European Union's Emissions Trading System ETS Research Paper

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European Union's Emissions Trading System (ETS)

The objective of this study is to research the European Union's Emissions Trading System (EU ETS) and to answer the questions of what is the stated purpose behind the EU ETS and why the concept of the EU ETS is agreed or disagreed with. The question of what the current and potential results of the EU ETS will be examined and other effects of the EU ETS. This work will examines whether the United States should participate in the EU ETS and what are two other options for achieving the stated purpose behind the EU ETS? The work of Egenhofer, Alessi, Georgiev, and Fujiwara (2011) reports that the objective of the EU ETS is to "promote greenhouse gas (GHG) reduction in a cost-effective and economically efficient manner." (p.1) This has both long and short-term perspectives and specifically "In a short-term perspective (i.e. until 2020), this would mean aiming at the lowest possible EU allowance price to reach a given objective. While this may be sufficient in the short-term, for example to reach the 2020 targets, it masks the fact that over the long-term -- 2050 and beyond -- an efficient climate change policy will need to accelerate the development and diffusion of new breakthrough technologies. If it does not, the EU risks being locked-in into high-carbon technologies, which, once carbon carries a higher price -- explicitly through taxation or emissions trading or implicitly through regulation -- EU industry would become uncompetitive." (Egenhofer, Alessi, Georgiev, and Fujiwara, 2011 p.1)

The European Union's Emissions Trading System (EU ETS) is reported to have been launched in 2005 and to work "on the cap and trade principle. This means there is a "cap," or limit, on the total amount of certain greenhouse gases that can be emitted by the factories, power plants and other installations in the system. Within this cap, companies receive emission allowances, which they can sell to or buy from one another as needed. At present, the vast majority of allowances are given out for free. The limit on the total number of allowances available ensures that they have a value." (European Union Climate Action, 2012, p.1) At each year's ending each company is required to surrender "enough allowances to cover all its emissions, otherwise heavy fines are imposed." (European Union Climate Action, 2012, p.1) The company that reduces its emissions can retain the spare allowances for covering future needs and may sell them to another company that is short on their allowances. It is reported that the flexibility that trading brings "ensures that emissions are cut where it costs least to do so." (European Union Climate Action, 2012, p.1)

The ETS is reported to operate in 30 countries, which includes 27 EU member states in addition to Iceland, Liechtenstein, and Norway. The ETS is reported to cover "O2 emissions from installations such as power stations, combustion plants, oil refineries and iron and steel works, as well as factories making cement, glass, lime, bricks, ceramics, pulp, paper, and board." (European Union Climate Action, 2012, p.1) It is expected that the EU ETS will undergo expansion to the petrochemicals, ammonia and aluminum industries, and additional gases in 2013, which begins the third trading period. Simultaneously there are reported to be a series of important changes that will take effect in the way the EU ETS works which will make the system stronger. Specifically reported is a "single, EU-side cap on emissions and auctioning will become the default method for allocating allowances, progressively replacing free allocation." (European Union Climate Action, 2012, p.1)

Meltzer (2012) reports that the EU, beginning January 1 of this year "included aviation within its cap-and-trade systems" and that Congress has also been actively involved, threatening to make it illegal for U.S. airlines to comply with the EU ETS." (p.1) In fact, there has been a great deal of opposition in not only the United States but in other countries such as China and Brazil to the application of the EU ETS to the aviation sector. The work entitled "Emission Trading: The Pros and Cons" states that it is difficult to internalize "the externality associated with the non-rival and non-excludable costs of the release of carbon dioxide into the atmosphere." (Climate Change, 2008, p.1) The recent use of emission trading is reported to have created a "Coasian market for polluting property rights, which has allowed for increased information sharing, preference revelation and signaling compared with approaches based on strict government intervention." The cap and trade system is reported to have been used for limiting "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." (Climate Change, 2008, p.1)

Emissions trading and conventional Pigovian taxation are reported as such that make provision of "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." (Climate Change, 2008, p.1) From a theoretical viewpoint, the control of either variable result in the same reduction in emission however, it is reported that the advantage of emission 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." (Climate Change, 2008, p.1) This point is illustrated in the following statement:

"if two firms were to face a tax, the emissions target (which would equate to the socially efficient level Q where MB = MSC if perfect information were to exist) would be achieved since neither firm will produce when it is no longer profitable to do so. If tradable permits were used, the firm for which emissions reductions are more costly could buy permits from the other firm, and Q. could be reached without sacrificing as much output. Emissions trading schemes arguably have lower administrative costs due to the incentive for firms to negotiate amongst themselves in order to achieve a least cost reduction (Pindyck & Rubinfeld, 2005). It also succeeds in promoting the development of innovative ways to reduce the original externality." (Climate Change, 2008, p.1)

There is however uncertainty that surrounds the probability and magnitude of future consequences due to limitations of knowledge and this results in an impossibility in measuring the size of the externality and determination of the level of emissions that is optimal. (Climate Change, 2008, paraphrased)

This is problematic in reductions and results in a fertile ground for the pushing of personal agenda by lobbyists. The use of markets has the appearance of bring about success in reduction of emissions at little cost however, it is held by critics that "trading schemes can provide a short-term incentive to over pollute. Harvey (2007) describes how firms that have already reduced their emissions in the past may lose out under such a system. This is because many such schemes allocate polluting permits based on the past emissions of each firm. Companies often have an incentive to increase polluting behavior prior to a scheme implementation in order to inflate past emissions data and receive a higher allocation." (Climate Change, 2008, p.1) This is referred to in the work of Michaelowa and Butzengeiger (2005) as 'grandfathering', which has as its outcome "blatant over-allocation, leading to a market with low liquidity and low permit prices." (Climate Change, 2008,…[continue]

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