Tradable Permit Systems: Considering Uncertainty in Emission Estimates

Abstract

We simulate the market for emission permits by considering uncertainty in emission inventory reports. The approach taken in this analysis is to enhance the emissions reported in each region by a certain part of their uncertainty when compliance with the Kyoto targets is being proved. While this formulation is not new in the literature, we define the uncertainty component in a way that enables comparison with the approach of effective permits presented in Nahorski, Horabik, and Jonas (2007) Compliance and emissions trading under the Kyoto protocol: Rules for uncertain inventories, (this issue). We show and explain that the transformation to effective permits bears additional costs apart from those resulting from shifting the Kyoto targets.

Appendix

1.1 Emissions Trading and Marginal Abatement Cost Curves

Below we present the economic bases of the emissions trading mechanism. It introduces a new type of property right that allows a specified amount of pollutant to be emitted. Thus, the total number of permits held by all sources puts a limit on the total quantity of emissions. Permits can be sold to anyone participating in the permit market. The system is initialized by central decision makers who decide on the number of permits to be put into circulation. As the total number of permits is usually lower than current total emissions, some emitters will receive fewer permits than their current emissions would normally allow.

Regional purchase or sale of permits until their marginal costs are equalized:

$$ MAC_{1} = MAC_{2} = P_{2} $$

This way the aggregate emission reduction is reached at the least cost for the whole market. The difference between the market price and the marginal cost in the absence of trade creates a potential gain that is shared between the two trading regions. This is illustrated in Fig. 1.

Fig. 1

Marginal abatements cost curves for two regions: MAC₁ and MAC₂

The origin of the marginal cost of control for the first source (MAC₁) is the left-hand axis and the origin of the marginal cost of control for the second source (MAC₂) is the right-hand axis. The diagram represents all possible allocations of the reduction between the two sources. The left-hand axis represents an allocation of the entire control responsibility to the second region, while the right-hand axis represents a situation in which the first source bears responsibility (Tietenberg, 1985). Initially region “1” must reduce hq amount of pollution, while region “2” tq amounts of pollution (looking from the right side of the axis). Total abatement cost is given by the area below the marginal abatement cost curves MAC₁ and MAC₂, respectively. Before trading, the total abatement cost for region “1” is the field “A”, and for region “2” is the sum of the areas B+C+D+E. Region “2” buys permits to emit more than is allowed (in other words, it reduces only the amount (tr) instead of the amount (tq), while region “1” abates more than it is obliged to do (hr), simultaneously selling (qr) permits.

After exchange of permits, costs for both sources is represented by the area (A + B + C ). The sum of the area A and B is the cost of control for the first source, while the area C is the cost of control for the second. The area D + E represents the amount saved by emissions trading. The costs of emission reduction is minimized, as the marginal costs are equalized across the emitters. Both regions have incentives to trade, as the marginal cost of control for the second region is higher than that for the first region. The second region will lower its costs as long as it can buy permits from the first region at a price lower than p ₃. When the price equals p ₂, neither region would have any further incentive to trade.