Licensing carbon dioxide emissions

A system which puts a value on carbon emissions and establishes a mechanism to trade them on a open market. The tradable permit system for emission of carbon dioxide (CO2) involves defining an overall target for emissions and then issuing permits to emit carbon to this level. Participants would have to hold permits equal to the value of their emissions. If they proved insufficient, they would have to buy or lease permits from other participants.

Of all the instruments examined, the system of tradeable emission rights attracts the most attention and is considered to be the most promising for reducing greenhouse gas emissions. It offers the advantages of flexibility, efficiency in pollution abatement, direct control of total emission levels, a mechanism for trading reduction in different gases and incentives for research into pollution abatement technology.

The key issue in the operation of a tradable permit system is how to allocate the permits. Among the various allocation mechanisms available to policy makers, there is probably a family of solutions that would work well based on percentage allocation applied differently to three or more groups of countries, with greater levels of abatement being required from those that would benefit most. Since the use of markets can dramatically lower the cost of controlling greenhouse gas emissions, it is clearly in the self-interest of major countries to act as "market leaders". The OECD countries, therefore, would bear the greatest burden of emission reductions in the initial allocation. Whatever is agreed, the initial allocation is not likely to affect the efficiency of the system – however, initial permits are allocated, the trading that subsequently occurs works to ensure that the system operates at minimum cost to the participants. Furthermore, the developing countries would initially be allocated a surplus of permits and the industrialized countries a deficit. In the ensuing trading, resources would automatically be transferred from the richer countries, where the cost of abatement is generally high, to the poorer ones, where it is generally lower.

One study of the way commodity markets work suggests that a market in which the world's three major emitters of CO2 – the EEC/EU, Japan and the USA – traded would be worth more than US$8,000 million a year and 40% of global CO2 emissions. This compares reasonably with other commodity markets. Under such a proposal, the recommended trading forum(s) would consist of three separate commodity exchanges, one located in each party's time zone, for 24 hour coverage and regional representation, augmented by over-the-counter forward and swap transactions. A pilot scheme could be gradually transformed into a more complete system on the basis of "learning by doing". Experience with other successful markets, ranging from that for wheat to the Eurodollar market, suggests that a pilot CO2 permit market could thrive even with relatively few active traders: a minimum of 10 nations responsible for about 20% of global CO2 emissions is thought to be needed.

According to how "fair allocation" is defined, the number of permits allocated to each country could be in proportion to: (1) Levels of national emissions after each country has made a uniform percentage reduction (the "same for all countries" principle, used in other agreements even thought it rewards the biggest polluters); (2) Levels of per capita emissions (based on the right of the individual to use the atmospheric resource); (3) Levels of emissions per unit of GNP (rewards economic activity but penalizes poor countries); (4) The inverse of per capita consumption of fossil fuels (rewards poor countries and those moving toward renewable energy); (5) Size of population (based on equal per capita shares); (6) Extent of land area (encourages low population density); (7) The inverse of cumulative per capita emissions (principle of historical responsibility); (8) Some weighted average or two or more of the above (combines the best features of a long list); (9) Different selections of the above rules for two or more groups of countries (the Montreal Protocol required developed countries to adopt a uniform percentage reduction but developing countries were allowed to increase production for 10 years); or (10) Each country choosing an abatement level at least as large as the uniform abatement level it would like to see all countries adopt (the Kantian rule). These are not the only possible definitions of equitable allocation but they give a flavour of the varieties possible. In a study commissioned by UNCTAD, none of the uniform allocation mechanisms worked well. Non-uniform permits fared better. The Kantian rule provided gains for all countries over a "no-agreement" situation, with substantial gains for developing countries. The implication is that there is probably a strategy based on a family of solutions that would work well, based on percentage allocations applied differentially to three or more groups of countries, with greater levels of abatement being required from those that would benefit most (i.e. OECD countries).

An UNCTAD report recommends that a tradable permit system for CO2 should be under the international control of a new United Nations body, probably acting under the Conference of the Parties. It would be responsible for allocating and creating new permits but would delegate to private industry the job of providing an efficient clearing house and organizing market exchanges on at least three continents. The UN agency would also organize self-monitoring by individual countries, estimate emissions form non-participants and publish annually a report on progress. Threat of public exposure would probably act as a sufficient sanction to enforce compliance with the provision of the convention.

At the Third Session of the Conference of the Parties to the UN Framework Convention on Climate Change (Kyoto 1997), there was disagreement over the issue of emissions trading and other means of achieving flexibility in national emissions reductions targets. Advocates argued that emissions trading was the most efficient means of achieving significant reductions. Others, particularly amongst the southern delegates, saw this as a way for the industrialized nations to avoid responsibility for their own emissions.