The Effect of Allowance Allocations on Cap-and-Trade System Performance

Abstract

We examine an implication of the "Coase Theorem" which has had an important impact both on environmental economics and on public policy in the environmental domain. Under certain conditions, the market equilibrium in a cap-and-trade system will be cost-effective and independent of the initial allocation of tradable rights. That is, the overall cost of achieving a given aggregate emission reduction will be minimized, and the final allocation of permits will be independent of the initial allocation. We call this the independence property. This property is very important because it allows equity and efficiency concerns to be separated in a relatively straightforward manner. In particular, the property means that the government can establish the overall pollution-reduction goal for a cap-and-trade system by setting the cap, and leave it up to the legislature -such as the U.S. Congress -to construct a constituency in support of the program by allocating the allowances to various interests without affecting either the environmental performance of the system or its aggregate social costs. Our primary objective in this paper is to examine the conditions under which the independence property is likely to hold -both in theory and in practice. A number of factors can call the independence property into question theoretically, including market power, transaction costs, non-cost-minimizing behavior, and conditional allowance allocations. We find that, in practice, there is support for the independence property in some, but not all cap-and-trade applications.

Understanding Effectiveness Skepticism

“…Another important aspect in public debates on pricing policies is their supposed effectiveness: opponents are often concerned that incentive programs will not solve the problems they are supposed to address (e.g., Gärling and Schuitema 2007; Harwatt 2008). This “effectiveness skepticism” stands in sharp contrast to a host of scientific studies demonstrating that incentive programs could effectively help reduce environmental problems such as traffic congestion (Verhoef et al 2004), traffic accidents (Bolderdijk et al 2011) and climate change (Hahn and Stavins 2011).…”

Emissions permit allocation and strategic firm behavior: Evidence from the oil sector in the European Union emissions trading scheme

“…As is well established, Coase (1960) posits that, "in the absence of transaction costs, third party impacts, and income effects, the same efficient emissions abatement outcome will result from bilateral negotiation between the polluter and recipient of an externality, independent of the initial allocation of emissions allowances" (Hahn & Stavins, 2011, p.267-268) . However, in one study, Hahn and Stavins (2011) examine potential instances where the Coase theorem may be violated. The authors empirically assess differences in rule-making across cap-and-trade systems, including the EU ETS, the U.S.…”

“…In fact, they find governments routinely set an emissions cap or abatement goal and leave it up to the political process to harness stakeholder support for cap-and-trade systems by allocating allowances among various interests, without reducing system performance or driving up social costs. While the independence property appears to be broadly validated in practice, Hahn and Stavins (2011) also examine instances when the "indepen- Relatedly, there is extensive literature on coalitional bargaining (Aivazian, Callen, & Lipnowski, 1987;Hyndman & Ray, 2007;Okada, 2000Okada, , 2011. In one study, Aivazian et al (1987) argue that the Coase theorem may not hold in instances of strategic coalitional behavior when more than two participants are involved in an externality.…”

“…The author finds "renegotiation may motivate bargainers to form a subcoalition first and to exploit the first-mover rents" Okada, 2000, p. 34) This process of renegotiation creates "vested interests" among coalition members, which can distort the equitable distribution of emission allowance allocations in an agreement. Particularly, the work by Hahn and Stavins (2011) emphasizes an important aspect of scholarly research on emissions trading, namely the disconnect between theory and practice, a point that is particularly highlighted by Matisoff (2010). As the author points out, in emissions markets there are imperfections, market volatility, and uncertainty about supply and demand.…”

A Blind Eye to Industry-Level Corruption? The Risk of Favouring Domestic Industries in the EU ETS

“…Notably, transportation, buildings, the service sector, and agriculture are not presently included although it was envisaged from the beginning that additional GHGs and sectors would be incorporated over time. Presently, the EU ETS includes about 45 per cent of the CO 2 emissions and a little less than 40 per cent of the GHG emissions of the EU (Hahn andStavins 2010, Markussen andSvendsen 2005).…”