Carbon Emission

Carbon Emission Trading

Table of contents

1. Why free markets are efficient? 3

What are free markets? 3

Market efficiency: marginal benefit equals marginal cost 3

2. Government Intervention or Not? 5

Carbon emissions: negative externalities 5

Government Intervention 5

Pros 6

Cons 6

3. Why is EU-ETS chosen? 7

What is the European Union Emission Trading Scheme? 7

Long term industry reaction 7

4. How does the EU-ETS work? 8

How was it created? 8

Allocation of caps and allowances 8

Price establishment 8

Types of trading allowed 9

Penalty 9

5. Is CET helping? 10

CET Today. 10

Is CET reaching the Kyoto Agreement? 11

References 12

Appendix A - Member states and Emission caps 13

Appendix B - Countries that are listed in the UNFCCC 13

Annex I countries (industrialized countries): 13

Annex II countries (developed countries which pay for costs of developing countries): 14

Annex B countries 14

Appendix C - EU-ETS price trading history 15

1. Why free markets are efficient?

What are free markets?

In economic terms, "free market" is defined as "an economy where all economic decisions are taken by individual households and firms and with no governmental intervention" (Sloman, 2000). In this, the assumption is made that households and firms make all decisions, and they all act in self-interest. Firms all seek to maximize their profits and are free to choose what to sell and which production methods to use. Consumers all seek to get the best value for money from their suppliers and are free to decide what to do with their incomes. Workers all seek to maximize their wages relative to the human cost of working in a particular job and are free to choose where and to work and how much.

The resulting supply and demand decisions of firms and households are transmitted to each other through their effect on prices.

Market efficiency: marginal benefit equals marginal cost

In an efficient market, the quantity demanded balances with the quantity supplied. In such cases the marginal cost of the supplier equals the marginal benefit of the consumer. Producing one more unit would cost more then the consumer is willing to pay.

Figure 1: market efficiency at the equilibrium

Figure 1 shows the demand and supply curve of a product. At the intersection we find the equilibrium quantity and price. Market forces persistently bring marginal cost and marginal benefit to this equilibrium, which maximizes the sum of consumer surplus and produced surplus.

However, there are some obstacles to efficiency of the free market. The most significant of these obstacles are:

1. Price ceilings and price floors

2. Taxes, subsidies and quotas

3. Monopoly

4. External cost and external benefits

5. Public goods and common resources

In the next chapter it becomes clear that point 2 and 4 are matters of concern, when the topic of 'Carbon Emission Trading' is discussed.

2. Government Intervention or Not?

Carbon emissions: negative externalities

A free market will only lead to social interest, when marginal benefits and marginal costs include all costs and benefits for the entire society.

Marginal Social Cost = Marginal Cost + Marginal External Cost

Marginal Social Benefits = Marginal Benefit + Marginal External Benefit

Externalities are either a cost or a benefit that arises from production of a good or service and falls on someone else than the producer of the cost or benefit. Externalities are also costs or benefits that arise from consumption of a good or service that falls onto someone else besides the producer. In the case of carbon emissions we are dealing with a negative production externality situation. The cost of this externality should be taken into account.

Government Intervention

Governments across the world have three tools to cope with negative externalities:

1. Taxes

2. Emission charges and

3. Marketable permits.

Taxes can be used by setting a tax rate equal to the marginal external cost, firms can be made to behave in the same way as they would if they bore the cost of the externality directly. An alternative to the taxes is the use of emission charges. In this method, the government sets a price per unit of pollution and charges per unit. With marketable permits, the government assigns a permitted pollution limit to companies who are potential polluters. The government assigns each company a permit to emit a certain amount of pollution and companies can buy and sell these permits.

Taxes and emission charges