One of the problems with emissions trading is setting the level of emissions that individual firms have a right to emit so that trading can occur. If the baseline level is too low, there will be few pollution rights for sale–because few firms will be able to reduce their pollution levels below the standards set. However, if the baseline level is too high, there will be few buyers of pollution rights–because most firms will be able to meet the standards. In either case, there will be too little trading.

There are various ways that baselines can be set. In the past the baseline level was usually set in the USA by making it the same as existing license limits. Opponents of emissions trading point out that these established license limits have not enabled states to meet air quality goals and that, while further reductions in emissions are needed, surplus rights should not be traded. Proponents argue that the problems lie with the licensing system, and that these problems should not prevent cost savings being made through the use of emissions trading.

In practice pollution credit trading did not prevent pollution growth resulting from economic growth. Baselines were set and companies could gain credits from keeping their emissions below the baselines and sell them to companies who had emissions above the baseline but since new firms were given the same baselines as established firms, the total pollution continued to climb.

As a result of some of these problems a new form of trading was introduced– allowance trading. With allowance trading a prespecified number of allowances is allocated or auctioned off to polluters. The total allocation can be based on the estimated capacity of the environment to take a certain amount of pollution. New firms have to buy up allowances in order to operate at all, if they have emissions of the particular pollutant in question. This system is also referred to as "cap and trade".

In the first instance of allowance trading the US EPA, in March 1993, allocated allowances to emit sulphur dioxide, which is a primary cause of acid rain. A small percentage of the allowances (2.24%) were also auctioned off. $US21 million was raised by selling 150,000 ‘allowances’ mainly to electricity companies. Each allowance allowed the company which paid for it to release 1 tonne of sulphur dioxide into the air after 1995. The price for each allowance was between $122 and $450, much cheaper than paying for flue gas scrubbers to remove sulphur dioxide from their emissions (Kiernan 1993: 10; Tietenberg 1997).

A similar alternative is to set baselines according to a reduction target. Authorities can work out what reduction in pollution they desire and make that the basis for deciding the allocation of permits. Those that have spare capacity on their permits or need to discharge more than they are permitted to can trade. Most recently three states in the USA have proposed such a system to clean up volatile organic compounds (VOC) in the air of non-attainment areas. The EPA has already approved one of these schemes in Chicago where it is hoped that VOC emissions can be capped at 12% less than 1996 levels. Companies that reduce their VOC emissions by more than 12% will receive credits that they can trade with companies that are unable to meet the 12% target (Hansen 2000).

The problem with such schemes is that if the baseline level is later found not to be the ideal ultimate level, or if new information comes to hand that means the regulator has to tighten the air quality standards, baseline levels will have to be reduced. How does that affect a firm’s ‘banked’ credits? Would the government have to buy them back? Otherwise, according to Hahn & Hester, "reductions that were once surplus would then be required, thereby effectively confiscating the property right held by the firm" (Hahn and Hester, 1989). This also adds to the uncertainty of firms that may not be inclined to get involved for fear of having their banked credits devalued.

One way of dealing with this problem is to allocate shares rather than credits or permits. Based on their share of the total pollution allowed, the emitter would get a permit to emit a certain volume of pollution per time period. The permits could be bought and sold. The share would be owned forever but the volume of pollution it permitted could vary if, for example, it was found that the pollution needed to be more strictly controlled or, in the case of greenhouse gases, because of new international agreements.

There are various ways of allotting shares or permits as we have seen. The two main ways are usually referred to as grandfathering and auctioning. Grandfathering involves allocating shares or permits to firms on the basis of their past emissions. Firms that polluted more in the past would have larger shares. If the share or permit they are allocated is less than their normal emissions, or if they increase their emissions, then such firms would have to buy extra permits. Similarly they would be able to sell those they don’t need if they reduce their emissions.

There are problems associated with each method. Auctioning means that each firm has to bear additional costs just to operate as they have to buy permits at auction to emit gases they had previously been emitting for nothing. This is especially hard for firms that are competing with overseas firms not having to bear these costs. It is for these reasons that auctioning appears to be less "politically acceptable", that is less acceptable to industry, than grandfathering. (AGO 1999)

Grandfathering, because it involves a free allocation to begin with, does not involve these costs. However, if the initial allocation is based on current emissions, firms may not have enough incentive to make the reductions necessary to meet targets. Also, grandfathering favours existing firms and disadvantages new firms wanting to set up. In order to establish itself, a new firm must buy up enough pollution rights to cover its emissions, or the government must increase the amount of rights available and give the new firm an allocation. Existing firms may be unwilling to make room for the new company and, if the government increases the rights available, pollution levels will increase.

Ironically, it is often easier and cheaper to install clean technology processes when a firm is newly established than to refit an older established firm with outdated and polluting equipment. Yet it is these new firms that could be squeezed out non-attainment areas if older firms are unwilling to compete with them. As the Australian Greenhouse Office points out, newcomers will be disadvantaged "thereby impeding domestic competition and innovation" which might otherwise lead to reductions (AGO 1999).

One suggestion is that shares could be allocated to new firms based on a mean figure for that industry, less a discount to account for the fact that new industries tend to have less emissions. The overall allocation could be reduced progressively over time (Young 1999).

References:

AGO (1999), National Emissions Trading: The Issuing of Permits, Discussion Paper 2, Australian Greenhouse Office, Canberra, 1999.

Hahn, R. and Hester, G., (1989) ÔWhere did all the markets go? An analysis of EPAÕs emissions trading programÕ, Yale Journal of Regulation 6: 109-53.

Hansen. B. (2000) ÔEPA approves emissions trading schemeÕ, Environmental News Service, December 19, http://ens-news.com/ens/dec2000/2000L-12-19-15.html

Kiernan, V. (1993) ÔWhat am I bid for two tonnes of sulphur dioxide?Õ, New Scientist, 10 April: 10.

Young. M. (1999), ÔGreenhouse Trading: An operational specification for the phased introduction of a nation-wide greenhouse emissions trading framework for Australia, paper presented at Emissions Trading Conference, ICM, Sydney, 13 July.

Tietenberg, T.H. (1990) ÔUsing economic incentives to maintain our environmentÕ, Challenge, March/April : 42-46.

Source: excerpt from Sharon Beder, 'Trading the Earth: The politics behind tradeable pollution rights', Environmental Liability, 9(3), 2001, pp. 152-160.

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