A broader use of emission trading systems (or of environmental taxation) would be one of the most efficient and effective ways of promoting green growth. The OECD has been analysing and promoting the use of marked-based instruments for many years. Most of the work was carried out under the auspices of the former Working Party on National Environmental Policies, and recently renamed the Working Party on Integration of Environment and Economic Policies. Part of the work has also been done under the auspices of the Joint Meetings of Tax and Environment Experts, where experts primarily from ministries of finance and of environment come together twice a year. These meetings are being served by OECD’s Centre for Tax Policy and Analysis and Environment Directorate, with contributions also from other parts of the organisation.
Emission trading systems contributes to economic efficiency by facilitating emission reductions where it is cheapest to achieve them. Polluters who would find it costly to reduce their emission are allowed to buy emission allowances from polluters that can abate at lower costs. In a ‘perfectly’ working market, the costs of reducing an additional unit of emissions would be equalised, and total costs of reaching a given environmental target would be minimised. Ex post evaluations of a number of tradable permit systems can be found in the publication Tradeable Permits: Policy Evaluation, Design and Reform.
There are two main types of trading systems: “Cap-and-trade systems” and “baseline-and-credit systems”. In a cap-and-trade system, an upper limit on emissions is fixed, and emission permits are either auctioned out or distributed for free according specific criteria. Under a baseline-and-credit system, there is no fixed limit on emissions, but polluters that reduce their emissions more than they otherwise are obliged to can earn ‘credits’ that they sell to others who need them in order to comply with regulations they are subject to.
In general, OECD recommends that the permits or emission allowances in cap-and-trade systems be auctioned rather than handed out for free (“grandfathered”). Auctioning makes sure that the rents linked to environmental policies goes to public authorities, instead of being captured by the existing polluters. However, in practice, most permits have so far been distributed for free. On the other hand, where environmental taxes are being used, they often include some differentiation in tax rates across polluters. Hence, none of these approaches normally follow “text-book” prescriptions, and the document Environmentally Related Taxes and Tradable Permit Systems in Practice discusses in detail which of the two alternatives perform the better from an economic efficiency point of view.
The current use of emission trading systems (and a number of other environmental policy instruments) is documented in a freely available database. The database gives information on the environmental problems addressed by the trading system, on the item that is traded, the trading partners, any revenues raised by the sale of permits, etc. The database is much used by civil servants, academics, industry representatives, etc., and OECD draws heavily on it for regular assessments of policies in member countries and partner countries.
While most emission trading systems are national or regional in character, the European Union has established a common emission system for CO2 emissions (the EU ETS), to which some other European countries have also linked up. An agreement has also been made on seeking to link the EU ETS and a future Australian emission trading system. The Kyoto protocol is also a sort of an international trading system, that includes both ‘cap-and-trade’ aspects (such as the emission limitation obligations of the Annex I countries) and ‘baseline-and-credit’ aspects (such as the possibilities to generate credits by undertaking emission reductions in e.g. developing countries).
In general, linking of emission systems will promote economic efficiency by allowing abatement to take place where it cheapest to undertake it. It is, however, important to make sure that the environmental integrity of the systems are preserved when linking takes place. With baseline-and-credit’ systems, it can be difficult to verify to what extent emission reductions are ‘additional’ – i.e. to what extent they represent something different from what would have happened in any case.
One issue of concern with a ‘cap-and-trade’ system, and with other types of upper limits on emissions, is when these are combined with other instruments – for example various subsidy schemes. There is a danger that the additional instruments only cause extra costs, without bringing any additional benefits. Such issues are discussed in detail in the document Interactions between Emission Trading Systems and Other Overlapping Policy Instruments.