Existing emission trading schemes – the instruments has proven itself

Emission trading as an environmental political instrument was implemented more than ten times during the last decade before it was finally introduced in the European Union. The existing emission trading schemes have overcome their teething troubles and, finally, the instruments has proven its effectiveness. The two most prominent ones are the SO2 trade in the USA and the CO2 trade in the United Kingdom.¹

With the amendment of the Clean Air Act of 1990, the USA introduced SO2 emission trading on January 1^st 1995. The aim of this program is a 50% reduction of SO2 emissions from power plants. The programme comprises three phases with significant increases in the reduction targets from phase to phase. In a grandfathering approach, emission allowances were allocated for free to the installations. While new entrants received 65% of the allowances for free in the first few years, they now have to purchase emission allowances entirely. Initially comparably low targets, cheap emission reduction opportunities from fuel switches, and the possibility of banking the allowances led to a market of limited liquidity during the first few years. Most participants expected rising SO2 certificate prices and, therefore, kept their allowances. Several changes in the "rules of the game" have helped to overcome these initial weaknesses, but increased the uncertainty for the participating companies too.²

The second prominent example is the CO2 emission trade in the United Kingdom which has been embedded in a Climate Change Programme since 2002. Different from the US programme, participation in the UK programme is voluntary and comprises two main routes and two further options for participation. Participants in the direct route are incentivised by government subsidies. In an auction, they "buy" these subsidies by offering emission reductions counted against certain historic emissions. Thereby, they receive an absolute emission target (cap-and-trade approach). In contrast, participants in the agreement route commit themselves to an individual Climate Change Levy Agreement with the authorities. A certain reduction target against a baseline (baseline-and-credit approach) is rewarded with an 80% statutory notice for the Climate Change Levy. The two further options for participation are a project for emission reduction operating with credits and the opening of a trader's account.³

Besides these and other official emission trading schemes, some companies have introduced similar approaches internally. Grohmann (2001) and Brockmann et al. (1999) describe the

1 A very detailed overview is provided by Hansjürgens and Gagelmann (2003).

2 Detailed descriptions of this first US emission trading scheme can be found in Rehbinder (2001) and Klemmer et al. (2002).

3 One of the most valuable descriptions of the UK system can be found in Spieth (2002), others are by Wackerbauer (2003) and Klemmer et al. (2002).

internal scheme of BP plc. Hansjürgens and Gagelmann (2003) refer to Royal Dutch Shell plc. Although the intention of these internal emission trading schemes is rather cost-saving than emission reduction, they can provide helpful proposals for climate protection politics.

Likewise, business games give suggestions for the actual designing of trade schemes.¹ 2.1.1.4 Other political instruments – from regulation to market

As pointed out in chapter 2.1.1.1, emission trading is only one political instrument counter-acting climate change within a wide set of instruments at the disposal of environmental politicians. The effects of the newly implemented European emission trading scheme (details follow in chapter 2.1.2.2) on the pulp and paper industry need to be considered in the context of existing environmental legislation applying several of these instruments. Thus, it seems necessary to outline the most important of these political instruments briefly in the following paragraphs of this chapter.

(1) Regulation

Besides from the socialisation of activities, regulation is the strongest political instrument at the disposal of politicians. Typically it is classified as a command-and-control policy (Dröge et al., 2003) comprising commands and prohibitions. Non-compliance results in sanctions (closure or penalties). Dales differentiates "across-the-board" and "point-by-point" schemes (1968, p. 84-89). While the first obliges all individuals to do the same thing (e.g., 20%

reduction of emissions), the latter allows differentiation.

The advantages of regulation are its effectiveness, the ease of managing the implementation and the relatively broad acceptance of the population, due to familiarity with its application (Dröge et al., 2003). Another advantage is the differentiability which helps counteract environmental hot-spot problems (Koch and Wieneke, 2001). In contrast, disadvantages are economic inefficiency and unfairness, respectively the inevitability of significant administrative efforts to overcome these problems. Meyer and Ströbele (2001) demonstrate the economic inefficiency of "across-the-board" regulation mathematically. Individuals are forced to reduce their emissions at different marginal avoidance costs. Thus, the aggregated costs of emission reduction cannot be at a minimum. Additionally, individuals have no further incentive to reduce emissions if they have fulfilled their specific target and early actions to reduce emissions are not rewarded. "Point-by-point" regulation could overcome these economic weaknesses and provide by "by chance" an efficient solution. However, administrative efforts will make proportionality doubtful. Furthermore, lobbying will be opposed to an efficient solution as well.

1 See Schleich et al. (2002) and Steinbrecher and Hahn (2003).

Examples of technology regulation are numerous. With respect to emission trading the EU Directive 1996/61/EC on integrated pollution prevention and control introducing emission caps (see chapter 2.1.2.2) is the most relevant.

(2) Subsidies

Dröge et al. define subsidies as (Dröge et al., 2003, p. 30):

"Economic benefit received by a private agent from public funds at no cost or below cost of producing the benefit […] or […] financial assistance (e.g. direct payments, tax exemptions) from the government to the private sector."

They are a common instrument of environmental politicians occurring as direct subsidies from the government and as indirect subsidies, i.e., the transfer of funds from individuals to other individuals with the authorities only setting the rules. Specific subsidisation (i.e., the amount of subsidies granted for avoiding one unit of pollution) can be differentiated by technologies in order to promote the development of certain technologies.

The direct incentivisation of the polluter to reduce their emissions is advantageous. As for companies, neither the purchase prices of raw materials and energy nor the tax burden rise directly and, therefore, industry typically favours subsidies over other instruments (Dales, 1968). However, as no subsidies can be paid without funding, welfare is reduced elsewhere.

Thus, Dales concludes that subsidies are neither fair nor efficient, as the recipients of the subsidies most probably have different reduction costs.

An example of subsidies is the promotion of electricity generation from renewable energy sources and of cogeneration in Germany. As these subsidies are not paid from the government's budget but funded by all electricity consumers, they can be classified as indirect subsidies. For details, please see chapter 2.1.2.3.

(3) Emission taxes and energy taxes

Emission taxation needs to be differentiated from the taxation of the consumption of energy sources such as fossil fuels or electricity. While the first directly taxes the pollution, the latter penalises a preliminary stage that will result in pollution. The additional VAT has a similar effect but not an ecological intention.

The instrument of emission taxation can be traced back to Pigou (1920, "Pigouvian-tax"). He suggested a charge for all pollution proportional to the marginal damage. Due to better ease of handling, nowadays the purchase of fossil fuels is often subject to taxation instead.

Additionally, taxes are levied on the consumption of electricity independently from the actual source of energy. Lobbying activities have usually led to exemptions or special provisions for certain industry sectors. The rationales behind these provisions are differences in the competitiveness between sectors and in the tendency to relocate production to other countries

(leakage effect). Some countries have introduced emission taxes in the course of implementing ecological tax reforms, refinancing e.g., the reduction of social security contributions.

Compared to regulation and subsidisation, emission taxation has one major advantage: it is economically efficient (Dales, 1968). The polluters reduce their emissions until the marginal avoidance costs equal the costs from taxation. Any further reduction would be more expensive than paying the taxes. Thus, companies with low marginal avoidance costs avoid more than those with high marginal avoidance costs (Dröge et al., 2003). The sole disadvantage is that the optimal level of emission (assuming it is known) can only be achieved in a trial-and-error approach (Dales, 1968). The authorities will hardly be able to calculate upfront which tax level will result in the optimal level of emission. Efficiency is lost as soon as exemptions from taxation are agreed for certain industries. An additional risk of inefficiency arises if energy consumption is taxed instead of pollution. Emission from different energy sources may be taxed differently and some emissions might be taxed twice (fuels for electricity generation).

The consumption of fossil fuels and electricity is subject to taxation in the entire EU with some temporary arrangements for the transition countries. Emissions are taxed only in Denmark, Netherlands, Norway, and Sweden. For details, please see chapters 2.1.2.2 and 2.1.2.3.

(4) Clean Development Mechanism and Joint Implementation

Besides from emission trading, Clean Development Mechanism and Joint Implementation are flexible mechanisms for reductions of greenhouse gas emissions which have been introduced with the Kyoto Protocol (for details, see chapter 2.1.2.1). They can be regarded as derivatives of emission trading. Both are project-based, i.e., they refer to emission sources that are not subject to the emission trading scheme anyway. These projects have two partners domiciled in different countries. While a project is conducted in country A, it is financed by a partner B in country C or by country C itself. The CERs (Certified Emission Reductions) in the case of Clean Development projects, respectively ERUs (Emission Reduction Units) in the case of Joint Implementation measures, are credited to the financing partner. Thus, CERs and ERUs acquired by company B help the company to comply with its reduction target from the emission trading scheme effective in country C and additionally helps country C to fulfil its Kyoto target. The basic difference between CDM and JI is that in JI projects both partners are domiciled in a country listed in Annex I of the UNFCCC (United Nations Framework Convention on Climate Change) while in CDM measures the project is conducted in a non-Annex-I country. While CERs can already be converted in the European emission trading scheme since 2005, ERUs cannot be used before 2008. Details for crediting projects have been defined in the Marrakesh Accords.

The major advantage of CDM and JI is the potential for additional emission reductions at low costs. The wider the range of potential emission reduction projects is, the lower the costs are.

Additionally, it can be assumed that especially developing countries (partners for CDM projects) offer numerous emission reductions at very low or even negative costs (e.g., fuel switch). Furthermore these countries can benefit from the knowledge and technology transfer involved. Uncertainties concerning crediting of the individual measures are disadvantageous.

The two main problems related to crediting are the definition of the baseline against which the reductions are counted and the proof of additionality compared to any development which would have taken place anyway. The interpretation of the additionality requirement is still disputed in CDM and JI. In the strict sense of "project additionality", the project's business case is unprofitable without the revenue from ERUs or CERs and gains profitability only with certification. In a more moderate sense of "environmental additionality", the project only needs to reduce CO2 emissions or increase absorption compared to the baseline. Whereas all doubt-free cases are accredited by an independent certifier in accordance with UNFCCC rules, all doubtful cases are decided by the highest authorities of JI and CDM, the JI Supervisory Committee, respectively the CDM Executive Board at the UN.

(5) Labelling

The economic literature differentiates labels and certificates. While labels have a clear consumer orientation, certificates are rather authority-oriented. Referring to labelling, Dröge et al. (2003) assume the following UNCTAD definition (UNCTAD, 1994):

"[…] the use of labels in order to inform consumers that a product is determined by a third party to be environmentally more friendly relative to other products in the same category […]"

Furthermore, they structure the different types of labels into governmental vs. private and compulsory vs. voluntary labels. Whereas labels provide consumers with information to facilitate a choice between different suppliers, certificates are intended to allow authorities to monitor certain actions or properties.

The advantage of labelling is that this instrument limits the freedom of individuals least. It assumes fully rational behaviour of consumers. In contrast, it is the instrument with the lowest effectiveness. Even if all consumers understand the favourability of the environmentally friendlier product, the above-mentioned free-rider problem hinders a significant effect.

Different from labelling, certification should not be regarded as an instrument itself but only as a means of implementing political instruments such as regulation or subsidisation.

Examples of the instrument of labelling are energy efficiency classes for white goods (governmental, compulsory), proof of origin for electricity (governmental, compulsory),

"Blauer Engel" for chemicals (governmental, voluntary), and "Bioland" for food or

"Environmental Product Declaration" for building products (private, voluntary).