Carbon dating: When is it beneficial to link ETSs?

Produced as part of the Governments, markets and climate change mitigation CCCEP research programme theme

This paper proposes a simple framework to evaluate the economic advantage of regulating carbon emissions by linking the emissions trading systems (ETSs) of two jurisdictions versus operating them under autarky. The ETSs are linked if the permits issued in one, and traded competitively across both, can be surrendered against emissions in the other. The paper’s main innovation is in analyzing the sensitivity of aggregate and jurisdiction-specific economic advantage to the characteristics of the jurisdictions, in particular the uncertainty affecting the benefits of emissions. We decompose the economic advantage of linking into pair size, volatility and dependence effects. We show that when jurisdictions are ex ante identical and there are no tax distortions or sunk costs, the aggregate economic advantage is always non-negative and equally shared. It increases in pair size and in volatilities of jurisdiction-specific shocks but decreases in their correlation. In other words, there are only good and better links. With differences in ETS size the economic advantage is not equally shared, and the smaller jurisdiction receives a larger share. That is, linking partners may not value the link equally. When we additionally introduce sunk costs of linking, one jurisdiction may prefer an ETS under autarky to linking even when aggregate economic advantage is positive. A similar conclusion emerges with unilateral tax distortions affecting international permit trade. In an empirical application, we calibrate shock characteristics to the observed fluctuations in data from the world’s 20 largest emitters and document substantial variation in economic advantage and its components.

This paper was originally produced in September 2015 and was updated in December 2016.