A theory of gains from trade in multilaterally linked ETSs

Produced as part of the Evaluating the performance of climate policies CCCEP research programme theme

A patchwork of emissions trading systems (ETSs) currently operate in several jurisdictions, including the EU, Switzerland, South Korea and several US states and Canadian provinces. China has also been experimenting with emissions trading in seven provinces and cities and is setting up a national system that will be much larger than the current largest system, the EU ETS.

A multilateral linking arrangement allows a permit issued in one jurisdiction to be used in any of the participating jurisdictions. This spreads emission abatement efforts cost-effectively and generates economic gains relative to a situation in which ETSs are kept separate.

This paper develops a novel theoretical tool with which a jurisdiction can evaluate the economic gains it can expect to obtain by linking its ETS to one, two or many ETSs at the same time, and proposes a reason why the global market remains a distant dream.

Key points for decision-makers

Linkages between emissions trading systems (ETSs) have an important role to play in the successful, cost-effective implementation of the Paris Agreement.
Little is known about the economic gains generated when ETSs are linked multilaterally. This paper provides a novel framework through which to evaluate these gains.
Using this framework the authors provide a formula for how jurisdiction-specific and aggregate gains behave in any conceivable linkage arrangement.
Policymakers can use this approach to rank the possible linkage arrangements in terms of their value, for each jurisdiction. Doing so demonstrates that rankings can differ across jurisdictions and that the global market may not be the most preferred outcome universally. This may be one reason why multilateral linkage arrangements, including the economists’ ‘holy grail’ of a global market, have been elusive.
Post-Brexit and provided the UK chooses to maintain an ETS to meet its own Paris Agreement goals, the framework can be used to inform UK policymakers about the value of remaining in the EU ETS or of reaching out to other existing and planned ETSs, to link with them individually or in a multilateral linking arrangement.

ISSN 2515-5709 (Online) – CCCEP Working Paper series
ISSN 2515-5717 (Online) – Grantham Research Institute Working Paper series