Pollution policy

Alessio D’Amato
Class of Environmental Economics and Policy 2023
Efficient level of flow pollution.
The cost-minimization perspective

• Pollution control can be analyzed also from the perspective of cost

minimization.
- Damage costs
- Pollution control or avoidance costs.
• Marginal damage costs generally increase with the amount of
pollution.
• Marginal control costs typically increase with the amount of pollution
that is controlled or abated.
• The cost-minimizing solution is found by equating marginal damage
costs to marginal control costs. 2
INSTRUMENTS OF ENVIRONMENTAL POLICY
• Direct regulation/command-and-control
• maximum emission level
• absolute terms
• relative to input/output level
• technology requirements: BAT, BATNEEC

• Market-based instruments
• emission taxes
• abatement subsidies
3
• tradable emission permits
 The pollution process Command and control instruments

Ambient pollution
Ambient pollution requirements
levels
Location of Zoning
emissions
Emissions
Emissions output licenses

Quantity of goods produced Output quotas

Production technique Technology controls

4
Inputs used Input restrictions
EXAMPLES OF CAC INSTRUMENTS
Instrument category Description

Command and control instruments

Input controls over quantity and/or mix of inputs Requirements to use particular inputs, or
prohibitions/restrictions on use of others

Technology controls Requirements to use particular methods or

standards

Output quotas or prohibitions Non-transferable ceilings on product outputs

Emissions licences Non-transferable ceilings on emission quantities

Location controls (zoning, planning controls, Regulations relating to admissible location of

relocation) activities
5
1. Non-transferable emissions licences
• Suppose that the EA is committed to attaining some overall emissions target for
a particular pollutant.

• It creates licences (permits or quotas) for that total allowable quantity.

• the EA distributes licences to emissions sources.
• licenses are non-transferable (cannot be exchanged among firms)
• each firm’s initial allocation of pollution licences sets the maximum amount of
emissions that it is allowed.

• Successful operation of licence schemes requires: adequate monitoring +

sufficiently high penalties on polluters not meeting licence restrictions. 6
1. Non-transferable emissions licences
• It is unlikely that conditions for cost-effectiveness would be satisfied.

• Necessary to know each polluter’s abatement cost function.

• It is very unlikely that the EA would possess, or could acquire, sufficient information.
• The costs of collecting that information could be prohibitive (may outweigh the
potential efficiency gains arising from intervention).
• Problem of information asymmetries; those who possess the necessary information
about abatement costs at the firm level (the polluters) do not have incentives to
provide it in unbiased form to those who do not have it (the regulator).

7
2. Instruments which impose minimum technology requirements

• Minimum technology requirements are imposed upon potential polluters.

• Technology controls have resulted in huge reductions in pollution levels. They are
usually not cost efficient.
• Examples of this approach have been variously known as best practicable means
(BPM), best available technology (BAT) and best available technology not entailing
excessive cost (BATNEEC).
• In some cases, specific techniques are mandated (i.e. requirements to use flue-gas
desulphurisation equipment in power generation or minimum stack heights).
• Sometimes the specific technique adopted is negotiated between the EA and the
regulated parties on an individual basis.

8
Ex. of use of BAT: Directive IPPC (integrated pollution prevention and control) - replaced
by Directive on industrial emissions 2010/75/EU (IED)

The IPPC Directive is based on several principles: (1) an integrated approach, (2) best
available techniques, (3) flexibility and (4) public participation.
o The integrated approach means that the permits must take into account the whole
environmental performance of the plant, covering e.g. emissions to air, water and
land, generation of waste, use of raw materials, energy efficiency, noise, prevention
of accidents, and restoration of the site upon closure.
o The permit conditions including emission limit values (ELVs) must be based on Best
Available Techniques (BAT). To assist the licensing authorities and companies to
determine BAT, the Commission organised an exchange of information between
experts from the EU Member States, industry and environmental organisations. This
resulted in the adoption and publication by the Commission of the BAT Reference
Documents (the so-called BREFs).
9
Market-based instruments
• Alter the structure of pay-offs that agents face, creating incentives for individuals
or firms to voluntarily change their behaviour.
• Change in relative prices. Two ways:
• By the imposition of taxes on polluting emissions (or on outputs or activities
deemed to be environmentally harmful), or by the payment of subsidies for
emissions abatement (or reduction of outputs or activities deemed to be
environmentally harmful).
• By the use of tradable emission permit (or allowance) systems in which permits
command a market price. Those prices are the cost of emitting pollutants.

• More generally, any instrument which manipulates the price system in such a way
as to alter relative prices could also be regarded as an incentive-based instrument. 10
Instrument category Description
Economic incentive (market-
based) instruments

Emissions charges/taxes Direct charges based on quantity and/or

quality of a pollutant
User charges/fees/natural resource taxes Payment for cost of collective services
(charges), or for use of a natural resource
(fees or resource taxes)
Product charges/taxes Applied to polluting products

Emissions abatement and resource Financial payments designed to reduce

management subsidies damaging emissions or conserve scarce
resources
Marketable (transferable, marketable) Two systems: those based on emissions
emissions permits reduction credits (ERCs) or cap-and-trade
Deposit-refund systems A fully or partially reimbursable payment
incurred at purchase of a product
Non-compliance fees Payments made by polluters or resource
users for non-compliance, usually
proportional to damage or to profit gains
Performance bonds A deposit paid, repayable on achieving
11
compliance
Liability payments Payments in compensation for damage
MARKET-BASED INSTRUMENTS
PIGOUVIAN TAX (EMISSIONS TAX)
Marginal benefit Marginal damage
(before tax)

Marginal
benefit (after
tax)
*

0 M* M̂ Emissions, M

An emission charge is a per-unit of pollutant fee, collected by the

government.
12
MARKET-BASED INSTRUMENTS
PIGOUVIAN TAX (EMISSIONS TAX)
• The tax brings about a socially efficient aggregate level of pollution and achieve
that aggregate target in a cost-effective way.
• Cost-efficiency requires that the marginal abatement cost be equal over all
abaters.
• As the tax rate is identical for all firms, so are their marginal costs.

• Knowledge of both the aggregate marginal pollution damage function and the
aggregate emissions abatement cost function are necessary for achieving a
socially-efficient emissions target. But it is not necessary to know each firm’s
marginal abatement cost function.
13
A general model (1)
• i = 1,..,n polluting firms (or agents)
n
• Strictly convex damages di (E) where E =  ei
i =1

• We allow for general impacts of emissions.

• Total environmental damages are as follows:

n
D( E ) =  d i ( E )
i =1 14
A general model (2)
• Production costs increase with output (qi) and with abatement (ai)
ci (qi , ai ) where cqi  0, cai  0, cqi qi  0, (cqi qi cai ai − c 2 qi ai )  0

• Emissions function:

ei = si (qi , ai ) where sqi  0, sai  0, sqi qi  0, sai ai  0

• Objective function of the (utilitarian) regulator
 qi
max qi ,ai  P (Q)dQ −  i ci (qi , ai ) − D( E )
0

15
FIRST BEST VS. DECENTRALIZED EQUILIBRIUM

• First best (interior solution):

ci ( qi , ai ) si ( qi , ai )
P (Q ) −
*
− D' ( E ) = 0  qi*
qi qi
ci (qi , ai ) si (qi , ai )
− − D' ( E ) = 0  ai*
ai ai

• Decentralized equilibrium
ci (qi , ai )
P (Q * ) − = 0  qid  qi*
qi
ci (qi , ai ) d
− = 0  aid = 0  ei  ei*
ai 16
COMPARISON BETWEEN POLLUTION TAXES AND ABATEMENT SUBSIDIES
LONG RUN EFFICIENCY
• Assume all firms are identical. Entry must take place up to the point where positive
marginal social welfare can no longer be obtained. The planner solves:
nq
max qi ,ai ,n  P (Q)dQ − nc(q, a ) − nF − D(ne)
0

where F are fixed costs.

• i.e., the FOCs w.r.t. n are: zero profit condition

P(n*q * )q * − c(q * , a * ) − F − D' (.)e* = 0

17
• The corresponding optimal number of firms is n*.
EMISSION TAXES
• Each (price taking) firm maximizes:
max qi ,ai pqi − ci (ai , qi ) − si (ai , qi )
ci (qi , ai ) s (q , a )
P(Q * ) − − i i i = 0
qi qi
ci (qi , ai ) si (qi , ai )
− − =0
ai ai
• First best is obtained if  = D' ( E * )

• Long run: firms enter the market up to where

p(nq )q − c(a, q ) − F − s (a, q ) = 0

18
• First best is, again, obtained.
EMISSION SUBSIDIES
• Each (price taking) firm maximizes:
max qi ,ai pqi − ci (ai , qi ) + veˆi − si (ai , qi ), si (ai , qi ) = ei

ci (qi , ai ) s (q , a )
P(Q * ) − −v i i i = 0
qi qi
ci (qi , ai ) s (q , a )
− −v i i i = 0
ai ai
• First best is obtained if v = D' ( E * )
• Long run: firms enter the market up to where

p(nq )q − c(a, q) + veˆ − vs(a, q) − F = 0

Additional term 19
• Larger profits = no first best (larger n).
COMPARISON BETWEEN POLLUTION TAXES AND ABATEMENT
SUBSIDIES
Pre-tax or pre-subsidy
marginal benefit Marginal damage

Post-tax or post-subsidy
marginal benefit

* S5
S3 S1
S4 S6 S2
0 M* ෡
M Emissions

An emissions tax and an emissions abatement subsidy (at the same rate) differ in
terms of the distribution of gains and losses. This has important implications for the
political acceptability and the political feasibility of the instruments. It also could
20
affect the long-run level of pollution abatement under some circumstances, by
changing the size of the industry.
Taxes vs. subsidies
 Both emission taxes and emission reduction subsidies lead to the
social optimum

BUT

Subsidies attract new firms in the market

Subsidies require public revenue

NONETHELESS

21
Subsidies preferred for “political” reasons
 22

https://data.oecd.org/envpolicy/environmental-tax.htm
 Fossil Fuels’ subsidies

23

https://www.nature.com/articles/d41586-021-02847-2
 Fossil Fuels’ subsidies

24

https://www.nature.com/articles/d41586-021-02847-2
 Fossil Fuels’ subsidies

25

https://www.nature.com/articles/d41586-021-02847-2
 Comparing costs

26

Source: REN21 2020

Pollution policy with imperfect information
• Under uncertainty instruments choice might depend on the information available.

• The optimal instrument depends on the position and on the relative slope of
marginal damages and marginal benefits.

27
Uncertainty about abatement costs – costs overestimated

MD

Loss when
licenses used

tH

t*
MC
Loss when (assumed)
taxes used

MC (true)

28
Mt M* LH
Emissions, M
Uncertainty about abatement costs – costs underestimated

MD

loss with tax

loss with
standard

t*
tL

MC (true)

MC
(assumed)

29
LL M* Mt
Emissions, M
Uncertainty about abatement costs – costs overestimated

loss with
standard
MD
tH

t*
MC
(assumed)
loss with tax

MC (true)

30
Mt M* LH
Emissions, M
Uncertainty about abatement costs – costs underestimated

MD

loss with
standard
MD

t*
tL loss with tax

MC (true)

MC
(assumed)

31
LL M* Mt
Emissions, M
 General result
• When the (absolute value of the) slope of the MC curve is less than the slope of the
MD curve, licences are preferred to taxes (as they lead to smaller efficiency losses).
• When the (absolute value of the) slope of the MC curve is greater than the slope of
the MD curve, taxes are preferred to licences (as they lead to smaller efficiency
losses).

32
Uncertainty about damage costs – damages underestimated

MD (true)

MD (estimated)

MC (true)

33
M* L
Emissions, M
Consequences of a threshold in the damages function

Total
damages
D

M0 34
Emissions, M
Hartwick and Olewiler (1998)
 General conclusions
• Where functions are linear, and uncertainty relates to the marginal abatement cost
(MC) function, then an EA (minimising the efficiency losses arising from incorrect
information) should prefer a quantity policy (licences) to an emissions tax if MC is
flatter than MD, and an emissions tax to a licence system if the reverse is true.
• Where uncertainty pertains to the MD function, knowledge of relevant slopes does
not contain information that is useful in this way.
• Once the existence of non-linearity and/or threshold effects is admitted, general
results are harder to find. In some circumstances at least, combined tax–quantity-
control programmes may have attractive properties.
• The presence of uncertainty substantially weakens the possibility to achieve a
“socially optimal” (Pareto efficient) pollution level (we may not know where it is!)
• Other approaches may be needed. 35
Two major questions about pollution policy:

➢ How much pollution should there be?

➢ Given that some target level has been chosen, what is the best
method of achieving that level?

36
Criteria for selection of pollution control instruments

37
Cost efficiency and cost-effective pollution abatement instruments

• Suppose a list is available of all instruments which are capable of achieving some
predetermined pollution abatement target.
• If one particular instrument can attain that target at lower real cost than any other,
that instrument is cost-effective.

• Cost-effectiveness is clearly a desirable attribute of an instrument.

• Using a cost-effective instrument involves allocating the smallest amount of resources to
pollution control, conditional on a given target being achieved.
• It has the minimum opportunity cost.
• The use of cost-effective instruments is a prerequisite for achieving an economically
efficient allocation of resources.

38
Least-cost theorem of pollution control

A necessary condition for abatement at least cost is that the marginal cost
of abatement be equalised over all abaters.

39
Least-cost theorem of pollution control

40
Least-cost theorem of pollution control
o N polluting firms, i = 1, . . . , N.
o Each firm faces a fixed output price and fixed input prices, and maximises
profits by choosing output level (Qi) and emission level (Mi) - uniformly mixing
pollutant.
o 𝜋ො 𝑖 is the maximised profit in the absence of any control over its emission level
(unconstrained maximum profit level); at this profit maximum firm’s emission
level is 𝑀 ෡𝑖 .
o 𝜋𝑖∗ is the maximised profit when it is required to attain a level of emissions
𝑀𝑖∗ < 𝑀 ෡𝑖 - (constrained maximum level of profits), with 𝜋𝑖∗ < 𝜋ො 𝑖

41
Least-cost theorem of pollution control
• firm’s abatement costs, C, are:
𝐶𝑖 = 𝜋ො 𝑖 − 𝜋𝑖∗
• Abatement costs are a function of the severity of the emissions limit. Suppose a
quadratic function:
𝐶𝑖 = 𝛼𝑖 − 𝛽𝑖 𝑀𝑖∗ + 𝛿𝑖 𝑀𝑖∗2
• Consider the problem of an environmental protection agency meeting some
standard for total emissions (from all N firms) at the least cost: M*

42
The firm’s abatement cost function

43
Least-cost theorem of pollution control
𝛽𝑖 − 2𝛿𝑖 𝑀𝑖∗ = 𝜇 ∗
• The Lagrangian is: - MC of an increase
in pollution abatement

o FOCs:

Since μ* is constant over all firms, a least-cost pollution abatement programme 44

requires that the marginal cost of abatement be equal over all firms.
 Conclusions from the least-cost theorem
of pollution control
• A least-cost control regime implies that the marginal cost of abatement is
equalised over all firms undertaking pollution control.

• A least-cost solution will in general not involve equal abatement effort by all
polluters.

• Where abatement costs differ, cost efficiency implies that relatively low-cost
abaters will undertake most of the total abatement effort.

45
 EMISSIONS TAXES ARE COST-EFFECTIVE

Each firm will independently reduce emissions until its marginal 46

control cost equals the emission charge. This yields a cost-effective
allocation
 EMISSIONS TAXES ARE COST-EFFECTIVE
Firms’ profit-maximising behaviour in the face of an emissions tax implies that the firm
will minimise the sum of its abatement costs and pollution tax costs:

min 𝐶𝑇𝑖 = 𝐶𝑖 + 𝑡 ∗ 𝑀𝑖 = 𝛼𝑖 − 𝛽𝑖 𝑀𝑖 + 𝛿𝑖 𝑀𝑖 2 + 𝑡 ∗ 𝑀𝑖
𝑀𝑖

FOCs:

𝜕𝐶𝑇𝑖
= −𝛽𝑖 + 2𝛿𝑖 𝑀𝑖∗ + 𝑡 ∗ = 0, 𝑖 = 1,2, … , 𝑁
𝜕𝑀𝑖

if t* is set equal to μ*, the two necessary conditions are identical.

The tax instrument achieves the total emissions target at least cost.
47
 EMISSIONS TAXES ARE COST-EFFECTIVE

In general, the EA will not know abatement costs.

ҧ is selected, and each firm is charged that

If an arbitrarily chosen tax rate (𝑡),
rate on each unit of emission, some total quantity of emissions (𝑀) ഥ will be
realised at least cost.
Of course, 𝑀 ഥ will in general be different from 𝑀∗ .
Only if 𝑡ҧ = 𝑡 ∗ 𝑀ഥ = 𝑀∗

An iterative trial-and-error process of tax rate change may enable the EA to

find the necessary tax rate to achieve a specific target.

48
 Marketable emissions permits
Marketable permit systems are based on the principle than any increase in
emissions must be offset by an equivalent decrease elsewhere.

There is a limit set on the total quantity of emissions allowed, but the regulator
does not attempt to determine how that total allowed quantity is allocated
among individual sources.

Two types:
o ‘cap-and-trade’ system
o emission reduction credit (ERC) system

49
 Cap and trade permit systems

A cap-and-trade emission permits scheme for a uniformly mixing pollutant involves:

• A total quantity of emissions of some particular type (the ‘cap’) that is to be
allowed.
• The creation of a quantity of emissions permits equal to the emissions cap (the
target level of emissions).
• A mechanism of allocation between potential polluters.
• A rule which states that no firm is allowed to emit pollution beyond the quantity of
emission permits it possesses.
• A system whereby actual emissions are monitored and penalties – of sufficient
deterrent power – are applied to sources which emit in excess.
• A guarantee that emission permits can be freely traded between firms at
whichever price is agreed for that trade. 50
The initial allocation of permits and the determination
of the equilibrium market price of permits

Two general methods of initial allocation:

• Case 1: the EA sells all permits by auction

• Case 2: the EA allocates all permits at no charge (which in turn requires that a
distribution rule be chosen)

51
 Auctioned permits case

Marginal abatement cost (aggregate)

Fixed supply of
permits

*

0 M* M̂ Emissions,
M
A firm will bid to purchase an additional emission permit whenever the marginal cost of abating
emissions exceeds the permit price. The market equilibrium permit price is determined by the 52
value of the aggregate marginal abatement cost at the level of abatement implied by the total
number of issued permits.
Free initial allocation case

Demand for permits

Supply of permits

*

0 EP* Emission permits

(EP) 53
 Comparison
• In a perfectly functioning marketable permit system the method of initial allocation of
permits has no effect on the short-run distribution of emissions between firms.
• But it does have significant effects on the distribution of income and wealth between
firms.
• With a competitive auction: each permit involves a payment by the firm to the
government (net transfer) + real resource cost of the abatement.
• With free allocation: no transfer of income from firms to government, but transfers
among firms + real resource cost of the abatement.
• Different net income effects means different long-run effects.

54
Efficient abatement with two firms and marketable permits

55
Least-cost pollution control using transferable emissions permits

Suppose that the EA issues to each firm licences permitting 𝐿0𝑖 units of emissions.
Firms are allowed to trade with one another in permits.
The ith firm will trade in permits so as to minimise the sum of abatement costs
and trade-acquired permits:
𝐶𝐿𝑖 = 𝐶𝑖 + 𝑃 𝐿𝑖 − 𝐿𝑖 0 = α𝑖 − 𝛽𝑖 𝑀𝑖 + 𝛿𝑖 𝑀𝑖 2 + 𝑃 𝐿𝑖 − 𝐿𝑖 0
where P is the market price of one emission permit.
Given Li = quantity of emissions produced after trade:
𝐶𝐿𝑖 = 𝐶𝑖 +𝑃 𝐿𝑖 − 𝐿𝑖 0 = α𝑖 − 𝛽𝑖 𝐿𝑖 + 𝛿𝑖 𝐿𝑖 2 + 𝑃 𝐿𝑖 − 𝐿𝑖 0

56
 Least-cost pollution control using transferable emissions permits
𝜕𝐿
The necessary condition for minimisation is: = −𝛽𝑖 + 2𝛿𝑖 𝑀𝑖 ∗ + 𝜇∗
𝜕𝑀𝑖∗
𝜕𝐶𝐿𝑖
= −𝛽𝑖 + 2𝛿𝑖 𝐿𝑖 ∗ + 𝑃
𝜕𝐿𝑖
which can be interpreted as the firm’s demand function for permits.
If the EA sets a total emissions target of M* then M* is the total supply of permits and:

𝑁 𝑁 𝑁
𝜕𝐿 𝜕𝐿
𝑀∗ = ෍ 𝐿𝑖 0
= ෍ 𝐿𝑖 = = − 𝑀∗ + ෍ 𝑀𝑖 ∗ = 0
𝜕𝜇 𝜕𝜇
𝑖=1
𝑖=1 𝑖=1

These two conditions are identical to FOCs in the 57

general problem if P = μ* (remember Li = M*i ).
A variation on cap and trade: an emission reduction credit (ERC) system
• In an ERC approach, a baseline profile of allowable emissions is established (for
both aggregate emissions and emissions by individual sources that must sum to
that aggregate).
• Emissions by any particular source above its baseline volume are subject to some
prohibitive non-compliance penalty.
• If a source emits less than its calculated baseline level, it earns a corresponding
amount of emission reduction credits.
• Such credits can be sold to other sources that anticipate exceeding their baseline
emission level.
• If banking is allowed, they may also be used by the source at a later date
• The purchased ERCs constitute an entitlement to exceed baseline emissions
without penalty.
• Each ERC is in principle equivalent to a marketable emissions permit. Other 58
things being equal, the equilibrium market price of ERCs would be identical to
that in a cap and trade regime.
Examples of existing ETS

• – 1995: US Acid Rain Program (NOx, SO2)

• – 2005: EU ETS
• – California+Quebec
• – RGGI (Regional Greenhouse Gas Initiative)
• – China
• – Others (New Zealand, Japan, Taiwan, South Korea, India, Switzerland….)

59
Air emission trading schemes around the world

60
European Emission Trading Directive – EU ETS

✓ On the road to Kyoto, the EU approved:

✓ Directive 2003/87/CE introducing a GHG Emission Trading system in the European
Community

✓ Objective: “…This Directive establishes a scheme for greenhouse gas emission

allowance trading within the Community…in order to promote reductions of
greenhouse gas emissions in a cost-effective and economically efficient manner.” [art.
1]

61
European Emission Trading – EU ETS

➢ It is the world's first and biggest international emissions trading system. It accounts for
over three-quarters of international carbon trading.
➢ Trial period: 2005-2007. Second trading period: 2008-2012
➢ Aim to meet obligations outlined by the Kyoto Protocol during the 2008-2012 trading
period, not during the trial period. Plan to continue after 2012 (post-Kyoto)
➢ Set an absolute cap on CO2 emissions in the EU.
➢ Tradable allowances distributed equal to cap quantity. Most allowances freely allocated.
➢ Facilities measure and report CO2 emissions. One allowance per ton of CO2 emitted.
➢ Initially limited to certain sectors (power, combustion facilities, certain industries -- not
transportation or buildings). Plan to expand over time. 62
European Emission Trading – EU ETS
• Characteristics (now):
➢ >11,000 installations, 31 countries; over 500 aircraft operators flying between EEA's
airports. It covers around 39% of the EU's GHG emissions.
➢ In phase 3 (2013-2020), the sectors with stationary installations regulated by the EU ETS
are energy intensive industries
including power stations and other combustion plants with >20MW thermal rated input (except hazardous or
municipal waste installations), oil refineries, coke ovens, iron and steel, cement clinker, glass, lime, bricks,
ceramics, pulp, paper and board, aluminium, petrochemicals, ammonia, nitric, adipic, glyoxal and glyoxylic
acid production, CO2 capture, transport in pipelines and geological storage of CO2.

➢ The aviation scope of the EU ETS was limited to flights within the EEA in the period 2013-
2016, pending the adoption of a global approach by the International Civil Aviation
Organization. To support the development of the Carbon Offsetting and Reduction
Scheme for International Aviation (CORSIA), in 2017 the limitation to intra-EEA flights was 63
prolonged until 2023.
European Emission Trading – EU ETS
• Characteristics:
• The EU ETS covers carbon dioxide (CO2) emissions, but also nitrous oxide (N2O) emissions
from all nitric, adipic, glyoxylic acid and glyoxal production, and perfluorocarbons (PFC)
emissions from aluminium production.
• Even though participation in the EU ETS is mandatory, in some sectors only installations
above a certain size are included.
• Participating countries can exclude small installations (emitting less than 25 000 tonnes of
CO2e) from the system if alternative and equivalent measures are in place.
• In phase 4 very small emitters (with reported emissions of less than 2 500 tonnes of CO2e
in the last three years) can be excluded from the EU ETS subject to the existence of
simplified monitoring arrangements to assess the quantity of their emissions.
• Participating countries may also add more sectors and GHGs to the EU ETS (so called “opt- 64
in”).
EU ETS – mechanism functioning (2003 Directive)

• EU Allowances (EUAs) = emission permits.

• Each allowance gives the owner the right to emit GHG emissions equivalent to 1
tonne of Carbon Dioxide (C02) or the equivalent amount of nitrous oxide (N2O) and
perfluorocarbons (PFCs).
• The number of allowances issued is determined by the level of the cap set.
• EUAs are given for free to polluter firm; the rest are sold by auction.
• At the end of every year, each emitter should own enough allowances to cover the
amount of GHG emitted during that year.
• Firms are allowed to buy some more permits on the market through auction or
from firms, which have reduced their emissions and have a surplus of permits.
65
EU ETS – mechanism functioning (2003 Directive)
• The CAP:
• In the first two phases (2005-2007 and 2008-2012): decentralized process in a
bottom-up way; each country had the power to decide the allocation of its
allowances, through National Allocation Plans (NAPs).
• The EU-wide cap was the sum of the NAPs.
• Problems in the pilot phase: NAPs were modest in term of ambitiousness, mostly
due to excessive discretion left to Member States and self-reported emissions data.
• In the first period, the allocated emissions exceeded the verified emissions by 360
million tons of CO2 in the EU-27; the decentralized nature of the system led
Member States to allocate too many allowances in order to protect their own
industries.
• The only countries that experienced a shortage of allowances in this first phase 66
were UK, Spain and Italy.
67
Second phase: cut of 10.4% compared to proposed caps

68
69
European Emission Trading – EU ETS
• Since 2009 => a surplus of emission allowances in the EU emissions trading system.
• The surplus of allowances is largely due to the economic crisis (which reduced emissions
more than anticipated).
• The surplus amounted to around 2 billion allowances at the start of phase 3 and
increased further to more than 2.1 billion in 2013.
• This has led to lower carbon prices and thus a weaker incentive to reduce emissions.
• Introduction of short- and long-term measures.
• In the short term: the surplus risks undermining the orderly functioning of the carbon
market.
• In the longer term: it could affect the ability of the ETS to meet more demanding
emission reduction targets cost-effectively.

70
https://ec.europa.eu/clima/policies/ets/reform_en
Market prices and quantities

71
European Emission Trading – EU ETS
• Subsequent amendments:
• 2008: inclusion of aviation;
• 2008: emission cap level to require a reduction of 21% compared to 2005 for EU ETS
sectors + Effort Sharing Decision to reduce emission by non-ETS sectors of 10%
compared to 2005 (shared among Member States);
• from the third period (2013-2020): linear reduction 1.74% of the average total quantity
of allowances issued annually in 2008-2012 + new allocation method: full auctioning for
the whole power sector; progressive transition to auctioning for other sectors (reduction
30% year); completely free allocation for sectors at risk of carbon leakage;
• - from the fourth phase (2021-2030): increase in the pace of emissions cuts (overall
number declining at an annual rate of 2.2%); better targeted carbon leakage rules (from
177 to 50 sectors at risk) and new mechanisms to stimulate low-carbon innovation and
energy sector modernization. 72
European Emission Trading – EU ETS
• Subsequent reforms:
➢2014: (short-term measure) Back-Loading of allowances: postponing the auctioning of 900
million allowances until 2019-2020.
This measure affects only the distribution of the allowances over the third period, not their
overall number:
• The auction volume was reduced by:
• 400 million allowances in 2014
• 300 million in 2015
• 200 million in 2016.
➢ From 2019: Introduction of the Market Stability Reserve (long-term measure):
• The back-loaded 900 million allowances transferred to the reserve rather than auctioned in
2019-2020.
• Unallocated allowances transferred to the reserve. The exact amount will only be known in
2020. However, market analysts estimate that around 550 to 700 million allowances could 73
remain unallocated by 2020.
EU ETS: emission reduction

74
 Price CO2 European Union Allowances 2017-2019

between 4€
and 6€
throughout
2016 and
2017
75
Price CO2 European Union (source: trading economics)

76
RUOLO ISTITUZIONI FINANZIARIE
ISPRA – SISTEMA REGISTRY EUROPEI
ALTRI SISTEMI: CINA (WU ET AL. 2021)
ALTRI SISTEMI: CINA (SLATER ET AL. 2019)
Intertemporal and spatial analysis of pollution
Case of stock pollutants that have relatively long damaging lifespan, but
which are uniformly mixing.

Two implications:
1. the uniformly mixing assumption implies that pollutant
concentrations do not differ from place to place, and so the spatial
dimension of emissions control is no longer of direct relevance.
2. persistence of pollution stocks over time means that the temporal
dimension is of central relevance.

An efficient pollution control programme will need to take into account

of the trajectory of emissions over time, rather than just a single point in
time. 81