Josephine V. Yam

What are the two main conditions that make emissions trading systems feasible in the European Union Emissions Trading System (EU ETS)?

Condition 1 - the participants covered by the program must be sufficiently varied for there to be potential gains from trading allowances. If all firms were the same, then they would all face the same abatement costs and so they would all be either net buyers or net sellers. Hence no trade would occur. In the European Union Emissions Trading System (EU ETS), the coverage includes power plants and five major industrial sectors (including oil, iron and steel, cement, glass, and pulp and paper) that together produce nearly half the EU’s CO2 emissions.

Condition 2 - there should be a sufficient number of polluters included in the scheme in order to ensure a reasonably liquid market. This increases the amount of trades that occur, hence allowing a clear price signal to emerge. In turn, this reduces the uncertainty that participants face when making long-term investment decisions because the expected gains from investing to abate are much clearer. Furthermore, the risk of any one participant holding extensive market power, which would restrict trading, is reduced. In the European Union Emissions Trading System (EU ETS), approximately 12,000 facilities in the 25 EU member states are covered.

In successfully meeting these two conditions, the EU ETS’ massive scale and breadth has enabled it to build a very robust emissions trading market in a short period of time. For example, in 2007, over 100 million allowances per month were traded. Moreover, rates of compliance amongst participants were encouragingly high.

Written: 2012 February
Source: PriceWaterhouseCoopers (PWC). (2009). Carbon Taxes vs. Carbon Trading: Pros, cons and the case for a hybrid approach”