Climate Policy 2 (2002) 97–103

Viewpoint

Why should emissions trading be restricted?

Hege Westskog∗Centre for International Climate and Environmental Research, P.O. Box 1129, Blindern, N-0318 Oslo, Norway

Received 6 December 2001; received in revised form 10 January 2002; accepted 15 January 2002

Abstract

The possibility of using flexibility mechanisms as a way to achieve national commitments under an internationalagreement to reduce climate gases has been a hot issue throughout the negotiating process of the Kyoto Protocol. Avariety of arguments either in favour of or against emissions trading have been put forward by different Parties andby different groups. The purpose of this viewpoint is to look further into the various arguments opposing emissionstrading or favouring their restriction (which are really arguments that could be used against all the different flexibilitymechanisms) and comment on their validity.

Keywords:Kyoto protocol; Emission trading; Supplementarity

1. Economic arguments

Objections to emissions trading may derive from genuine concerns about the functioning of a market-based policy design at the international level. During the Kyoto negotiations, Japan, for instance, focusedon the functioning of the market and demanded that any trading of emissions should be competitive,transparent and open (Grubb et al., 1999). This demand probably reflects the concern that several featuresof an emissions trading market could lead to inefficiencies. Here, I discuss the problem of market power,transaction costs and ancillary benefits.

Comments from Cathrine Hagem, Sæbjørn Forberg and Lynn P. Nygaard are highly appreciated.∗Present address. CICERO, P.O. Box 1129, Blindern, 0317 Oslo, Norway. Tel.:+47-2285-8759; fax:+47-2285-8751.

E-mail address:hege.westskog@cicero.uio.no (H. Westskog).1After the final round of climate negotiations for ratification of the Kyoto Protocol, the COP7 in Marrakech, the supplementarity

clause introduced in the Kyoto negotiations remained intact. The Protocol text states that the flexibility mechanisms should be asupplement to domestic action, but it is not defined what supplemental should mean. Hence, the EU did not succeed in establishingbinding restrictions for emission trading within the Kyoto Protocol.

2The main cleavage has been between (1) EU and developing countries, which are sceptical to the flexibility mechanismsand call for restrictions and (2) the USA and the so-called Umbrella Group (comprising Japan, the US, Canada, Australia,New Zealand, Iceland, Norway, Russia, Ukraine and Kazakhstan), which see flexibility almost as a prerequisite to joining anagreement. Environmental NGOs have also played an active role in the debate.

1469-3062/02/$ – see front matterPII: S1469-3062(02)00009-8

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1.1. Market power

The market for emission quotas must be competitive to achieve economic effectiveness, i.e. achievethe goal of emission reductions in the cheapest way possible. This economic effectiveness could bethreatened if certain agents could influence the price of quotas (i.e. exercise market power in the quotamarket). Several authors have discussed the problem of market power in a tradable quota system, the firstbeing Hahn (1984). Westskog (1996) discusses this problem in connection to an international tradableCO2-quota market.

To determine whether the problem of market power really justifies restrictions on emission trading, itis important to address two questions:

1. Is the market power problem really of such dimensions that it is better to choose another policyinstrument, such as non-tradable quotas?

2. Can the market be organized such that this problem does not become excessive?

In the study by Westskog (1996), it is shown that that under specific conditions the market powerexercised by certain agents in an emissions trading market could amount to a 10% efficiency loss comparedto a competitive market. Seen in the context of the Richels et al. (1996) study, which shows that anemissions trading system that allows for flexibility regarding where emission reductions are made canreduce costs by more than 60% compared to a non-trading system, the market power problem can hardlybe an argument against emissions trading. Moreover, concerns of market power effects may also be raisedeven when trading is restricted. Ellerman and Wing (2000) demonstrate that restricting emissions tradingby imposing concrete ceilings on imports of emission quotas gives rise to monopsonistic effects similar tothose that characterize a buyer’s cartel. Limiting quota import may reduce the cost of emissions reductionsfor the importer because demand restrictions are likely to result in a lower quota price. So, the answer tothe first question is most likely “no.”

With respect to the second question, the way quotas are allocated and designed and who and howmany may participate in the trading are important determinants of the extent and effects of market power.Westskog (1996) shows that the way quotas are initially allocated significantly influences the level ofthe efficiency loss from market power. Further, in a study by Hagem and Westskog (1998 ) that focuseson the intertemporal design of the emission quotas, it is shown that quotas that are durable (last formore than one period) may reduce the market power problem at the cost of increasing inefficiency acrossperiods, compared to a banking and borrowing system where quotas last for only one period, but wherequotas can be banked or borrowed across periods. This shows that the design of an international emis-sions trading market can help reduce the market power problem, and answers the second question witha clear “yes.”

1.2. Transaction costs

Transaction costs may also be a problem in an emissions trading market. Transaction costs may arisefrom limits and conditions imposed on emissions trading that can result in large search and informa-tion costs, bargaining and decision costs and monitoring and enforcement costs. (Stavins, 1995, whichdiscusses this issue). The consequence of this is increased costs of reaching the agreed emission goal.

Although not completely comparable to international emissions trading systems, experiences from thenational level (the Acid Rain Program in USA and the New Zealand’s Fishery License Trading Program

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for instance) show that the transactions costs are quite low with emissions trading systems (UNCTAD,1998). The lesson that can be drawn here is that the design issue is again crucial and by a clever design of themarket and the quotas the extent of the transaction cost problem would be reduced. The emissions tradingsystem should, for instance, be designed to provide needed information (Stavins, 1995). Each Party’sobligations must be clarified, performances of different agents must be transparent and the responses tocompliance and non-compliance must be common knowledge.

1.3. Ancillary benefits

Other arguments against following a cost-minimization strategy like full flexibility in emissions tradinghave also risen in the debate. Schleicher et al. (2000) argue that GHG abatement activities can have variousbeneficial side effects. In addition to the reduction of emissions, abatement activities may also give riseto what they call ancillary benefits, e.g. measures to reduce GHGs may also reduce air pollution, whichmay in turn reduce health damages (Aaheim et al., 1999). Ancillary benefits are of a local and regionalcharacter and come about in addition to the global effects of reductions of climate gases. It is argued that acost-effective policy like international emissions trading would lead to conflict with other policy targets,i.e. emissions trading provides incentives to reduce emissions abroad, thus robbing the local communityof the ancillary benefits of its climate investment.

Several arguments could be raised against this way of reasoning: first of all, side effects abatement ofclimate gases like reduced local air pollution could be handled properly through the use of other nationalpolicy instruments in combination with a fully flexible emissions trading system, e.g. through the use ofnational taxes (Hoel, 1993 for a discussion of this issue). Second, emissions trading may in fact realizegreater overall ancillary benefits. Since the extent of the ancillary benefits depends on the state of theenvironment in a given country, undertaking emissions reduction in a country that is already relativelyclean will only result in marginal ancillary benefits. The countries that would purchase quotas in anemissions trading market will be those with high abatement costs and also often countries with relativelysatisfactory local air quality. On the other hand, the countries that would sell emission quotas are thecountries with low abatement costs and are mostly those with relatively large local air pollution problems(the eastern European countries for instance). In other words, the trading mechanism could result inlarger abatement activities (and improved local air quality) in countries with a huge local air pollutionproblems at the cost of only marginal reductions in the local air quality in the countries that buy quotas,compared to a situation with restrictions on emissions trading. So the possible loss of ancillary benefitsby a fully flexible emissions trading system is from my point of view, a poor argument for restrictingemissions trading.

2. Hot-air

Parties that are allocated assigned amounts under the Kyoto Protocol that exceed what their emissionswould be even in the absence of any limitation contribute to the so-called hot-air problem when otherParties purchase these quotas to help meet their targets, or if these quotas are banked for future use.Hot-air quotas that are sold or banked will not represent an equivalent emissions reduction amount inthe seller or banking country. By transferring the surplus either by selling or banking quotas, emissionsincrease more than they would in the absence of trading and banking.

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The problems connected to the allocation of hot-air quotas by having transferable quotas that were notrepresented by an equivalent emission reduction, was one of the reasons that the EU, at the EuropeanCouncil of Ministers meeting in June 1997, concluded that mechanisms such as emissions trading shouldbe supplementary to domestic actions and common coordinated policies and measures (Grubb et al.,1999). They suggested restrictions on quota purchases and sales, where quota sales that are not a resultof an equivalent emissions reduction amount in the seller country should be restricted. However, thequestion is whether restrictions on emissions trading would reduce the problem of hot-air. Even withoutthe possibility of banking quotas, it is not clear whether restrictions on emission trading would have anyimpact on the hot-air problem.3 This will depend on the demand conditions for quotas. The effects ofrestrictions with a country that only sell hot-air quotas are quite clear. Restrictions on the possibility forselling quotas, would here limit the amounts of hot-air quotas sold. However, for countries that do both—sell hot-air quotas and also abate emissions to sell additional quotas, the effects of restrictions are unclear.Restrictions may here only affect the amounts ordinary quotas sold. Empirical studies are needed to givethe answer. In a study by Holtsmark and Mæstad (2000), they find that the EU proposal for restrictingsale of emission quotas, effectively limits the amount of hot-air released through the international marketfor emission permits.4 Further, they underline that restrictions on acquisitions of quotas is not justified.

However, even effective restrictions on quota sale would not necessarily reduce the hot-air problem.The Kyoto Protocol includes a banking possibility. So, a Party with hot-air quotas could bank the unsoldhot-air quotas for future use and hot-air would still be transferred.

3. Technological progress

The Kyoto commitments with full flexibility may provide so much latitude for the OECD countriesthat they need not take much action at home. They might shoulder the burden of abatement globally, butonly by spreading established techniques and never being forced to innovate. If the richest nations neverhave to seriously change course, the prospects for long-term solutions are very remote. By contrast, ifthey are forced to implement some difficult measures at home, they might generate solutions that couldthen spread globally.

This argument for restricting emissions trading reflects the fact that abatement investments may stimu-late endogenous technological innovation by improving factor productivity. Most greenhouse gas abate-ment policy models that incorporate technological change treat such changes as autonomous, i.e. unaf-fected by changes in prices brought about by policy reforms. However, the rate of technological changeresponds to policy initiatives. Climate change policies, in particular, by raising the prices of conventionalcarbon-based fuels can create economic incentives to engage in more extensive research and developmentoriented toward the discovery of new production techniques that involve a reduced reliance on conven-tional fuels. In addition, such policies may lead to increased R&D aimed at discovering new ways toproduce alternative, non-carbon-based fuels. To the extent that expanded R&D efforts bear fruit, they

3 Fewer hot-air quotas sold would not necessarily be a result of imposed restrictions. As Elzen and Moor (2001) argue, a marketwhere the price of emission quotas are driven towards zero (and this is especially so after the exit of the USA, would not be inthe sellers interest. We could expect that a large quota seller with large amounts of hot-air quotas like Russia, would exercisemarket power and limit the amounts of quotas offered on the market.

4 In a study by Zhang (2001) their results are confirmed. He concludes that a ceiling on emissions trading as suggested by EUcould prevent one-third of the amount of hot air from entering the market.

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lead to technological progress. Thus, climate policies, R&D and technological progress are connected:there is an induced component to technological change.5

Hence, if these effects are not included in the considerations when the goal of emissions reductions isdecided, the goal could be said to be to lax and restricting emissions trading would result in higher levelof technological change, which could reduce the abatement costs and allow the possibility of negotiatinga more stringent target at the next crossroads. However, this is really not an argument against emissionstrading, but rather an argument for taking into consideration the issue of technological progress both insetting climate targets and when implementing a climate policy at the national level.

Arguments raised regarding the autonomous technological change effects are also connected to theuneven distribution of opportunities for other agents to introduce technical innovation. If the rate of tech-nological change depends upon who abates, free trade of quotas would influence this rate. For example, ifthe EIT countries have few opportunities to introduce technological innovation through their abatementactivities, whereas the abatement activities carried out by other Annex I countries would induce techno-logical change, sale of quotas from EIT countries to other Annex I countries would reduce technologicalchange. Hence, this might be a valid argument for restricting emissions trading, since we would expectthat the EITs would be sellers of quotas and many other Annex I countries, buyers.

4. Ethical arguments

Emissions trading are viewed as an economically efficient policy instrument, i.e. the target for emissionsreductions is achieved in the cheapest way possible. This logic of economic effectiveness is based on a con-sequentialistic ethical thinking. Various climate policy instruments should be ranked in accordance withtheir consequences and the policy instrument that generates the best consequences should then be chosen.However, consequentialistic thinking is not the only ethical perspective. Non-governmental organizationslike the Reseau Action Climate (Climate Action Network, France) view emissions trading as an immoralactivity that would allow countries to pollute others’ air (Tosteson, 1998). The Rising Tide Network,which is a coalition of groups and individuals “committed to a grassroots approach to fighting climatechange” (http://www.risingtide.nl/statement.html), also opposes carbon emission trading. They argue thatthe burden of reducing greenhouse gas emissions must overwhelmingly be borne by the largest producersof greenhouse gases—the corporations themselves (http://www.xs4all.nl/∼ceo/greenhouse/mania.doc).

This argument against emissions trading is based on a notion of what they call climate justice. His-torically, ‘developed’ nations have had a greater negative effect on the atmosphere, which amounts toan ‘ecological debt.’ These historical polluters should reduce emissions proportional to this debt. . . ”(Tosteson, 1998). This could be viewed as holding a deontological ethical position as opposed to aconsequentialistic way of thinking.

A deontological ethical position focuses on the disposition behind the act and demands that we actin agreement with rights and obligations (not justified by the value of the consequences from actions).The justification for those rights and obligations vary; examples include the ideas that human beings

5 Goulder and Schneider (1999) discuss the significance of endogenous technological change for the attractiveness of carbonabatement. They conclude that climate policies are generally more attractive when the impacts of these policies on technologicalchange are taken into consideration. Schleicher et al. (2000) also discuss the issue of endogenous technological change and theyconclude that “creating appropriate long-term incentives through GHG abatement policies will be an effective way to encouragetechnical progress which is an important force for improving competitiveness and stimulating economic growth.”

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are created in the image of God, that some fundamental rights and obligations are somehow includedin universal reason, or that basic rights and obligations can be derived from the categorical imperative(Kant, 1996). Deontological arguments against emissions trading, like the ones mentioned above, areoften based on a view that pollution that causes systematic, foreseeable and preventable harm should beavoided. The reason for this is that pollution inflicts injury to living beings’ inherently valuable capacityfor flourishing. From this point of view, tradable allowances can be seen as a license to pollute, particularlyif grandfathering is used as a principle for initial distribution and are thus considered an unsuitable policyinstrument.6

Hence, viewing the world through glasses other than the consequentialistic ones could produce perfectlyvalid arguments against emissions trading, like the ones used above. Here the disagreement lies in thefundamental criteria for judging a policy instrument, the norms for determining a good instrument, notthe functioning of this policy instrument.

5. Conclusion

I argue here that both a deontological ethical position and the existence of an uneven distribution ofopportunities for some countries to introduce technical innovation may point toward restricting emissionstrading. Neither the economic arguments nor the arguments related to reducing the hot-air problem, inmy opinion, are sufficiently weighty to justify restrictions of quota trade. In any case, before introducingrestrictions on emissions trading, it is important to ask whether benefits of restrictions (for instance thepossibility for more technological innovation) could be achieved through the use of other instrumentsin combination with an unrestricted emissions trading system. Could we, for instance by subsidizingR&D activities that could reduce the emissions of climate gases, obtain the same results as with restrictedemissions trading and at the same time enjoy the benefits of reduced abatement costs achieved throughan unrestricted emissions trading system? If so and if at lower costs than with restrictions on emissionstrading, we only have the deontological argument for restrictions left. This argument rejects efficiency asa relevant concern and focuses on other criteria like justice and ecological soundness as fundaments forclimate policies.

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