Emissions Trading Schemes

An emissions trading scheme (ETS) consists of a market in which companies trade among each other tradable emission rights representing each a certain amount of emissions, with the objective of achieving reductions of emissions at the lowest possible cost. Such a market allows in theory the promotion of three important policy objectives: (1) environmental effectiveness; (2) cost-effectiveness and economic efficiency; (3) equity. When the amount of tradable emission rights is set ex ante by the regulator, the environmental effectiveness is in theory defined by the cap. Further, the functioning of the market promotes cost-effectiveness in achieving the target, by promoting allocative efficiency. Lastly, it is possible to promote equity through the allocation methodology.9

While the concept of an ETS is in theory very simple, its actual design and implementation has an important influence on the degree to which the three objectives are actually achieved. The edifice of an ETS is built upon six main pillars: (1) the mechanism to set the cap; (2) the rules to set the scope (or coverage) (3) the methodology to allocate emission rights to companies participating in the scheme; (4) the mechanism for monitoring, verifying and reporting the emissions; (5) the market itself where allowances can be traded; (6) the system of penalties.

A too-lenient cap, an incomplete coverage in terms of competitors, allocation rules which distort competition within the market, lack of competition in the market, defective measuring, verifying and reporting rules (or their defective application), and inadequate and/or insufficient penalties may all constitute factors that reduce the beneficial effects of the scheme. The risks that any of these problems arise increase when an ETS is introduced at a multi-juris-dictional level, with each jurisdiction enjoying competence to make important design choices on those pillars. Hence, in these cases, a highly harmonized approach could seem in principle preferable.

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