Journalists reporting on the United Nations Bali negotiations and ongoing plans for addressing climate change need to appreciate that the term “tradable permits system” does not imply a one-size-fits-all single strategy.

Rather, numerous and diverse policy design considerations would go into shaping a tradable permits approach. Many of them involve considerable controversy – Who pays? Who benefits? What are the costs? And more.

Reporting accurately on the relative merits of varying approaches can improve public understanding as society moves over time toward binding emission reductions in greenhouse gases (GHG).

Upstream vs. Downstream Regulation

A tradable permits system can regulate emissions at the point where carbon enters the economy, the point where greenhouse gases are actually released, or somewhere in between.

Under an upstream program, producers and importers of GHG-producing fuels would be required to hold permits for any fuel they sold, based on the GHG emissions associated with those fuels. The price effect of an upstream permit system would spread out throughout the economy, raising the price of energy produced in proportion to carbon releases and creating an incentive for increased energy efficiency and more use of alternative energy generation technologies.

Upstream solutions will benefit from greater coverage and simpler implementation than downstream solutions, as there may be as few as 2,000 or so entities required to hold allowances. However, upstream solution may be less politically palatable given their wide coverage of sectors for which price increases may be particularly unpopular.

Downstream solutions, on the other hand, would be quite expensive to implement outside of the rather narrow power sector. Regulating emissions at the tailpipe, for instance, clearly would be impractical for all 300 million vehicles on the roads in the United States, and costs would be prohibitive. If a downstream solution focused on a particular sector, as the Kyoto Protocol focuses on the power sector, some leakage between regulated and non-regulated sectors would be inevitable.

For example, regulating just large power producers would create an incentive to run smaller generators under the threshold for regulation. Costs of meeting a particular overall emissions target would be higher for specific goods in a limited downstream system, while an upstream system with broad coverage would spread out costs more broadly.

There is also a question of how the price signal would differ if permits or fees are disconnected from the point of emissions. For downstream users in an upstream system, the incentive for emissions abatement would be solely embodied in the GHG intensity-weighted price of fuels. Price increases in fuel would create an incentive to minimize fuel use, or minimize power purchased from generators using expensive fuel. As long as greenhouse gas emissions from any given fuel are independent of the method in which the fuel is used, a price mechanism theoretically should have an identical effect no matter where it is placed in the product “stream”.

However, shifting the price signal upstream from the point of emissions could dampen the abatement incentive by shifting the focus from reducing emissions to reducing costs. As there are potential options for reducing the greenhouse gas emissions of a given fuel, especially for non-carbon fuels that can be converted to a more benign form (e.g., methane incineration), pricing emissions downstream could potentially create more incentive for innovative emissions reduction solutions, rather than just for energy efficiency.

Initial Allocations of Permits: Auctioning vs. Grandfathering

Given the potential value of emission permits, initial permit allocation is extremely important. Permits can be allocated by grandfathering or auctioning. Grandfathering involves giving firms permits based on a certain baseline year, preferably far enough in the past so as not to influence recent investment decisions. The European experience with Kyoto suggests that grandfathered permits can result in windfall profits for firms if the cost of permits can be passed through to consumers while the benefits of permit sales are not.

Experts say this outcome is particularly likely in strongly regulated markets with little price competition between power providers. Grandfathering also poses a barrier to entry for new firms in a sector, as they would have no initial allocation of permits and would have to purchase them all from existing firms.

As an alternative to grandfathering, the government could initially auction permits. The auctions could reduce potential barriers to entry of new firms, as all firms would have to pay for their permits. Because permit prices might change since the initial auction, however, the relative burden on companies may depend on their time of entry.

Auctions could provide a revenue stream for offsetting the effects of higher energy prices. Most firms would likely strongly object to auctions as they could involve fairly substantial transfers of wealth from firms to the government even if that revenue is subsequently recycled. Auctions also could pose the risk of inefficiently high initial permit prices, especially if the permits involved are indefinite and risk-averse firms expect the system to become stricter over time.

Revenue Recycling: Efficiency and Distributional Concerns

Revenue raised from auctioning of permits and/or sale of annual permits could be used to offset the expected increase in energy costs associated with a tradable permit system. As increasing energy prices will tend to have a regressive effect on the economy, given that poor people tend to spend a larger portion of their income on energy, revenue could be used to progressively reduce income or payroll taxes.

However, there always is a tradeoff between offsetting the equity and efficiency effects of the system. A system that offsets purely regressive tax effects might be less efficient than one focusing purely on cutting corporate taxes, which many economists consider the most efficient revenue recycling.

Permit Banking

Banking would allow firms to preserve unused permit with the option of later using that unit of emission. As a hedge against future permit market volatility, firms may choose to bank excess permits rather than selling them.

Work (pdf) done by economist William Pizer indicates that tradable permit systems allowing banking generally are less volatile than those without banking. However, if initial permit allocations prove too high, as happened in the initial phase of the European Union Emissions Trading System, banking could have the perverse effect of watering down future compliance periods.

National vs. International Trading: Linkage Issues

Considerable uncertainty of course still surrounds the shape of any post-Kyoto greenhouse gas regulatory regime.

A number of people are beginning to argue that we may be better served by a “silver buckshot” of interconnected national-level policies rather than a single silver bullet in the form of an international treaty such as the Kyoto Protocol.

However, the prospect of numerous national-level climate change policies raises questions of how such disparate systems could be linked and nagging questions of consistency and uniformity for those regulated. Tradable permit systems could be more effective and efficient through international trading, but such trades also would raise verification and enforcement concerns.

Tradable permit systems could be limited to intranational trading, could allow trading within similar blocks of signatory countries, could include trading between disparate comparable systems, or could incorporate mechanisms like the Kyoto Protocol’s Clean Development Mechanism (CDM) to encourage investment in emissions abatement in non-signatory countries.

One innovative strategy to ensure that international permit trades are both verifiable and enforceable is what economist David Victor terms “buyer liability.” In a system of buyer liability, the buyer of the permit is responsible if the permit seller fails to make actual emissions reductions or defaults on their obligations. This approach would lead to a risk-weighting of permits in the market based on the perceived risk of default, and it would create an incentive for countries to undertake actions to guarantee the quality of their permits in order to obtain a better price in the market. Such buyer liability systems, already part of the CDM, have been shown to be effective.

Designing future international climate policy clearly will be no easy task. Seemingly simple choices can involve billions of dollars in revenue transfer, and many will lobby hard for system characteristics best serving their own interests.

Editors and reporters need to be aware of effects of different proposals on different sectors. Their role is critical in communicating the intricacies of emerging carbon markets to a lay audience.

Also see:

Climate Policy Analysis: Taxes and Tradable Permits (Pt. 1)

A Question Haunting Bali Conference: Silver Bullet? Or Silver Buckshot? (Pt. 3)

Zeke Hausfather

Zeke is an energy systems analyst and environmental economist with a strong interest in conservation and efficiency. He was previously the chief scientist at C3, an energy management and efficiency company,...