Emission Trading

The externality associated with the non-rival and non-excludable costs of the release of carbon dioxide into the atmosphere is inherently difficult to internalise. Emissions trading has emerged as a popular method of achieving socially optimal emissions reduction. The following analysis discusses the flaws in emissions trading – particularly in light of its use in the European Union – and puts forward suggestions regarding policy initiatives that may help overcome these problems.

The recent use of emissions trading has created a Coasian market for ‘polluting property rights’, which has allowed for increased information sharing, preference revelation and signalling compared with approaches based on strict government intervention (DEFRA, 2003). The so called ‘cap and trade’ system has been used to limit total greenhouse gas emissions and grant allowances to companies giving them the right to pollute. Firms wishing to exceed their allowance must purchase credits from those polluting below their allocation or face heavy penalties.

Both emissions trading and conventional Pigovian taxation provide incentives for individuals and firms to reduce their greenhouse gas emissions to a socially optimal level. Pigovian taxes involve the government increasing the cost per unit of ‘carbon inputs’ while the market determines the efficient quantity. By contrast, ‘cap and trade’ emissions trading schemes involve a government set quantity with a market determined price of carbon based on the reallocation of polluting permits (Gittins, 2007). Controlling either variable theoretically yields the same emissions reduction; however the advantage of emissions trading is that polluting rights are allocated through a market to those who can make the most efficient use of them. Companies that can affordably reduce their emissions will do so in order to sell their credits while firms that generate the highest valued output per unit of input will choose to buy polluting rights (DEFRA, 2003).