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INSTITUTIONAL DESIGN OF EMISSION TRADING SYSTEMS:

LESSONS FROM THE EU CASE

element Assignment II Examination Institutional perspectives on societal change and spatial dynamics Name Francesco Nicoli Student number S4176286 Mail address Francesco.nicoli@usi.ch

ABSTRACT The aim of this article is to show why the traditional inter-national schemes are only a sub-optimal solution to mitigate the global warming effects, and to provide some recommendations with the aim of increasing their efficacy. In order to demonstrate the suboptimal efficacy we will present the case of the European Emission Trading System, underlining the institutional limits of the international approach; furthermore, we will present two institutional propositions to enhance the grade of mitigation obtained through market dynamics.

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INTRODUCTION
This paper aims to further develop some findings of the group essay. In that work, we have studied the institutional dynamics that led the global efforts to mitigate the global warming effects. We underlined that the most relevant institutional problem that frustrates the efforts of the actors involved in this important challenge is the absence of a global political power that can use both persuasion and coercion to push nation states into cooperation; without such kind of global governance, nation states have strategic interests to not cooperate. Nevertheless, if the optimal political solution seems to be far from being reached, there exists a second best solution based on market dynamics, the institution of a global emission trading scheme. Why an emission trading scheme, that adopts a market approach to reduce emissions, is only a sub-optimal solution, and how can we enforce its efficacy? We find two kinds of answers, that are going to be presented in the following sections.

WHY A SUB-OPTIMAL SOLUTION?

Basically, an emission trading system is a market for pollution rights in which a country (or a group of countries) distributes permissions to firms to emit a certain amount of greenhouse gasses. Enterprises are expected to have an environmental accountability and at the end of a given period, they must give back to the political authority an amount of permissions that cover the realized emissions or incur in administrative sanctions. In the meantime, the political power sets out a market where enterprises can trade between them the pollution permissions; they will buy permissions if they choose an high emission production path, and they will sell emissions if they choose to invest in low emission technologies. Therefore, the equilibrium realized through demand and supply of permissions will generate additional costs for polluting enterprises, costs that increase relatively to the number of polluting companies. From a theoretical point of view, the system represents an internalization of an externality (pollution) and, if well designed, creates strong economic incentives for the companies to invest in the long run in low-intensive technologies to produce their goods and services. Several nations and regional organizations, in the world, have adopted trading systems inspired by this scheme: between them the most advanced program concerns the European Union, but also Australia and Canada have adopted a similar approach, based on the recommendations of the Kyoto Protocol. From an institutional point of view1, an emission trading system represents an approach that concerns mainly the public sphere and the market sphere. The relative weight of the state and the market could change if the ideological framework of the policy makers is more or less market oriented, but there is no doubt that the civic sphere is relegated mainly to the activity of making pressure on the public power.2 A further distinction must be made between public and private actors participating in the market sphere, and public and private actors that do not participate in the market game. Within the first category we can of course consider private companies, that trade goods and emission permissions, and the agency of the state charged (at least) of the initial allocation of the permissions. The actions of these actors directly influence the price of the permissions and consequently the efficacy of the system. In the second category, we find other private and public actors, as for example the Government that decides the amount of the distributed permissions. Figure 1 represents a general model of this scheme. Why does this kind of system, even if extended on the global arena, still represent only a second best solution, while the first best solution is represented for a global political governance? We found out two kinds of answers: the first kind, partially already examined in the previous group work, is mainly a theoretical point of view based on some economic reflections. The second is mainly a problem of institutional design and the study of the European Emission Trading Scheme, that we are going to present in its evolution, shows some evidence of that. 1) Economic reflections From an economic point of view, we can find two kinds of problems that make this solution a second best alternative. Firstly, we must keep in mind that the first best alternative, a comprehensive global governance, must be considered as point of reference. Such global political governance would be able to recur at some direct instruments (that we called in our previous work hard regulation, taxation and incentives3) that are more
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See Figure 1 in the annexes In the final recommendations we will underline that a direct role of the Civil society organizations, as well as a more active role of the state, can improve the efficacy of these schemes. 3 Van Bussel, Toptsidou, Nicoli, Teigny, Basaran (2011, groupwork) pag. 15-16

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precise if applied on the global scale: one of the criticisms that concern these instruments, is that independent nation states, if they are not bound in some way, have a strategic interest not to apply them; in the ideal case of a global political governance this problem is avoided and these instruments are efficient and precise because the Global Government can exactly decide how much pollution can be realized, which technologies are forbidden, etc. Differently, in a market based instrument (at least in the traditional design) the state has only the role of designing the market and providing the initial amount of permissions: the price of these permissions (and consequently the size of the market incentive for reducing emissions) depends on the calculations of the companies, that depend on a plurality of variables, on the general economic situation, etc.4 That means that an emission trading system is much more imprecise than a pure regulation scheme; it becomes an attractive solution only if the global governance solution is not available for political reasons because it doesnt need a comprehensive agreement on global warming, but a basic agreement that is easier to reach. But in the case of an absence of common political power, the permissions are distributed by nation states, with the connected risk of an oversupply of permissions to national enterprises to help them into the international competition, falling again into a strategic dilemma that will lead the system to decrease the emissions less than expected. This point will be better explained in the next section, through the example given from the evolution of the European Emission Trading Scheme. 2) Some lessons from The EU Emission Trading Scheme (EU-ETS) A second element that helps us to understand why a market for pollution rights is an imperfect solution to the global warming mitigation problem concerns the institutional organization of the market itself. The study of the evolution of the EU-ETS shows that the simple coordination of national based trading schemes is not enough to provide strong incentives in reducing greenhouse gas emissions. The EU-ETS was prepared by the European Commission and the Council of the European Union between 1997 and 2005, and was firstly organized mainly as an inter-governmental process. The system of relations between the public power and the market sphere is inspired by the typical liberal scheme, where the public powers are limited to regulate the functioning of the markets and to provide the initial amount of permits. The implementation of the projects was divided in operative phases allowing the public power to learn in the previous phase and to modify the system in the following terms, reducing the total amount of available permits. The first phase started in 2005 and finished in 2007, covering about 46% of EU CO2 emissions5; the second phase started in 2007 and will finish in 2013; the third phase will consequently start in 2013. As the expectations arisen around this instrument were high, the final results of the first phase and the ongoing results of the second phase are perceived as a sign of the partial failure of the system. What is interesting for us is that this partial failure can easily be explained by an analysis of the institutional setting. The first two phases have been defined as learning terms. A first pilot period covered the three years 20052007: during this term the Nation States determined the total amount of the permissions to distribute national companies, through the National Allocation Plans6; the European Commission could only verify if the amount of permits decided by the states met the general requirements of the Directive. The result was an over-allocation of permits, because nation states wouldnt generate additional costs for national companies7; that generated, after a first increase in prices, a drop of the value of the permits down to 0, generating the partial failure of the system. This drop of the prices was also determined by the impossibility to trade the permissions after the end of the term, generating a loss of value in the last months. In this first step, the role of the public power (represented by nation states) is mainly limited to the initial supply of permissions and a general supervision
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Particularly interesting under this perspective is the dynamic of the permissions prices during Phase I EU ETS (20052007). As the system was new, in the first period the lack of information induced companies into defensive behaviour, leading them to buy permissions, thereby raising the price. However, when it became clear that there were too much permissions (over-allocation) and that the permissions saved in the first phase wouldnt be accepted in the second, companies started to sell them; the price reached its lowest level in April 2006 and stood at this level until the end of the phase in 2007. See A.J.Drew (2009) Government Failure and the EU ETS: What prospects for phase 3?. Published version of a Master of Science Dissertation, London School of Economics and Political Science, London, UK, pag.4 5 J. Kruger, W. E. Oates, and W. A. Pizer (2007) Decentralization in the EU Emissions Trading Scheme and Lessons for Global Policy. RFF Discussion Paper 07-02, pag.8 6 N.Stern (2006)The Economics of Climate Change. Cambridge University Press, 2006, pp 327 7 C. DOultremont (2010) The EUs Emission Trading Scheme: Achievements, key lessons, and future prospects. Egmont Paper 40, Royal Institute for International Relations, 2010, pag. 11

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after this action: the final quality of the output depends on the markets dynamics generated by the initial availability of permissions. The result was that the emissions were effectively reduced, but less than expected.8 9 The second term started in 2007 and is expected to finish in 2013; the second version of the scheme contains some important technical improvements, as the possibility to trade permissions within two temporal terms, the possibility to have recognized green investments made abroad-namely in the developing countries,10 and the enlargement of the concerned sectors to aviation; despite of that the institutional problem was not solved; it still were the nation states that decided national caps and distributed permissions; and again, they were too generous in their allocations11, obliging the Commission to recur to its supervision power rejecting several propositions for national caps; in the following legal dispute the European Court of Justice recognized the legal validity of the nation states purposes, obliging the Commission to prepare a third phase of the scheme, where the power to decide national caps would be centralized in the communitarian level in order to avoid strategic defections from the scheme. Note that in the phases I and II the public power in the market is the nation state as original supplier of permissions, where the Commission is a public actor out of the market12; we can conclude that in the phases I and II The EU-ETS essentially links the domestic trading programs of 25 countries, which, although subject to some common standards and oversight from the European Commission, still have considerable autonomy.13 The European Commission seems to have understood the institutional problems that have generated the partial failure of the phases I and II. Designing the phase III some more changes have been taken into account, including a major evolution: after 2013, instead of 27 national caps approved from the Commission, it will be the Commission itself that will decide an European cap, distributing permits to member states; moreover, by November 2010 the European mechanism of auctions for permissions was approved.14 These modifications represent a major evolution both from an institutional design point of view, and from the strategic interaction point of view. Under the first kind of analysis, this means that the Commission will now be the public actor in the market, were the nation states are going to be marginalized.15 From a strategic point of view this is a crucial evolution: the centralization of the power to distribute permissions allows to avoid the strategic interactions dilemmas that led states to over-allocate permissions, increasing the capacity of the system to reach its targets. This simplified centralized scheme is resumed in the appendix in the image 3. The analysis of the EU-ETS supports our claim that the emission trading schemes are a sub-optimal solutionif compared with a comprehensive international political agreement: to work properly they need a transfer of political sovereignty (As in the case of the EU) because the intergovernmental coordination still leads the agents into strategic dilemmas; But in the case that states are world-widely disposed to give a real political sovereignty away, then other instruments (excluded before as they needed large political agreements) become more attractive because they are more precise and less influenced from external factors than emission trading schemes. In other words, trading schemes help to challenge mitigation problems, but they are not a substitute for a political agreement because still they need it to work properly. In the last section we will briefly propose two institutional improvements that could enhance the effectiveness of the system as well as the role of the Public action (subordinated to the market dynamics in the traditional model) as well as the role of the civil society institutions, that are completely irrelevant in the traditional model.

TWO PROPOSITIONS TO ENFORCE THE ROLE OF THE CIVIL SOCIETY AND OF THE PUBLIC POWER.

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A.J.Drew [2009, cfr. Note 4] pag.5 For the first period, the over-allocation has been estimated to exceed the 6%. see A. D. Ellerman and B. K. Buchnerb (2007 ) Over-Allocation Or Abatement? A Preliminary Analysis of the EU-ETS Based on the 2005-06 Emissions Data. Environmental and Resource Economics, Vol. 41, n2, pag. 13-14. C. DOultremont *2010 cfr note 7] pag. 17-19 11 Ibidem pag.12 12 The institutional setting of the phases I and II is summarized in figure 2. 13 J. Kruger, W. E. Oates, and W. A. Pizer [2007, cfr. Note 5] pag.23 14 Department of Energy and Climate Change (2011) The EU Emissions Trading System: Preparing for Phase III (and implementation of Phase II). Internal Working paper. Pag.6. 15 See image 3 in the appendixes.

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The EU-ETS, in its third phase, is going to evolve from a system based on intergovernmental cooperation to one based on sovereignty transfer, probably improving considerably its effectiveness for the period 2013-2020. Still, I think that some other measures can be adopted to enforce it even more: these propositions are summarized in the appendix in the image 4. Firstly, we have said that the periods 1 and 2 were learning terms: the Commission used the useful signs that arrived from the first two administrative terms to design the system for the third administrative term. We have also said that the public power (the nation states in terms I and II, the commission in term III) are actors in the market. This is not completely true: they are actors in the market only during the constitutional phase of the market, when they design the system and distribute permits. After this constitutional moment, they retreat themselves from the market until the end of the administrative term, learning from the market dynamics and evolving the system in the following term. The market designed in this way responds to a pure liberal ideology, where the state has only a role of regulator of last resort. But it is not the only available idea of market. We can also imagine a market where the activism of the public power is more relevant, and where the public power must not wait for the next administrative term in order to correct imperfections of the system: it would be possible, for example, if the Commission would dispose of a central bank of emissions, that - acting exactly as a monetary central bank (buying and selling financial instruments to influence interest rates) - is enabled to buy and sell permissions in order to avoid drops in the prices. In this way the temporary distance between the learning moment and the correction moment will be enormously reduced, allowing the public power to address the system in a better way. This perspective also opens several options for a civil societys activism in the market. In the traditional liberal scheme, the civil sphere is completely marginalized to the role of making pressure on political institutions: in a pure market-based system that aims to reach emission reduction targets through automatically generated economic incentives, there is no space for social activism. But I think that this statement is the consequence of an incorrect idea of the market: non-profit enterprises, as well as the public power agencies, are part of the market in the measure that they participate in buying and selling goods even if the profit is not their goal. Under this perspective, nothing prevents us to imagine free associations of citizens that collect funds from the activists and invest them on the permission stock exchanges, retreating permissions from the market and generating an increase in their prices, thereby making pollution more expensive; there are also possible forms of sustainable investment for profit, if, for example, these associations of activists sell their permits at a slower pace than they buy them (we can call them ONGs of investment). A large number of different initiatives, combinations, chances is available if the actors are encouraged to perceive the market arena as an open space where a plurality of interests finds a way to be balanced; a change in perspective about what is perceived as market, and about how the market should be regulated and influenced, can in my opinion substantially increase the effectiveness of the system, restoring - as a side effect - a democratic supervision on a field (the control of CO2 emissions) where the risk of technocratic drifts is always high.

BIBLIOGRAPHY
Pew Center on Global Warming (2005). The European Union Emission Trading Scheme (Eu-Ets). Insights and opportunities. Working paper. J. Kruger, W. E. Oates, and W. A. Pizer (2007) Decentralization in the EU Emissions Trading Scheme and Lessons for Global Policy. RFF Discussion Paper 07-02. C. DOultremont (2010) The EUs Emission Trading Scheme: Achievements, key lessons, and future prospects. Egmont Paper 40, Royal Institute for International Relations, 2010. A. D. Ellerman and B. K. Buchnerb (2007 ) Over-Allocation Or Abatement? A Preliminary Analysis of the EU-ETS Based on the 2005-06 Emissions Data. Environmental and Resource Economics, Vol. 41, n2, pp. 267-287; A. D. Ellerman and B. K. Buchnerb (2007) The European Union Emissions Trading Scheme: Origins, Allocation, and Early Results. Review of Environmental Economics and Policy, volume 1, issue 1, winter 2007, pp. 6687 N.Stern (2006)The Economics of Climate Change. Cambridge University Press, 2006, pp 326-329. Department of Energy and Climate Change (2011) The EU Emissions Trading System: Preparing for Phase III (and implementation of Phase II). Internal Working paper, UK government. A.J.Drew (2009) Government Failure and the EU ETS: What prospects for phase 3?. Published version of a Master of Science Dissertation, London School of Economics and Political Science, London, UK.

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ANNEX: IMAGES

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