International Trade Rules and Climate Change Policy: Part II

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"The EU experience has led policymakers. . .to return to the idea of auctions as an allocation tool for allowances for greenhouse gas emissions."

As the U.S. Congress begins to consider how to follow-through on President Obama's call to create a cap and trade system to limit greenhouse gas emissions, it ought to begin by looking at the European experience with cap and trade.

The European Emissions Trading Scheme (ETS), which first went into effect in 2005, is the first significant attempt at establishing a wide-scale cap and trade system to limit the emission of carbon dioxide.

Like any significant new policy program, it had to work out some kinks in its early days, and the United States would do well to heed the lessons learned from the European experiment.

The ETS was itself modeled on the U.S. cap and trade scheme for reducing emissions of sulfur dioxide—the principal cause of acid rain. The U.S. acid rain scheme had been put into place in the mid-1990s as a first test of academic theories that market-based mechanisms for reducing pollution could reduce emissions of harmful substances more cost-effectively than traditional command-and-control regulatory regimes.

Like the U.S. acid rain scheme, the EU ETS, in its first phase, allocated emissions allowances for free to various industries and plants, rather than auctioning them off.

Unfortunately, because limited data required reliance on estimates of historical emissions levels and projections, the total amount of allowances initially allocated by the EU authorities placed no significant overall constraint on emissions levels. This led to a collapse in the market price of the allowances when the full measure of the cap became evident.

The EU experience has led policymakers in the EU and many other countries to return to the idea of auctions as an allocation tool for allowances for greenhouse gas emissions. Auctions have long been favored by academics as a more efficient mechanism—one that treats new market entrants on an equal footing with well-established firms.

Auctions also avoid the potential distortions of allocation decisions that can result from lobbying, especially where—as in the case of greenhouse gases—hard data on historical emissions levels may be limited.

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