The EU ETS as an Environmental Instrument - Green Energy and Efficiency: An Economic Perspective - page 354

be achieved. On the other hand, a carbon market gives clear information on total
emissions into the atmosphere ( ) but the price is unknown, since it will not

be constant as it would be with a carbon tax but

“ the cap ”

oating, depending on the supply
and demand balance. In this case, the price signal needs to represent the marginal
cost, i.e. the cost of the latest emission reduction made to meet the emission cap.
This is the basic idea behind the EU ETS.
A carbon tax policy wouldmean that every facility 5 would have to pay a xed price

for each tonne of CO 2 emitted. Under this scheme the price of carbon is established
and settled by the market regulator. As C2ES [ 4 ] mentions:

In principle, a carbon tax
could be designed to produce the same overall level of emissions, distribution of
emission reductions across sources and sectors, and aggregate costs as a cap-and-trade
system. However, achieving this level could require adjusting the tax rate several
times because of the uncertainty surrounding consumers

“

”
On the other hand in a market based scenario each facility must surrender one
emission allowance for every tonne of CO 2 emitted. The price of the allowances is
settled by the market itself with no intervention by third parties. Therefore, in a
market based mechanism the emitter could decide whether to increase its demand
for allowances and go to the market to buy the marginal tonnes or reduce its
demand of allowances and sell the surplus on the market. In this way the

' response rates.

rst
emission reduction is always the one with the lowest abatement cost. This mech-
anism pursues not only environmental effectiveness but also economic efciency.
As Ellerman et al. [ 5 ] state: These transactions produce a price per unit of pollution

that provides the incentive to polluters to reduce emissions and sell the surplus to
those who need to buy to cover their emissions. Emissions trading also provides
signal to innovators to come up with new and better way to reduce emissions.
Because those who can do so at least cost will reduce most, the overall burden on
the economy of meeting the cap is likely to be achieved at close to minimum cost.

“

”
According to economic theory both tools achieve the same results, with no
externalities or uncertainties in either case. Therefore policy makers must decide
whether they prefer predictability in the amount of the emission reduction (cap-and-
trade system) or predictability in the price signal price of abatement (carbon tax).
The EU decided to obtain a de ned emission reduction target but with the risk of

price volatility.
If the policymaker chooses a cap and trade scheme, then the rst issue to be

addressed is the cap of the market. 6 , 7 A carbon market is an arti cial market, so it

depends on generating a shortage on a formerly free commodity (a tonne of carbon)

5 The scope of this chapter does not include road transport. For further information on this issue
see [ 3 ].
6 This is not the only item that hinders the predictability and the behavior of the system. There are
other two factors that cannot be predicted: the future and real costs of abatement and future energy
prices and policies.
7 This chapter considers the case of a cap and trade system where allowances are allocated for free
through quotas of allowances issued to facilities as in the EU ETS example. There are other cases
of cap and trade systems where allowances are not allocated for free [ 10 ].