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A country committed to a limit on its GHG emissions can meet this limit by implementing a tradable permit system that directly or indirectly limits emissions of the domestic sources covered by the commitment. The large number and diverse nature of the sources covered by national limits on GHG emissions raises issues of how to assign permit liability. If permit liability is imposed at the point of release to the atmosphere, a so-called “downstream” system, individual vehicle owners and households would have to participate.
Some emissions, such as HFCs, sulphur hexafluoride (SF6), and energy-related CO2, can be controlled indirectly, with a so-called “upstream” system, by limiting substances that ultimately result in GHG emissions (see, e.g., IPCC, 1996; Bohm, 1999).36 Since energy-related CO2 emissions are linked to the carbon content of fossil fuels, the system could be implemented by requiring fossil fuel producers and importers to hold permits equal to the carbon content of the fuels sold domestically.37 Permit liability for energy-related CO2 emissions could be imposed at any point in the fossil fuel distribution chain and at different points for different categories of sources, for example downstream for large industrial sources and on petroleum companies for transportation fuels.38 Industrial non-energy sources of GHG emissions also lend themselves, at least partially, to inclusion in a tradable permit system (Haites and Proestos, 2000).
Permits equal to the emissions limit are distributed (gratis or by auction, usually to permit-liable entities) and each permit-liable entity is required to hold permits equal to its actual GHG emissions or actual sales of regulated substances as appropriate. Permits may be traded, at least domestically and at least among permit-liable entities. Such a tradable permit system is well known from the literature to be cost-effective if transactions costs are not prohibitively high and if there are no significant imperfections in the permit market and other markets pertaining to the emitting activities (see IPCC, 1996, p. 417).39
Some sources of GHG emissions, such as methane emissions from livestock, as well as small sources, are very difficult to include in a tradable permit system because it is difficult to measure actual emissions (or an accurate proxy for actual emissions). In practice, then, the emissions cap for the tradable permit system is less than the national emissions limit and some sources need to be addressed by other policies.40 For example, a government that takes part in an international agreement, such as the Kyoto Protocol, may establish an emissions cap for the tradable permit system on the basis of the initial national limit or the ex post limit, taking into account its net transfers under the Kyoto mechanisms.41
With a significant number of permit-liable entities it should be possible to establish market institutions that have low transaction costs and that limit the scope for market power.42 The only situation in which there might not be enough permit-liable entities is in a small country with an oligopolistic market for fossil fuels and an “upstream” trading system.43 In particular, if an exchange institution is used, transaction costs are likely to be small and market power (the possibility of one or more market parties to manipulate market conditions in their favour, or to try to achieve such a result by taking speculative positions) is unlikely to have a noticeable influence on the transaction volume or final market prices (e.g., Smith and Williams, 1982; Carlén, 1999).44 If the domestic tradable-permit system is integrated with an IET market (see Section 6.3.1)–which further increases cost-effectiveness–any remaining market power concerns are greatly diminished.
Some analysts argue that to allow entities, in addition to permit-liable participants, to participate in the market is desirable for several reasons. It allows the risks of changes in permit prices to be borne by the entities (e.g., private brokerage firms, traders, professional speculators, or arbitrators) best able to bear those risks. It may also improve intertemporal efficiency if other entities have relevant information not heeded by permit-liable participants. The behaviour of participants in the permit market might need to be supervised in the same manner as in other financial markets, regardless of whether they are permit-liable or not, to prevent abuses such as insider trading and efforts to manipulate the market.
Permit prices fluctuate, but this does not mean that prices of the products of permit-liable entities fluctuate to the same extent. Crude oil prices change daily, but the prices of various petroleum products, such as gasoline, are much more stable. Forward contracts and options are used to transfer the risks of price fluctuations to sources willing and able to bear those risks.45 The same mechanisms are likely to be used by permit-liable entities to deal with the risks of fluctuations in permit prices.
The market value of the permits needed by a permit-liable entity is passed on to customers in the form of higher prices, to employees through lower wages, to shareholders through lower returns, and to suppliers through lower prices. To answer how the costs are shifted to these different groups requires a comprehensive model of the economy with accurate values for relevant price elasticities. Ultimately, the costs are borne by individuals, with the impact on a particular person reflecting his or her role as an employee, investor, and/or consumer of various products.46
Permits can be distributed to permit-liable entities (and/or others) gratis or by auction.47 Gratis allocation requires a rule for distributing the permits among the recipients. Since the permits represent an asset transferred to the recipients it can be difficult to find a rule that is considered fair by all. An auction raises revenue. All of the revenue could be returned to permit-liable entities, but this needs to be done in a manner that leaves them with an economic incentive to reduce their emissions. The revenue could also be used for a variety of other purposes. Compensation could be provided to industries, whether or not they are permit-liable entities, or households that bear a disproportionate share of the impact. The revenue could also be used to reduce existing distortionary taxes and so reduce the net cost of the emission reduction policy (see Section 6.5.1). The introduction of an emissions trading programme, like the imposition of any new tax or regulation, imposes adjustment costs on the affected entities. This is true whether the permits are auctioned or distributed gratis. Moreover, some gratis allocation rules discriminate against new entrants (IPCC, 1996; Cramton and Kerr, 1998; Zhang, 2000).
Assuming compliance, permits are a more certain means than taxes of achieving quantified national emission limits. In addition, a tradable permit system with auctioned permits is more likely to provide the efficient price signal than a tax rate set by the government. However, the certainty of achieving the emissions levels provided by a tradable permit system incurs the cost of permit prices being uncertain. Some have argued in favour of introducing a trigger price into a permit trading system to meet this concern, namely the absence of an upper bound on the price and hence on compliance costs (See e.g., Kopp et al., 1999a). When the permit price reaches the trigger, additional permits are sold by the government to prevent the price from rising further. Such a hybrid system fails to guarantee particular emissions levels, but does limit the economic cost of the programme for its users.48
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