Framework Convention on Climate Change (COP3) in 1997 and in the latest developments in COP15 in Copenhagen, Denmark, in 2009. From now on, the focus will be on how we can build a system that enables significant long-term reductions in carbon dioxide (CO2) emissions.

#### A new emissions trading system derived from experimental economic analysis

Besides various projects under the Clean Development Mechanism (CDM) and carbon taxes, a market mechanism has been utilized as a way to assign an economic value to CO2 emissions reductions as exemplified by the European Union's Emissions Trading System (EU-ETS). The Japanese government has proposed to achieve a 25% cut in its greenhouse gas (GHG) emissions by 2020 and a 80% cut by 2050, both compared to the 1990 emissions level, provided that all major economies agree to set, and commit to achieving, their respective ambitious reduction goals.

The consensus reached to date among environmental economists is that the use of a market mechanism will help achieve greater results in addressing climate change. That is, assigning a price to CO2 will help reduce GHG emissions from the current level. Previously, environmental groups had been opposed to such a market-oriented approach, saying that such a scheme would enable emitters to emit just as much simply by purchasing emission rights. Today, however, they support emissions pricing.

Some people might purchase carbon offsets and eco-friendly products out of pure moral consideration. But even so, the total emissions volume would not change, if other people were to increase their emissions. A market-based approach is to design a system in such a way that everyone would feel compelled to reduce emissions for his or her own sake. There has been increasing support for this idea.

In fact, the 1990 Clean Air Act of the United States, which called for the establishment of an emissions trading mechanism, has proved to be a successful attempt, not only having reduced sulfur dioxide (SO2) emissions from power plants by nearly half but also induced the development of a new emissions control method which in turn resulted in greater-than-expected reductions in costs. Now, in addressing the problem of climate change, it is believed that we need to introduce carbon taxes applicable to all emitters and set up some sort of emissions trading scheme. But then, what specific policies should be implemented?

Carbon taxes are (to some extent) more desirable than emissions trading as a way to reduce GHG emissions on a global level, not only from an economic theoretical point of view(*A) but also in terms of ensuring effectiveness even in the absence of any reduction mechanism on the part of developing countries. In reality, however, governments are more inclined to opt for emissions trading. The EU-ETS has been launched in the EU. Likewise in the U.S., the Waxman-Markey bill has been put forward in a legislative step toward creating a cap-and-trade mechanism. Carbon taxes have been introduced or are being considered for introduction in some countries, but they are either energy taxes or a combination of energy and carbon taxes in substance. In Japan, the Tokyo Metropolitan Government has launched its version of cap-and-trade system, pilot programs for nation-level emissions trading are being implemented under the initiative of the Ministry of the Environment, and emissions trading is defined as a primary instrument for addressing climate change in the government-proposed Basic Act on Global Warming Countermeasures currently under deliberation in the Diet. With these observations in mind, I would like to propose a new emissions trading mechanism based on findings from our experimental economic analysis.(1)(*B)

#### Problems and factors associated with existing emissions trading systems

One common problem with emissions trading systems is that it is impossible to determine the optimal level of total emissions when information available under such a regime is incomplete. Even if total emissions could be set at a certain fixed level, emission credit prices would be determined by the market. Thus, price volatility would remain unpredictable for regulators. In other words, when such uncertainty exists, there is no telling what prices are fair and reasonable, which would induce strategic and/or speculative moves by market participants, resulting in excessive volatility in emission credit prices.

In fact, the EU-ETS market has been unable to provide adequate price signals due to substantial volatility in emission credit prices. Upon going into operation, the market exhibited extreme volatility with the price of EU Allowances (EUAs) - as emission credits are officially called in the EU - fluctuating between about 18 euro and 30 euro per ton of CO2 (t-CO2). Subsequent price trends show that sufficient stability has yet to be achieved. Also, a comparison with the marginal costs of emission reduction estimated by individual countries shows that emission credits or allowances are generally undervalued in the market.

In Japan, for instance, the marginal cost of CO2 reduction is estimated to be 100 dollars per t-CO2 at the least. If CO2 prices in the international emissions market turn out to be too low, developed countries could lose their incentive to make reduction efforts, thereby impeding the development of relevant technologies. As such, inadequate pricing of emission credits in the market would have significant impacts on GHG emission reductions both in Japan and abroad. Therefore, it is important to discern whether the market would be capable of determining fair value for emission credits and ensuring fair trading, and to understand what factors could affect the market.

While there are a series of factors causing the volatility and uncertainty of emission credit prices, they can be broadly classified into two types, namely, "external factors" that are factors outside the market and "internal factors" that are attributable to the institutional and trading mechanisms of the market.

External factors affecting emission credit prices include political events and developments, unexpected accidents and incidents, and speculative movements, while defects in institutional arrangements, the timing at which to retire emission credits, and the type of trading mechanism (the choice of trading method) can be cited as internal factors. Attention generally tends to be focused on external factors. However, in designing an institutional framework, the setup of internal factors is of particular importance. Needless to say, how to mitigate external shocks is an important issue and has been subject to extensive analysis, as has been the case with respect to financial markets. But defects in the institutional design of a market could turn out to be far more critical in their impact. Not only could they cause the collapse of the institutional system itself, such an inefficient institutional mechanism could adversely affect other markets.

A number of analytical studies have been carried out on various trading mechanisms. A real-time process in which potential buyers and sellers submit their bid and ask prices as seen in securities trading, has been empirically proven for its advantage, in particular, as a mechanism for trading general goods. It has been also shown that theoretically desirable emissions trading could be achieved in a double auction market. Indeed, a double auction type mechanism has been adopted in the EU-ETS and other existing emissions trading markets.

#### Why a uniform price auction is preferable to a double auction

Findings from our analysis show that a uniform price auction is preferable to a double auction. Under a uniform price auction, sellers and buyers would submit a unit price at which each of them wishes to sell or buy an item for trade. Then, the ask prices would be ranked from the lowest to the highest and the bid prices from the highest to the lowest, from which the auctioneer - typically a central or local government - would determine the most desirable price as a uniform unit price at which the item would be actually traded.

A double auction type mechanism, widely used for emissions trading, would not be able to sufficiently fulfill its intended function. The aggregate amount of economic gain for companies can be used as a parameter in comparing various trading mechanisms. One factor that would lower the value of this parameter under a double auction is the speculative behavior of market participants in the course of real-time trading. In an attempt to take profits by reselling emission credits at a price higher than which they were bought, market participants might hold emission credits equivalent to an excessive volume of emissions. Under a uniform price auction, market participants would be left with little room for speculation because the unit price would be uniquely determined.

In other words, we have found that we might be able to improve the efficiency of the existing emissions markets by introducing a trading mechanism that can achieve a more socially desirable distribution of emission credits and provide greater price stability than a double auction type mechanism widely in use today. In particular, a uniform price auction, being simple in its mechanism, would help reduce the difficulties of institutional design, a major impediment to introducing emissions trading in developing countries.

#### Policies toward creating a global low-carbon society

Establishing an efficient domestic emissions trading system is an important step forward but should not be the end of the story. Ultimately, it is essential to create a global emissions market to combat global warming. Thus, we need to incorporate a global perspective in designing and implementing an emissions trading system and carbon taxes. Even today, developed countries account for only half the total GHG emissions in the world. And the proportion accounted for by those countries will decrease in the coming years. This dictates the necessity of having China and other developing countries participate in global efforts to address climate change. One way to achieve this end is to impose border tax adjustments (BTAs) on imports from countries that are not implementing comparable environmental policies. With this, exporters from such countries would be required to pay additional tariffs (carbon tariffs) in an amount equivalent to carbon taxes or the cost of emission credits on top of ordinary tariffs, thereby prompting the governments of those countries to introduce stricter environmental policies.

Lastly, what is important is to create a mechanism under which reducing emissions will result in cost reductions. By doing so, we can open up the possibility of technological innovation - the development of new technologies or alternative methods - to reduce emissions at low costs.(4)(5) In other words, establishing a market that fairly values carbon credits would enable companies to find a new value in initiating new efforts.

Even a model built on what appears to be a very optimistic emissions reduction scenario assumes that carbon credit prices, initially set around $30 per t-CO2, would eventually have to be raised to$200 or more per t-CO2. Those built on a more pessimistic scenario call for a higher price level. Carbon pricing is an indispensable policy in addressing climate change and the development of an effective carbon pricing mechanism hinges on how we can formulate policies to promote a shift to a low carbon society in Japan and on a global scale.

>> The original column was published in Japanese on May 25, 2010

#### Notes:

• *A: The concentration of GHG gases in the earth's atmosphere, which is believed to be the cause of climate change, is dependent not on yearly emissions but on cumulative emissions. For instance, carbon dioxide (CO2), nitrous oxide (N2O), and chlorofluorocarbons (CFC) stay in the atmosphere for 200 years, 114 years, and 45 to 200 years respectively. Therefore, a curve representing the marginal external cost of such pollutant emissions has a flattened shape. In such a case, the marginal benefit curve is steeper than the marginal cost curve, which shows the relative desirability of carbon taxes as a policy option. In other words, based on this ground, we can argue for the advantage of carbon taxes as a policy tool for addressing climate change.(2)
• *B: In the above article, I did not focus on subsidies and renewable portfolio standards (RPS) because, according to research findings in the U.S., these policies are believed to be less efficient than carbon taxes and emissions trading.

However, as a reference for the case of Japan, let me briefly introduce findings from our analysis of the effect of subsidies. As part of tax reform in fiscal 2009 (April 2009 through March 2010), the government introduced tax breaks for the purchase of environmentally friendly vehicles, a new green tax incentive on top of those already in place, effective from April 2009 in a bid to mitigate global warming effects from the transportation sector. The scheme aims to reduce CO2 emissions from the transportation sector by promoting a shift to vehicles with higher environmental performance. The preferential tax treatment, applicable to a wide range of environmentally friendly vehicles, has had a sizable effect on promoting hybrid and other green vehicles.

In our analysis,(3) we examined the CO2 emission reduction effect of the green car tax incentives with respect to new vehicles produced and sold in Japan. Specifically, we estimated the volume of incentive-attributable reductions in CO2 emissions based on findings from our quantitative analysis. The price of CO2, calculated using this estimated volume, is 15,000 yen per t-CO2. The amount is approximately 23 times the carbon tax rate proposed by the Ministry of the Environment in 2005, i.e., 2,400 yen per ton of carbon (which translates into 655 yen per t-CO2). This shows the growing importance of the environment in general, and a carbon trading market in particular, as a national policy issue.

In consideration of the prospect of carbon taxes being introduced in the forthcoming years, I would like to briefly discuss some additional practical advantages of carbon taxes. First, as evident from discussions in the run up to the drafting of the proposed Basic Act on Global Warming Countermeasures, Japanese manufacturers would support the introduction of carbon taxes. As they assume that emission limits would be set in terms of per unit output, reducing CO2 emissions per unit economic activity - and hence minimizing carbon taxes - would be acceptable and reasonable as a goal of business activities. Furthermore, emissions trading is problematic in that it tends to give greater initial emission allowances to less carbon-efficient companies, which would be unfair for those that have achieved high efficiency through voluntary efforts. Also, emissions trading tends to require a very complex institutional framework, which would result in higher administrative costs. This is another reason why carbon taxes are more likely to win support than emissions trading.

The U.S. Congress is also deliberating on a bill to create a cap-and-trade system. But it should be noted that U.S. and Japanese companies are quite different in their stance toward global warming mitigation policies proposed by their respective governments. U.S. manufacturers generally favor emissions trading. This is because they believe that emissions trading combined with offset mechanisms would allow greater flexibility in business management as compared to carbon taxes. In addition, while carbon taxes would increase revenue to the government, the proposed cap-and-trade system could bring revenue to companies because initial emission allowances would be granted, free of charge, to existing companies. Also, as a general tendency, U.S. companies are not as concerned about the efficiency of production processes as their Japanese counterparts.

#### References:

1. Kotani, K., Tanaka, K., and Managi, S. 2010. Designing Emission Trading: Experimental Approach. Working Paper.
2. Kumar, S. and S. Managi. 2009. Energy Price-Induced and Exogenous Technological Change: Assessing the Economic and Environmental Outcomes. Resource and Energy Economics 31 (4) 334-353.
3. Kumar, S. and S. Managi. 2010. Sulfur Dioxide Allowances: Trading and Technological Progress Ecological Economics 69 (3) 623-631.
4. Kuriyama, K. and Managi, S. 2008. Kankyo Keizaigaku o Tsukamu [Understanding Environmental Economics], Yuhikaku Publishing Co., Ltd.
5. Tanaka, K. and Managi, S. 2010. Eko-ka Genzei no Keizai Bunseki [Economic Analysis of Green Car Tax Incentives], Working Paper.

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