Emissions TradingDenny EllermanSenior Lecturer (retired)Sloan School of Management, MITEngineering, Economics and Regulationof the Electric Power SectorMay 10, 2010A. Denny EllermanPage 2Outline•What is Cap-and-Trade? •Some History and Pictures•Allocation, Allowance Value, and Electric Power RegulationA. Denny EllermanPage 3Two Types of Emissions TradingCredit Trading, or Baseline-and-CreditCredit for over-control of some specified standard usable to excuse under-control elsewhereTrading in differences from pre-existing standardAllowance Trading, or Cap-and-TradeTrading in limited “rights” from the “bottom up”No prescribed standard for individual sourcesSources respond to the “new price” by reducing emissions where internal cost < market priceA. Denny EllermanPage 4Evolution of Emissions Trading• Credit Trading has evolved out of conventional regulation to provide flexibility– Pre-existing standard (baseline) already in place– High transaction costs have limited use– Now, more project, off-system reductions• Allowance Trading is radically different– Decentralized, self-contained property rights system– Emerged in the U.S. out of political stalemate– Far more successful than expectedA. Denny EllermanPage 5A Closer Look at the Cap-and-Trade Mechanism• An absolute limit is decided for the environmental problem• Emitters issued tradable permits = “cap” < previous emissions• A fundamentally different “command” to the firm– Measure and report emissions and – Surrender allowances = emissions– No prescribed practice, technology, reduction, etc.• Tradability enables market and single price to coordinate efficient abatement actions (equal marginal cost)A. Denny EllermanPage 6Three Unique Features• Rights to emit must be created and allocated– Unique in being explicit and transparent– Free allocation to auctioning to “cap-and-dividend”• Emissions must be measured and reported– Radical innovation in environmental regulation• Maintenance of Registry or Tracking System– Analogous to a check-clearing systemA. Denny EllermanPage 7Consequences and ReactionsEfficient, Decentralized Property Rights System,But“Rights to Pollute”?Transformed Regulator…Bank-like clerkButRemoves Administrative DiscretionA. Denny EllermanPage 8Outline•What is Cap-and-Trade?•Some History and Pictures•Allocation, Cost, and Electric Power RegulationA. Denny EllermanPage 9Some History (1)• Early credit-based trading (U.S., late 1970s-1980s)– Some cost savings, but generally disappointing• Leaded-gasoline phase-down (US: 1985-86)– 1stprogram w/o individual approval; successful• Los Angeles RECLAIM Program (1994- )– SO2and NOx; local; multi-sector• US Acid Rain (SO2) Program (1995- )– Canonical cap-and-trade, very successful– National scope, power plants onlyA. Denny EllermanPage 10Some History (2)• OTC/NOx Budget Program (1999- )– Regional, mostly power plants• EU ETS (2005 - )– First CO2and multi-national system– Largest cap-and-trade market and program• Kyoto Protocol (2008 - )– Government trading; essentially voluntary• Regional Greenhouse Gas Initiative (2009 - )– 1stmandatory US program; very low pricesA. Denny EllermanPage 11Why the SO2Program was SuccessfulMonitored reduction in wet sulfate deposition due to Acid Rain Program1989-91 1997-99>403525 302015105Wet SO42- (kg/ha)>403525 302015105Wet SO42- (kg/ha)Image by MIT OpenCourseWare.A. Denny EllermanPage 13CO2Prices in the EU ETS€0€5€10€15€20€25€30€35Weekly observations20052006 20072008Dec07 PricePh2 PriceCER Price20092010What have we learned?• More effective and lower cost than conventional regulation– Firms do respond to prices• Many new, unexpected ways to reduce emissions– Many more ways than could be mandated– No favored approaches/technologies• Cheapest reductions tend to where there are the most emissions: “Dirtier is cheaper”– A matter of amortizing fixed costs: Paid by the tonA. Denny EllermanPage 15Outline•What is Cap-and-Trade? •Some History and Pictures•Allocation, Allowance Value, and Electric Power RegulationA. Denny EllermanPage 16The Allocation Problem• Cap creates a scarcity rent embodied in allowances. Who should receive it?• Prior Use Claims—incumbent emitters– Also, compensation and political uses• Public Use Claims—the government– Expenditures or tax/debt reduction• Cap-and-Dividend—Per capita to households• Always recycled. Issue is how & to whom?A. Denny EllermanPage 18Free Allocation vs. Auctioning• The usual dichotomy in allocation debate– Allowance value to gov’t or corporations– Auctioning often coupled with “double dividend”• But ignores who is the ultimate recipient– Both govt and corp are legal shells– Quite different distributional outcomes• US debate now focused on ultimate recipientsA. Denny EllermanPage 19Cost Implications• Free allocation raises opportunity cost issue– Typically fixed and historical; independent of current emissions or production– Allowance use incurs an opportunity cost– Do emitters recognize opportunity cost?• Straight-forward with auctioning/purchase– Pay as for any other input into productionA. Denny EllermanPage 20Interaction with Electric Power Regulation• Liberalized power markets marginal cost pricing– Allowance cost incorporated into price– Free allocation over-compensates assumingopportunity cost is recognized and passed on• Cost-regulated markets average cost pricing – Only incurred costs are included– Free allocation reduces consumer price effectSummary• A known, tested, and tried concept– Creates a price on emissions and reduces emissions with few other side effects• A highly desirable form of environmental regulation– Radically different from conventional “command-and-control”– Object is to reduce and limit emissions only– Trading is means for least-cost compliance, – Profit is by-product, not the object of tradingMIT OpenCourseWarehttp://ocw.mit.edu ESD.934 / 6.695 / 15.032J / ESD.162 / 6.974 Engineering, Economics and Regulation of the Electric Power SectorSpring 2010 For information about citing these materials or our Terms of Use, visit: