An international system of tradable emission permits has engendered interest as a way to control emissions of sulfur dioxide (SO2) in Europe. Like other forms of incentive-based regulation, emission permit trading has the potential to achieve a given emissions reduction goal at less cost than command-and-control regulation. However, the full cost-saving potential of SO2 emission trading in Europe's electricity industry, which generates 65 percent of Europe's total SO2 emissions, is significantly undermined by the structural and regulatory diversity of that industry. Despite this fact, emission permit trading can be justified on the ground that it would promote the reflection in electricity prices of the social costs of pollution resulting from electricity generation. The internalization of social costs in these prices is critical to Europe's realization of economic unification and to the liberalization of European energy markets.
Emissions of sulfur dioxide (SO2) are thought to contribute to acidification of soils and water, deterioration of visibility, and corrosion of materials; they are also thought to aggravate respiratory problems in humans. One possible approach to the control of SO2 emissions is the trading of SO2 emission permits on an international level. In 1990 the United States initiated the largest experiment of this type of environmental regulation in history by adopting a national system of SO2 emission permit trading.
A system of tradable emission permits typically works as follows. A cap is set on total emissions of a given pollutant in a given geographic area, and a fixed number of permits to emit some quantity of the pollutant is issued to the pollutant emitters, who can then trade the permits among themselves. In theory, those who find that their pollution abatement costs are relatively low will choose to reduce their emissions and sell their unneeded permits, while those who find that their pollution abatement costs are relatively high will choose to buy permits rather than to reduce their emissions. Ideally, decisions about whether or how much to invest in pollution abatement and in permits will depend on the relative cost of each.
Two potential benefits are often ascribed to a system of tradable emission permits. The first is that such a system allows an environmental objective to be achieved at least cost. The second is that, because the price of emission permits tends to be reflected in the price of final products and services, individuals are encouraged to consider the social costs of pollution in their consumption decisions.
The first of these benefits will be difficult to obtain through the trading of SO2 emission permits within Europe's electricity industry, which is a major focus of SO2 emissions control efforts in Europe. The lack of incentives to minimize costs and other obstacles to emission permit trading in that industry suggest that the cost savings of such trading may not be fully realized. Nevertheless, the fact that SO2 emission permits can lead to the internalization of social costs in the price of electricity provides a compelling reason to pursue emission permit trading.
SO2 emissions reduction and electricity markets
Among the most important efforts to curb SO2 emissions in Europe to date are a protocol issued by the United Nations Economic Commission for Europe (UNECE) in 1985 and a directive adopted by the European Community (EC) in 1989. The protocol—which was signed by 21 countries, not including Poland and the United Kingdom, and ratified by 16 countries in 1987—calls for UNECE member countries to reduce their annual level of SO2 emissions by at least 30 percent of levels in 1980. The Large Combustion Plant Directive specifies percentage reductions in emissions of sulfur dioxide and nitrogen oxides for each EC member country and places specific limits on such emissions from power plants.
According to researchers at the International Institute of Applied Systems Analysis (HASA) in Laxenburg, Austria, the combined effect of current SO2 emissions control commitments on the part of European countries will be to reduce Europe's total annual SO2 emissions in 1995 by perhaps 29 percent of levels in 1980. However, a reduction of 50 percent to 70 percent of 1980 levels must be attained in order to reverse soil acidification caused by sulfur deposition.
By the year 2000, sulfur dioxide emissions are expected to decline significantly in the northern and western regions of Europe and to decline somewhat less significantly in the countries of Central and Eastern Europe. However, they are expected to increase in the southern region of Europe, the countries of which have not yet committed to any SO2 emissions reductions targets.
The attention given SO2 emissions reductions by many European countries reflects a concern about environmental protection in general. In turn, this concern has been reflected in economic unification efforts. For instance, the Single European Act (SEA) of 1987 placed protection of the environment on an equal footing with economic growth, free trade, and policies to encourage competition. The Treaty on Political Union has further strengthened political consideration of the environment in the EC. As both the treaty and the SEA suggest, the EC—which has replaced member states as the initial source of environmental regulations—recognizes that economic growth as a consequence of economic unification will have environmental implications.
With regard to reducing SO2 emissions, the question at hand is how the EC's commitment to environmental protection will affect Europe's path toward economic integration and vice versa. Since approximately 65 percent of all SO2 emissions in Europe originate from the generation of electricity, the structure and regulation of European electricity markets will be an especially important factor in determining how SO2 emissions reductions will be achieved. Historically, financial subsidies have played an important role in European markets for electricity and other forms of energy. These subsidies have cost European taxpayers billions of European currency units (ECUs) over the years. The EC has claimed that the buying and selling of electricity among EC member countries could produce cost savings of between 1.5 billion and 3 billion ECUs per year and that an internal market for all forms of energy could lead to savings of 0.5 percent to 1 percent of gross domestic product across the EC. An open international electricity market is expected to be developed in several phases. In the market, EC member states will retain authority for electricity system planning and all aspects of electricity pricing.
Benefits of tradable emission permits
There are two reasons why tradable emission permits have attracted more interest than emission fees and other forms of incentive-based (IB) environmental regulation as a means for regulating SO2 emissions in Europe. First, under an emission permit trading system, the EC could directly control the total level of SO2 emissions in Europe by restricting the number of permits it issues to SO2 emitters. Second, by constraining trading in certain areas or by certain polluters, it could control the level of such emissions in the locations that suffer the most from the environmental and health effects of sulfur deposition.
Two potential benefits of an emission permit trading system are the cost-effective achievement of a given emissions reduction goal and the internalization of the social costs of pollution in the prices of goods and services.
As noted above, there are two potential benefits of an emission permit trading system. The most commonly cited benefit is the attainment of productive efficiency—that is, the cost-effective achievement of a given goal. Emission permit trading (and other forms of IB environmental regulation) can often achieve a given environmental goal at less cost than command-and-control (CAC) regulation of emissions. Unlike CAC regulation, under which regulators might specify use of the best-available pollution control technology, emission permit trading encourages the development of both production technologies and pollution control technologies that in the future would reduce the cost of complying with emissions limits set by regulators.
The second potential benefit of emission permit trading is that it helps to internalize in the prices of goods and services the costs to society of pollution emitted after firms have complied with environmental laws. Under CAC regulation, this residual pollution remains unpriced because firms are given free-of-charge access to the land, air, or water that assimilates it. As a consequence, society demands too much electricity because the price of electricity is too low. Under an emission permit trading system, firms must pay through the purchase of emission permits for access to the environmental media that assimilate their residual pollution. The resulting pricing of residual pollution raises product prices and causes secondary adjustments in economic behavior, such as decreases in consumer demand, that promote efficiency in the allocation of resources to economic activities.
Obstacles to emission permit trading
Simulations of SO2 emission permit trading in Europe conducted by HASA and others indicate that such trading could greatly reduce the costs of meeting Europe's SO2 reduction goals. One opportunity for reducing these costs stems from the fact that EC member states often pursue pollution abatement strategies that subsidize important domestic constituencies but that do not obtain pollution reductions at least cost. Another opportunity for reducing costs stems from the considerable differences across the EC in preexisting emission standards that form the benchmark for percentage emissions reductions required by the Large Combustion Plant Directive. The disparities in marginal abatement costs produced by these differences could be exploited in a system of emission permit trading. Under such a system, a country could determine whether it would be cheaper to reduce its emissions by a given amount or to compensate another country for reducing its emissions by the same amount, and act accordingly. Unfortunately, neither of these two opportunities to reduce costs is likely to be exploited in the implementation of emission permit trading in Europe's electric industry.
Among European countries, asymmetries in the nature of regulation and in incentives to pursue specific environmental compliance options will tend to undermine the economic principles of an emission permit trading system.
Virtually all analyses of the potential savings from emission permit trading and other forms of IB regulation have been limited to examinations of competitive product markets or to the role of market power on behalf of producers in an unregulated product market. These analyses depend fundamentally on the expectation that firms will respond to economic incentives by choosing a least-cost strategy for compliance with environmental standards. With regard to the electricity industry in Europe, this expectation may not be realistic for several reasons.
European electric utilities may not have the incentive to maximize profits or to minimize costs that competitive firms have. State-owned electric utilities might lack incentives to minimize costs for several reasons. First, doing so might cause their production targets to be increased by the government in the future. Second, they are protected by the government from financial failure through subsidies, tax exemptions, easily obtained credit, and other forms of financial aid. Thus their survival and growth may depend more on their relation to the current government bureaucracy and on certain aspects of their performance that are of concern to society than to success in the market.
Privately owned electric utilities might also lack incentives to minimize costs. With the exception of those in England, almost all privately owned utilities in Europe are lightly regulated monopolies that typically recover all their costs through tariffs. Because they are not subject to prudence reviews that can lead to the disallowance of some costs, they can engage in pricing that approximates cost-plus pricing, in which firms pass along all costs to consumers. In some instances, such as when prices are based on standard rather than on actual costs, they will have a modest incentive to reduce costs.
There are two other reasons why the potential cost savings of emission permit trading are unlikely to be realized. First, firms that are regulated typically do not make decisions on the basis of market prices, but rather on the basis of distorted opportunity costs that reflect regulatory practices. Implicit in the current regulatory practices of European countries are biases in the treatment of depreciation, recovery of capital costs, risk associated with investments, and fluctuating production input prices.
The cost-saving potential of emission permit trading and other forms of incentive-based environmental regulation is diminished in Europe's electricity industry because European electric utilities may not have the incentive to maximize profits or to minimize costs that competitive firms have.
Asymmetries among European countries in the nature of regulation and in incentives to pursue specific environmental compliance options will tend to undermine the economic principles of an emission permit trading system. Second, regulators in each country are likely to favor explicitly certain types of compliance activities that promote social objectives other than the control of pollution at least cost.
Investment behavior on the part of all electric utilities is affected by the national energy policies of European governments, which have played an increasingly important role in planning electricity-generating systems and in making decisions about new investments in the electricity and other energy sectors of their national economies since the early 1970s. Energy policies have been and continue to be used as a tool for macroeconomic policies and for policies aimed at providing aid to specific fuel industries. For example, energy policies in Spain, England, and Germany support the use of coal; those in the Netherlands support the use of gas; and those in France support the use of coal and nuclear energy. Such policies clearly discourage the implementation of efficient cost control practices.
One way to overcome, at least in part, the lack of incentives to minimize costs in the electric industry is to promote the EC goal of making electricity pricing transparent—that is, distinguishing among the various components of delivered electricity services and explicitly accounting for the costs embedded in each component. Transparent pricing of electricity has two benefits. First, it discourages subsidization of electricity generation technologies, because the costs of the technologies are open to public review and criticism. Second, it promotes competition in electricity markets by helping to establish the relative cost advantages of technologies.
In the United States an element of price transparency is provided by the Uniform System of Accounts, which recommends accounting practices to state regulators. As the EC moves toward an internal energy market and increased economic integration with the rest of Europe, the establishment of a similar institution in Europe would promote emission permit trading by helping to make assymetries in the regulation of electric utilities apparent. A template for consistent cost accounting in the electric industry should be developed as part of an international agreement for SO2 emission permit trading across Europe.
Emission permit trading in an international economy
Despite the many obstacles to minimizing emission reduction costs through emission permit trading, such trading should remain of interest because it has a significant virtue. It and other forms of incentive-based environmental regulation allow decision makers to consider social costs in the context of their own opportunity costs and, depending on how product prices are set, to reflect social costs in product prices. In internalizing social costs in the price of electricity, emission permit trading is consistent with the economic objectives of the EC—free trade and economic competition—and with the economic integration of Europe. However, strategic considerations in the implementation of international environmental policies may undermine this virtue of emission permit trading. These considerations suggest that international environmental agreements must not only specify environmental goals but also articulate the mechanism through which such goals are to be achieved.
In internalizing social costs in the price of electricity, emission permit trading is consistent with the economic objectives of the EC—free trade and economic competition—and with the economic integration of Europe.
Consider an international agreement for SO2 emissions control that specifies (potentially tradable) emission targets for each country but leaves the mechanism for achieving the targets up to the individual country. Is there reason to believe that, acting unilaterally, national governments would implement national systems of tradable emission permits? A country's firms may find it cheaper to comply with such IB regulation than to comply with CAC regulation, but their cost savings must be weighed against the reduction in their international competitiveness that would result from the effect of emission permit trading on their product prices. This effect, as noted above, is to raise product prices by including in the prices not only the marginal cost of pollution control but also the opportunity cost of using the atmosphere's absorptive capacity. The distinction between marginal and average costs makes a direct comparison of emission permit trading and CAC regulation in Europe difficult, but it is probable that a firm's opportunity cost in purchasing an emission permit—a cost reflected in the monetary value of the permit—would be higher than the firm's savings in environmental compliance costs under emission permit trading. In this case, the national benefits that result from competitive pricing under CAC regulation might outweigh the benefits that result from savings in pollution control costs under IB regulation. Furthermore, the benefits to individual firms that utilize comparatively more polluting technology might be greater than those to firms that utilize comparatively less polluting technology.
Hence, absent a specific mechanism to implement IB environmental regulation as a component of international environmental agreements among European countries to reduce SO2 emissions, it is unlikely that national governments of Europe will unilaterally adopt such regulation. As a result, the costs of achieving environmental goals may be higher than they need to be, and the necessary precepts for the economic integration of Europe—namely, transparent pricing of electricity and the elimination of subsidies implicitly provided by some national environmental policies—may be undermined.
Because the benefits that result from competitive pricing under CAC regulation may outweigh the benefits that result from savings in pollution control costs under IB regulation, it is unlikely that countries will unilaterally adopt a national system of emission permit trading.
Given these potential consequences, it makes sense for the countries of Europe to pursue a system of tradable SO2 emission permits on an international level. A critical issue in implementing such a system will be the initial distribution of emission permits. In order to realize cost savings through the exploitation of marginal emissions abatement costs, the permits should be distributed directly to electric utilities and other SO2 emitters rather than to national governments. If permits are initially allocated to nations, there is no guarantee that the price of a permit or the opportunity cost of discharging a unit of SO2 emissions would be passed on to industry or to consumers. Furthermore, it is likely that national governments would use CAC regulation that is consistent with their holdings of permits to achieve emissions standards set under an international environmental agreement. If so, governments would have an opportunity to subsidize domestic electricity utilities and other domestic industries that make extensive use of electricity.
One of the benefits of emission permit trading is that the allotment of permits can promote cost-sharing among countries that each bear different emissions control costs. Within the electric industry, the fuels used to generate electricity are an important factor in determining these costs. While there is great diversity among European countries in the fuels used to generate electricity, there is little diversity in the fuels any one country uses to generate electricity. The countries whose electric utilities rely on coal in generating electricity will bear the greatest costs to reduce SO2 emissions. To lessen the cost burden of these countries, permits could be distributed on the basis of historic levels of emissions. However, this approach has one disadvantage. Given current regulatory practices, electricity prices would be unlikely to reflect the opportunity cost of using permits if the permits were distributed to electric utilities free of charge. An alternative approach is to distribute permits through an auction. However, coal-based electric utilities would oppose this approach. Thus it may be preferable to distribute the majority of permits as endowments, doing so on the basis of historic levels of emissions, and to auction the remaining permits. Over time the endowments could be phased out and replaced by an expanding auction. Revenues from permit auctions could then be allocated in ways that would lessen the burden of emissions control on the electric industry as a whole and on the countries bearing the greatest emissions control costs.
Importance of internalizing social costs
An international system of tradable emission permits will not be easy to implement in Europe. Economic integration of Europe is unlikely to lead individual countries to surrender control of their energy, environmental, and industrial policies. Moreover, each country is likely to continue to appease influential social interests within its borders.
Additional problems will lessen the prospects for achieving the benefits of SO2 emission permit trading in Europe's electricity industry. Structural and regulatory diversity within this industry is an obstacle to realizing the full cost-saving potential of emission permit trading because it imposes regulatory biases that obscure the full social opportunity cost of tradable SO2 emission permits. As noted above, the adoption of accounting practices that make this cost explicit and the distribution of emission permits to individual electric utilities rather than to national governments would help solve this problem.
Even if the full cost-saving potential of tradable emission permits cannot be realized in Europe's electricity industry, the internalization of social costs in electricity system planning and potentially in the price of electricity is sufficiently critical to advancing Europe's agenda of economic integration and liberalization of energy markets that it alone justifies emission permit trading. Such trading and other forms of IB regulation are the only kind of environmental regulation consistent with the economic objectives that have been set out in Europe. However, the lack of incentives for the countries of Europe to implement unilaterally SO2 emission permit trading at a national level is an obstacle to the internalization of social costs in energy prices. In order for such internalization to occur, international negotiations on transboundary pollution must establish emission permit trading (or some other form of IB regulation) as the mechanism for achieving SO2 emissions reduction goals.
Dallas Burtraw is a fellow in the Quality of the Environment Division at Resources for the Future. A detailed account of the issues in this article can be found in discussion paper QE93-22, "The Promise and Prospect for SO2 Emission Trading in Europe," by Dallas Burtraw.
A version of this article appeared in print in the October 1993 issue of Resources magazine.
A version of this article appeared in print in the October 1993 issue of Resources magazine.
