Linking permit markets multilaterally

Produced as part of the Competitiveness in the low-carbon economy 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 an emission 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 to evaluate the determinants, magnitude and distribution of these gains.
  • Using this framework the authors decompose jurisdiction-specific and aggregate gains in any conceivable linkage arrangement into two parts, namely effort-sharing and risk-sharing.
  • The authors provide a quantitative illustration by applying this framework to hypothetical ETSs covering the power sectors in five real-world jurisdictions which all use or have considered using both emissions trading and linking (Australia, Canada, the EU, South Korea and the US), under the assumption that they implement their Paris Agreement pledges under autarky. Linking is found to generate annual gains of up to US$3.26 billion (constant 2005 US$) relative to the case of no linkages, split roughly equally between effort- and risk-sharing.
  • In two extensions to their framework, the authors show that the paper’s key results are largely unaltered when domestic emission caps are selected strategically by jurisdictions’ regulators, or when unrestricted banking and borrowing of permits is allowed.
  • Policymakers can use the approach developed in this paper to rank the possible linkage arrangements in terms of their value, for each jurisdiction. The authors demonstrate that these rankings differ across jurisdictions and that the global market is unlikely to 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.

Earlier versions of this working paper were published in March 2018 and in September 2017, the first draft appearing under the title A theory of gains from trade in multilaterally linked ETSs, which is available upon request.

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