Löschel, Andreas; Lange, Andreas; Hoffmann, Tim; Böhringer, Christoph; Moslener, Ulf

Transcription

1 econsto De Open-Access-Publikationsseve de ZBW Leibniz-Infomationszentum Witschaft The Open Access Publication Seve of the ZBW Leibniz Infomation Cente fo Economics Löschel, Andeas; Lange, Andeas; Hoffmann, Tim; Böhinge, Chistoph; Moslene, Ulf Woking Pape Assessing Emission Allocation in Euope: An Inteactive Simulation Appoach ZEW Discussion Papes, No Povided in Coopeation with: ZEW - Zentum fü Euopäische Witschaftsfoschung / Cente fo Euopean Economic Reseach Suggested Citation: Löschel, Andeas; Lange, Andeas; Hoffmann, Tim; Böhinge, Chistoph; Moslene, Ulf (2004) : Assessing Emission Allocation in Euope: An Inteactive Simulation Appoach, ZEW Discussion Papes, No This Vesion is available at: Nutzungsbedingungen: Die ZBW äumt Ihnen als Nutzein/Nutze das unentgeltliche, äumlich unbeschänkte und zeitlich auf die Daue des Schutzechts beschänkte einfache Recht ein, das ausgewählte Wek im Rahmen de unte nachzulesenden vollständigen Nutzungsbedingungen zu vevielfältigen, mit denen die Nutzein/de Nutze sich duch die este Nutzung einvestanden eklät. Tems of use: The ZBW gants you, the use, the non-exclusive ight to use the selected wok fee of chage, teitoially unesticted and within the time limit of the tem of the popety ights accoding to the tems specified at By the fist use of the selected wok the use agees and declaes to comply with these tems of use. zbw Leibniz-Infomationszentum Witschaft Leibniz Infomation Cente fo Economics

2 Discussion Pape No Assessing Emission Allocation in Euope: An Inteactive Simulation Appoach Chistoph Böhinge, Tim Hoffmann, Andeas Lange, Andeas Löschel and Ulf Moslene

3 Discussion Pape No Assessing Emission Allocation in Euope: An Inteactive Simulation Appoach Chistoph Böhinge, Tim Hoffmann, Andeas Lange, Andeas Löschel and Ulf Moslene Download this ZEW Discussion Pape fom ou ftp seve: ftp://ftp.zew.de/pub/zew-docs/dp/dp0440.pdf Die Discussion Papes dienen eine möglichst schnellen Vebeitung von neueen Foschungsabeiten des ZEW. Die Beitäge liegen in alleinige Veantwotung de Autoen und stellen nicht notwendigeweise die Meinung des ZEW da. Discussion Papes ae intended to make esults of ZEW eseach pomptly available to othe economists in ode to encouage discussion and suggestions fo evisions. The authos ae solely esponsible fo the contents which do not necessaily epesent the opinion of the ZEW.

4 Nontechnical Summay The EU-wide emissions tading scheme coveing majo CO 2 poduction sites will be enacted in Many design issues most notably the initial allocation of allowances ae left to EU Membe States. Unde the EU emissions tading Diective Membe States must daw up National Allocation Plans (NAPs) in which they (i) allocate the national emissions budget defined in the EU buden shaing ageement (EU BSA) to the diffeent sectos of the economy and (ii) lay down the geneal ules that goven the initial emissions allocation to the fims eligible fo emissions tading. This pape quantitatively analyzes aspects of efficiency and sectoal buden shaings that may esult fom diffeent allocation ules. Futhemoe it pesents a flexible web-based simulation model whee the use can specify the design of National Allocation Plans fo each EU-Membe State an then evaluate the cost implications at the egional and sectoal level. Ou analysis focuses on the hybid natue of the EU tading scheme, i.e. a mixtue of diffeent egulatoy egimes: some sectos (industy and enegy) ae included in the tading scheme while othes (e.g., tanspot, sevices) ae not. The co-existence of an emissions tading and a non-tading pat of the economy poses the poblem of patitioning the oveall emissions budget between the two pats of the economy. We show that this can damatically incease the compliance costs of emission egulation. Ou qualitative assessment is based on a simple patial equilibium model fo the EU-15 CO 2 maket using maginal abatement cost cuves that ae specified sepaately fo the tading and the non-tading secto. Implementation of the EU BSA is simulated fo illustative policy scenaios: (i) without emissions tading; (ii) with emissions tading and the oveall optimal allocation of pemits to the tading and non-tading sectos and (iii) with emissions tading whee the tading sectos eceive enough pemits such they can emit at thei business-as-usual levels.

5 Assessing Emission Allocation in Euope: An Inteactive Simulation Appoach Chistoph Böhinge a,b,c,timhoffmann a, Andeas Lange a,b, Andeas Löschel a, Ulf Moslene a Abstact. Implementation of an EU-wide emissions tading system by means of National Allocation Plans is at the coe of Euopean envionmental policy agenda. Membe States ae faced with the poblem of allocating thei national emission budgets unde the EU Buden Shaing Ageement between enegy-intensive sectos that ae eligible fo intenational emissions tading and the emaining segments of thei economies that will be subject to complementay domestic emission egulation. The county-specific segmentation of national emission budgets between tading sectos and non-tading sectos will detemine the cost efficiency of the EU emissions tading system and the gains fo each Membe State vis-à-vis domestic abatement policies. We pesent an inteactive simulation model whee uses can specify the design of National Allocation Plans fo each EU Membe State and then evaluate the induced economic effects. Ou numeical famewok is based on maginal abatement cost cuves fo (emissions) tading and non-tading sectos of the EU-15 economies. Illustative simulations highlight the impotance of a coodinated design of National Allocation Plans in ode to avoid substantial excess costs of egulation and dastic buden shifting between nontading and tading sectos. JEL classification: D61, H21, H22, Q58 Keywods: emissions tading, allowance allocation, National Allocation Plans Acknowledgements: We ae gatefully acknowledge financial suppot fom the Reseach DG, Euopean Commission. The views expessed ae those of the authos and should not be attibuted to the Euopean Commission. a Cente fo Euopean Economic Reseach (ZEW), P.O. Box , Mannheim, Gemany. b Institute fo Intedisciplinay Envionmental Economics, Univesity of Heidelbeg, Gemany. c Coesponding autho: boehinge@zew.de

6 1 Intoduction In 2005, an EU-wide emissions tading scheme (EU (2003)) that coves majo CO 2 poducing sites shall come into foce. The key objective of the tading scheme is to pomote costefficiency of cabon eduction unde the EU Buden Shaing Ageement which pescibes specific commitments fo the abatement of geenhouse gas emissions acoss EU Membe States (EU (1999)). Pio to the enactment of the Euopean tading scheme, each EU Membe State must develop a National Allocation Plan that defines the oveall cap on cabon emissions fo installations included in the tading scheme as well as specifies the allocation ule fo allowances. Complementay domestic abatement policies must be undetaken in the sectos not coveed by the emissions tading scheme in ode to balance the counties emission budgets as given by the EU Buden Shaing Ageement. While aiming at cost-efficiency, each Membe State has to account fo two cental constaints in the design of National Allocation Plans: (i) allocation of emission allowances to installations (sectos) coveed by the tading scheme must be mainly fo fee 1,and (ii) competitive distotions involving diffeent teatment of identical installations (fims o sectos) acoss EU counties should be avoided. 2 Consideing these as guidelines fo the implementation of the EU emissions tading scheme, Böhinge and Lange (2004) have shown that it is geneally impossible to peseve efficiency while equiing fee allocation of emission allowances and non-discimination of simila fims acoss counties. The intuition is staightfowad: Oveall efficiency implies equalized maginal abatement costs acoss all emittes within the EU. 1 Membe States must allocate 95 % of emission allowances dedicated to the emissions tading sectos fo fee in the wam-up phase fom 2005 to In the next phase - fom 2008 to this theshold can be educed to 90 %, wheeas the ules fo late phases have been not yet decided upon. 2 The National Allocation Plans will be scutinized by the EU Commission with espect to common citeia such as competitive distotions (Annex III, EU (2003)). 1

7 Even if counties wee fully identical, diffeences in exogenous emission eduction equiements as pescibed by the EU Buden Shaing Ageement imply that identical fims will face diveging specific allowance assignments, i.e. allocation factos. 3 When adopting hamonized ules fo fee allowance allocation, Böhinge and Lange (2004) point out two policy options in ode to achieve identical allocation factos and, thus, avoid competitive distotions between identical fims within the EU emissions tading scheme: Stating fom a cost-efficient patitioning of the national emission budget between tading sectos (i.e. sectos coveed by the EU emissions tading scheme) and the non-tading sectos (i.e. sectos outside the EU emissions tading scheme) of the economy, a national govenment may implement hamonized (exogenous) allocation factos by: (i) eithe auctioning off o buying the emaining pemits coesponding to the diffeence between the efficient amount of pemit allowances fo the tading sectos and the county s oveall emission budget unde the EU Buden Shaing Ageement, o (ii) e-adjusting the initial patitioning of the county s oveall emission budget to meet the pescibed allocation facto. The two options diffe substantially with espect to thei implications fo oveall efficiency and fee allowance allocation, i.e. compensation to enegy-intensive fims coveed by the EU emissions tading scheme. The fist option peseves efficient patitioning of national emission budgets but is in conflict with the equiement of fee allowance allocation to tading sectos. The second option, in tun, maintains fee allocation of emission allowances but involves potentially lage efficiency losses as the e-patitioning of the county s emission budget implies diffeences between maginal abatement costs of the EU-wide tading scheme and the domestic maginal abatement costs in the non-tading segments of each EU Membe State. 3 The allocation facto is defined as the atio between assigned emission allowances and some histoic emission base. 2

8 This pape complements basic economic easoning with an inteactive simulation model based on maginal abatement cost functions fo sectos subject to emissions tading in the EU scheme (theeafte efeed to as DIR sectos) and those sectos subject to complementay domestic emission egulation (theeafte efeed to as NDIR sectos). The model is able to quantify the inheent tade-offs between efficiency, compensation, and competition neutality fo altenative designs of National Allocation Plans in EU Membe States. The inteested eade can access the model though a web-inteface ( specify abatement cost functions, set up National Allocation Plans, and calculate the associated economic implications. An impotant featue of ou inteactive simulation model is the assessment of emission egulation costs not only at the level of EU Membe States but also fo tading enegyintensive DIR sectos as well as non-tading NDIR sectos. In the policy debate on appopiate allocation factos fo the DIR sectos, it is often ovelooked that compensation to DIR sectos via geneous allocation factos implies lage eduction equiements and hence highe economic costs fo NDIR sectos given that both segments of the economy togethe ae only endowed with the oveall national emission budget unde the EU Buden Shaing Ageement. Theefoe, the design of National Allocation Plans does not only bea an efficiency dimension due to the hybid egulation of DIR and NDIR sectos but also a potentially impotant equity dimension. In policy-elevant simulations, we find that National Allocation Plans waanting EU-wide unifom allocation factos of one (i.e. DIR sectos ae allocated thei business-as-usual emissions) induce total costs that ae 10 times highe than the aggegate costs fo an efficient tading scheme and 6 times highe than puely domestic abatement action (without intenational emissions tading). The associated cost fo NDIR sectos incease substantially vis-à-vis the efficient egulation while the espective costs fo DIR sectos fall to zeo. The emainde of the pape is stuctued as follows. In section 2, we develop a simple analytical famewok to demonstate the tade-offs between efficiency, compensation and hamonization (competitive neutality) inheent to the fothcoming implementation of the 3

9 hybid EU egulation scheme. In section 3, we pesent a numeical famewok based on maginal abatement cost cuves to assess the economic implications of altenative National Allocation Plans. In section 4, we discuss the economic implications of illustative policy scenaios. In section 5, we conclude. Instuctions fo the use of the inteactive web-inteface and the concete algebaic model fomulation (including the pogam code) ae elegated to the Appendix. 2 Analytical Famewok We set up a simple stylized patial model to illustate the implicit tade-offs between thee cental policy objectives undelying the fothcoming implementation of an EU-wide emissions tading scheme: efficiency, compensation, and hamonization. We conside R egions (=1,...,R). Each egion is constained by an aggegate emission budget E (as given fo EU Membe States by the Buden Shaing Ageement). In designing the National Allocation Plan each govenment has to decide on the numbe of emission allowances it wants to distibute to the DIR sectos eligible fo emissions tading, the faction with espect to E being denoted by θ. The emaining pat ( 1 θ ) E constitutes the emission budget fo the NDIR sectos which ae not included in the tading system. Aggegate abatement costs in DIR sectos ae given by C DIR (e) with ( C DIR / e 0, 2 C DIR / e 2 >0), and likewise fo NDIR sectos by C NDIR (e) with ( C NDIR / e 0, 2 C NDIR / e 2 >0), whee e denotes emissions. Total abatement costs ae epesented by C (E ) with the same cuvatue popeties. Efficiency Aggegate efficiency equies minimization of total abatement costs of all egions 4 : 4 We assume that the eduction taget must be achieved within the EU: Thee ae neithe intenational emissions tading oppotunities beyond EU bodes no abatement options using poject-based mechanisms like the Clean Development Mechanism that could futhe educe oveall compliance costs. 4

10 s. t. DIR DIR NDIR NDIR min DIR NDIR [ C ( e ) + C ( e )] e, e DIR NDIR DIR NDIR ( e + e ) = e + e = θ E + ( 1 θ ) E = E Denoting the Lagange multiplie with σ, and diffeentiating with espect to e and e NDIR, DIR we obtain the fist-ode condition of equalized maginal abatement costs acoss all emission souces: σ = C E C = e DIR DIR C = e NDIR NDIR The esulting optimal emission levels ae denoted by E, e *, e * DIR NDIR * whee * * DIR NDIR * E = e + e. The diffeence between the exogenous emission budget E and aggegate optimal emissions * E, i.e. * E E,endesthe optimal tade volume in emission allowances. Figue 1 illustates the case whee domestic abatement costs to each the domestic taget E ae below the intenational emission pice; hence, the egion becomes an expote of emission allowances. - C NDIR / e - C DIR / e - C / e σ * NDIR e * DIR e * E Expots E Figue 1: Optimal emissions in NDIR and DIR sectos at intenational emissions pice σ Fom the pespective of an (EU-) social planne, the efficient solution could be decentalized by imposing unifom emission taxes at the optimal ate σ on the NDIR sectos. The emaining emission budget, * NDIR E e, would then be given as initial endowment to the DIR sectos 5

11 eligible fo intenational emissions tading, i.e. the optimal faction of the egional emission θ = E e / E. NDIR budget to be allocated to DIR sectos amounts to ( ) * * Compensation Compensation to DIR sectos has been a conditio-sine-qua-non fo the legal appoval of the tading initiative by the EU Paliament. In this vein, implementation of the EU tading scheme via National Allocation Plans pescibes fee allocation of emission allowances to DIR sectos. As to allocation ules, two appoaches ae pominently discussed: Emission allocation should be based on output levels (benchmaking) o on histoic emissions (gandfatheing). Applied to histoic data, these ules boil down to lump-sum tansfes to fims in the DIR sectos. 5 Reflecting cuent policy poposals, we assume that fims in the DIR sectos eceive an initial allocation of allowances based on some histoic emission level e. The total allocation of allowances to DIR sectos in egion,i.e. θ 0,DIR E, is detemined by the allocation facto λ accoding to: * 0 θ E = λ e, DIR. Hamonization Fom a legal point of view, equests fo hamonized National Allocation Plans imply equal compensation of identical fims acoss diffeent counties. In pactical tems, this means that allocation factos λ should be the same acoss identical fims. Tade-offs between efficiency, compensation and hamonization Unde efficient patitioning of national emission budgets and (non-distotionay) static * θ E emission-based allocation of fee allowances the endogenous allocation factos λ = 0 e, DIR 5 In contast, distotions and efficiency losses esult if the basis fo allocation is updated ove time. Such dynamic allocation ules povide stategic incentives to incease output and/o emission intensity and thus wok as distotionay subsidies. Böhinge and Lange (2003) povide a geneic analysis of the economic implications of dynamic allocation schemes fo emission allowances. They find that in open tading systems whee the allowance pice is peceived as exogenous emission-based allocation is moe distotionay than output-based allocation since it does not only distot poduction but also emission intensities. 6

12 will geneally diffe acoss egions. If hamonization is the pimay policy objective, this means eithe giving up on efficiency (by e-adjusting θ ) o on compehensive compensation (by auctioning potentially lage pats of the efficient emission budget fo DIR sectos * DIR * e = θ E ). 3 Numeical Famewok In ode to quantify the policy elevance of the tade-offs between efficiency, compensation, and hamonization, we tansfom the stylized analytical famewok of section 2 into a simple numeical model based on maginal abatement cost cuves fo DIR and NDIR sectos in the EU-15. They ae calibated to empiical data. Model Paameteization Maginal costs of emission abatement may vay consideably acoss counties and sectos due to diffeences in cabon intensity, initial enegy pice levels, o the ease of cabon substitution possibilities. Continuous maginal abatement cost cuves fo the DIR and NDIR sectos in EU counties can be deived fom a sufficiently lage numbe of discete obsevations fo maginal abatement costs and the associated emission eductions in the DIR and NDIR sectos. In applied eseach these values ae often geneated by patial equilibium models of the enegy system (such as the POLES model by Ciqui and Mima (2001) o the PRIMES model by Capos et al. (1998)), that embody a detailed bottom-up desciption of technological options. Anothe possibility is to deive maginal abatement cost cuves fom computable geneal equilibium (CGE) models (see e.g. Reilly et al. (1999) o Eyckmans et al. (2001)). We adopt the latte appoach and geneate a educed fom of complex CGE inteactions in tems of maginal abatement cost cuves that ae diectly accessible to the non- CGE specialist. In ode to obtain such maginal abatement cost cuves fo the DIR and NDIR sectos acoss EU counties, we make use of a standad static multi-egion, multi-secto CGE model fo the EU economy (see Böhinge (2002) fo a detailed algebaic exposition) based on the most ecent consistent accounts of EU Membe States poduction and consumption, 7

13 bilateal tade and enegy flows fo 1997 (as povided by the GTAP5-E database see Dimaanan and McDougall (2002)). With espect to the analysis of cabon abatement policies, the sectos in the model have been caefully selected to keep the most cabonintensive sectos in the available data as sepaate as possible. The enegy goods identified in the model include pimay caies (coal, natual gas, cude oil) and seconday enegy caies (efined oil poducts and electicity). Futhemoe, the model featues thee additional enegyintensive non-enegy sectos (ion and steel; pape, pulp and pinting; non-feous metals) whose installations in addition to the seconday enegy banches (efined oil poducts and electicity) ae subject to the EU emissions tading system. The emaining manufactues and sevices ae aggegated to a composite industy that poduces a non-enegy-intensive maco good, which togethe with final demand captues the activities (NDIR segments) that ae not included in the EU tading system. To geneate ou educed fom model, we pefom a sequence of cabon tax scenaios fo each egion whee we impose unifom cabon taxes (stating fom 0 to 200 pe ton of cabon in iso-distant steps of 1 ). We theeby geneate a lage numbe of maginal abatement costs, i.e. cabon taxes, and the associated emission eductions in DIR and NDIR sectos. The final step involves a fit to the set of obsevations. Vaious types of functional foms could be employed. Common foms include iso-elastic exponential functions (of the type b C ( e) = a ( e o e) ), quadatic o moe elaboate polynomial functions 2 ( C ( e) = a1 ( eo e) + a2 ( eo e) + ) as well as exponential functions ( 0 ) ( ( ) C ( e) = a exp b eo e e ) (see e.g. Reilly et al. (1999) o Böhinge and Löschel (2003)). 6 Fo ou numeical famewok, we apply a least-squae fit by a polynomial of thid degee which povides sufficient flexibility. 6 Baseline emission levels eo do not impose a binding emission eduction hence, the associated maginal abatement costs fo emission use at the baseline level ae zeo. Clealy, zeo maginal abatement costs also hold fo emission levels e > e. o 8

14 The functional fom of the maginal abatement cost cuves in egion fo the DIR and NDIR sectos is, thus, given by: C ( e ) = a i i { DIR NDIR} 2 3 ( eo ei ) + a i ( eo ei ) a i ( eo ei ) i, i 2, + i 3, i 1, i Table 1 lists the associated least-squae estimates fo the coefficients of maginal abatement cost cuves acoss egions. Costs ae measued in 1997 dollas pe ton of cabon, while the quantities ae measued in million tons of cabon. Table 1: Coefficients fo maginal abatement cost functions (base-yea: 1997) Diective Sectos (DIR) Non-Diective Sectos (NDIR) a 1, DIR, a 2, DIR, a 3, DIR, a 1, NDIR, a 2, NDIR, a 3, NDIR, Austia Belgium Denmak Finland Fance Gemany Geece Ieland Italy Nethelands Potugal Spain Sweden U.K Obviously, simulation esults ae sensitive to both the quality of the fit as well as the accuacy of the undelying obsevations. In ou case, maginal abatement cost functions captue the economic costs of educing cabon at a histoical point in time, i.e If egulation applies to futue peiods, the pospective adjustment costs must be measued against the pojected business-as-usual. The concete assessment of futue maginal and infamaginal abatement costs then hinges on baseline pojections fo the economy which given the uncetainty about the futue is a challenge fo quantitative analysis and demands fo compehensive 9

15 sensitivity analysis. In ou context, Table 2 illustates the impact of the base-yea choice on the magnitude of effective emission eduction equiements which ae a key dive of maginal and infamaginal costs. Table 2: Cabon emissions and eduction equiements (EUROSTAT (2002) and EiE (1999)) CO 2 - Emissions Reduction equiements (in % with espect to) * * Austia Belgium Denmak Finland Fance Gemany Geece Ieland Italy Nethelands Potugal Spain Sweden U.K EU (total) *Emissions as pojected in EiE (1999) The fist thee columns list the cabon emissions fo 1990 (the efeence yea of the eduction commitments unde Kyoto and the EU Buden Shaing Ageement), fo 1997 (the base-yea fo ou model simulations) as well as the pojected emissions fo 2010 (the cental yea fo which emission eduction should be achieved). 7 The effective eduction tagets unde the Buden Shaing Ageement can change damatically along the time-path. While Gemany, fo example, stats out with a athe stingent eduction taget of 21 % with espect to 1990, the effective eduction taget halves with espect to baseline emission levels in 1997 o The commitment peiod fo achieving on aveage the emission eduction tagets unde Kyoto and the EU Buden Shaing Ageement is

16 Spain, in tun, had been attibuted an emission budget of 15 % in excess of its 1990 emissions but due to economic gowth faces an effective eduction of 6 % in 1997 which ises up to 14 % vis-à-vis pojected business-as-usual emission levels in Fo easons of uncetainties and potentially lage inconsistencies associated with business-asusual pojections, we base ou simulation analysis on histoical data fo 1997 the most ecent yea fo which a consistent economic data set at the EU level is available. Acknowledging the impotance of the efeence peiod, howeve, ou web-based inteface accommodates the flexible paameteization of maginal abatement cost functions and associated base-yea-emissions. Patial vesus Geneal Equilibium Analysis The educed fom epesentation of economy-wide adjustment to emission egulation povides a tanspaent and easy access to numeical analysis. A potential dawback of such a simplifying appoach is the neglect of maket inteaction and spillove effects. Thee ae seveal aticles illustating the impotance of such indiect effects (Böhinge (2002), Böhinge and Ruthefod (2002), Benad et al. (2003), Kleppe and Peteson (2002)). In the context of cabon abatement policies, induced tems-of-tade effects on fossil fuel makets may substantially alte the diect costs of abatement. Depending on the magnitude of global cuts in fossil fuel demand and the level of fossil fuel supply elasticities, a dop in intenational fuel pices povides seconday benefits fo fossil fuel impotes while it huts fossil fuel expotes. Adjustment costs in one county thus geneally depend on how much othe counties educe thei emissions. Against this backgound, the cucial question egading the obustness of patial equilibium esults based on maginal abatement cost cuves is whethe tems-of-tade effects ae sufficiently small. Fo ou policy issue, the omission of tems-of-tade effects is in place: On the one hand, when detemining the impact of diffeent National Allocation Plans, policies outside the EU can be taken as exogenous. On the othe hand, changes in the allocation ules in EU counties do not affect the oveall Euopean eduction taget, which afte all has a 11

17 negligible impact on wold pices as EU emission cutback unde the Buden Shaing Ageement amounts only to a vey small shae in global cabon emissions. 8 Apat fom tems-of-tade effects, othe potentially impotant geneal equilibium inteactions concen evenue-ecycling. It is well-known that the manne in which evenues fom envionmental egulation ae ecycled to the economy can have a lage impact on the goss costs of envionmental policy (see Goulde (1995) o Bovenbeg (1999)). Within the National Allocation Plans, a lage pat of allowances, i.e. scacity ents, is handed lump-sum to enegy-intensive industies. Thus, omission of altenative ecycling stategies can be justified. 9 4 Policy Scenaios and Results Policy Scenaios The pimay objective of emissions tading is to achieve potential efficiency gains. So-called whee-flexibility assues that emissions will be abated whee it is cheapest acoss all emitting souces. Full whee-flexibility implies flexibility acoss counties say egional flexibility and flexibility acoss the sectos of the economy say sectoal flexibility. Itisthe natue of a hybid emissions tading egime such as the EU scheme fo cabon dioxide that sectoal flexibility is esticted in the sense that not all sectos ae eligible fo tading. We illustate the policy elevance of tade-offs between efficiency, compensation and hamonization in implementing National Allocation Plans along thee stylized policy scenaios: (i) NoTade: The NoTade scenaio delives a benchmak fo the magnitude and distibution of efficiency gains emeging fom coss-county flexibility of emission abatement within the EU. Unde NoTade, EU Membe States meet the emission eduction 8 The cutback in emissions unde the Buden Shaing Ageement amounts to 1.7% of global cabon use in 1997 and 1% of pojected global cabon use in 2010 with negligible impacts on intenational fossil fuel pices. 9 A cude shotcut to an explicit epesentation of tax inteaction effects is the use of estimates fo maginal costs of public funds that may be applied ex-post to assess the double dividend of ecycling evenues fo cuts in distotionay taxes (see e.g. Böhinge and Ruthefod (2002)). 12

18 taget as pescibed by the Buden Shaing Ageement though domestic action only: Domestic cabon taxes ae set sufficiently high to keep with the exogenous emission budget. Hee the counties minimize thei individual abatement costs but do not tade. This is equivalent to a setting whee domestic govenments auction off thei national emission budget to domestic emittes, i.e. a situation with full sectoal flexibility but without any egional flexibility. (ii) NAP_Opt: The countepat to the NoTade case is the scenaio NAP_Opt whee National Allocation Plans ae coodinated to exploit the full potential of efficiency gains fom whee-flexibility in emission abatement acoss EU Membe States. This implies that the patitioning of national emission budgets between DIR and NDIR sectos assues equalization of maginal abatement costs acoss all cabon emittes. In technical tems, the cost-efficient design of National Allocation Plans can be deived fom unesticted emissions tading acoss all sectos and EU Membe States. Emissions of NDIR sectos fo the cost-efficient solution then detemine the emaining budget of emission allowances fo the DIR sectos (equal to the diffeence between the national emission budgets and the NDIR emissions). Obviously, the cost-efficient county-specific allocation factos λ ae endogenous. In the NAP_Opt scenaio thee is full whee-flexibility including egional and sectoal flexibility. (iii) NAP_Unity: This scenaio accounts fo two cental elements in the policy debate on the implementation of the EU emissions tading scheme. Fistly, thee is the concen egading competitive distotions due to non-unifom allocation factos acoss EU counties. Secondly, thee ae feas that enegy-intensive industies in most EU counties will be foced to decease thei poduction levels as a consequence of binding emission constaints. In ou static famewok, peseving competition neutality though unifom allocation factos and waanting business-as-usual poduction comes down to an allocation facto of unity. The settings fo the NAP_Unity scenaio eflect these policy consideations by adopting a hamonized allocation facto of λ = 1 (unde emissions-based allowance assignment) fo all egions. In ode to achieve the hamonized allocation facto of unity, the optimal patitioning 13

19 of the national emission budget (as detemined by scenaio NAP_Opt) will be abandoned and maginal abatement costs between DIR and NDIR sectos will fall apat inducing an efficiency tade-off due to hamonization. In the NAP_Opt scenaio sectoal flexibility between DIR and NDIR sectos is esticted but thee is full egional flexibility within the DIR sectos of the egions. Fee emission allocation to DIR sectos is based on histoic emissions of these sectos fo the base-yea Table 3 povides a summay of the cental policy settings acoss the fou scenaios. Table 3: Oveview of scenaio chaacteistics Scenaio Regulation Scheme Intenational Emissions Tading DIR sectos NDIR sectos Allocation Facto NoTade CO 2 tax CO 2 tax No None Pemits / Yes NAP_Opt emission-based allocation CO 2 tax (in DIR sectos) Endogenous NAP_Unity Pemits / emission-based allocation CO 2 tax Yes (in DIR sectos) Exogenous λ = 1 Results Table 4 epots quantitative esults fo ou scenaios on maginal abatement costs as well as total abatement costs diffeentiated in both DIR and NDIR sectos. Unde NoTade, the maginal abatement costs ae equivalent to the domestic cabon tax which EU Membe States must levy to achieve thei espective emission eduction taget unde the Buden Shaing Ageement. A key deteminant fo the magnitude of maginal abatement costs is the effective cutback equiement. Ceteis paibus, the moe emissions a county has to educe, the moe costly it is at the magin to substitute away fom cabon in poduction and consumption. 14

20 Table 4: Maginal abatement costs and total compliance costs Maginal abatement costs (in 97 pe ton of CO2) Compliance cost (in million 97) NoTade NAP_Opt NAP_Unity NoTade NAP_Opt NAP_Unity DIR NDIR Total DIR NDIR Total DIR NDIR Total DIR NDIR Austia Belgium Denmak Finland Fance Gemany Geece Ieland Italy Nethelands Potugal Spain Sweden U.K EU

21 The high maginal abatement costs fo egions such as Austia, Belgium, and Denmak eflect lage eduction equiements vis-à-vis counties such as Sweden o Fance that have low maginal costs along with small abatement tagets. Clealy, counties that do not face any binding emission taget in ou case: Geece and Potugal have maginal abatement costs of zeo. Apat fom the magnitude of emission eduction equiements, othe impotant deteminants of maginal abatement costs include initial enegy pices, cabon intensities, o the ease of cabon substitution in poduction and consumption activities that ae eflected in the slope and cuvatue of sectoal maginal abatement cost cuves. These additional deteminants explain why a county (e.g. Austia) may need highe cabon taxes than anothe county (e.g. Denmak) although its effective pecentage eduction taget is smalle. The ponounced diffeences in maginal abatement costs acoss EU counties fo the NoTade case esult fom the lack of egional flexibility. They indicate the potential fo efficiency gains fom coss-county emissions tading. An efficient implementation of the hybid egulation unde National Allocation Plans would imply equalized maginal abatement costs of 9.9 pe ton of CO 2 which epesents the pice of taded emission allowances in the DIR sectos as well as the tax ate to be levied on CO 2 emissions in NDIR sectos. The patten of pemit tade emeges fom the magnitude of maginal abatement costs unde NoTade vis-àvis the equalized maginal abatement costs fo the case of tadable pemits. Counties whose maginal abatement costs unde NoTade ae below the unifom pemit pice will sell pemits and abate moe emissions. In tun, counties whose maginal abatement costs ae above the unifom pemit pice will buy pemits and abate less. Imposition of unifom allocation factos that gant DIR sectos thei BAU emission levels, i.e. λ = 1, imply an effective eduction equiement of zeo fo these segments given that the base-yea fo emission allocation coincides with the taget yea fo abatement compliance Clealy, this is a athe exteme setting but it seves the pupose to illustate the implications of geneous allowance allocation to DIR sectos that appeas as a common featue in the concete specification design of National Allocation Plans acoss EU Membe States. 16

22 All the abatement is shifted to NDIR sectos which ae excluded fom intenational emissions tading. The hybid egulation then leads to extemely high maginal abatement costs in the NDIR sectos of seveal EU Membe States. The diffeences in maginal abatement costs acoss scenaios ae eflected in the diffeences of aggegate EU abatement costs unde the Buden Shaing Ageement. Total compliance costs amount to nealy 2 billion fo the NoTade case. These costs can be substantially educed via implementation of an efficient EU emissions tading scheme. In ou case, the cost savings equal moe than a thid of the NoTade compliance costs. All counties ae bette off unde efficient tading as compaed to puely domestic action. In ou patial equilibium famewok whee we neglect tems-of-tade and income effects this esult does not come as a supise: Compehensive whee-flexibility must be paeto-supeio. Ceteis paibus a county s gains fom unconstained whee-flexibility ise with an inceased deviation of its autaky maginal abatement costs fom the efficient intenational pemit pice. Fo example, the efficiency gains unde NAP_Opt fo Gemany compaed to the NoTade case ae vey small (ca. 0.2 %) since Gemany s autaky cabon value is vey close to the intenational pemit pice. In contast, Austia gains moe than 60 % fom efficient tading as its NoTade maginal abatement costs ae six times the intenational pemit pice. Counties which do not face a binding emission constaint unde NoTade unambiguously will have negative costs unde NAP_Opt, i.e. they will be bette off with EU egulation than without because thei evenues fom pemit sales exceed the domestic abatement costs (hee: Geece and Potugal). Likewise counties with elatively low abatement tagets may moe than offset oveall abatement costs with evenues fom pemit sales (hee: Fance and Sweden). As soon as we estict whee-flexibility at the sectoal level and do not depict the efficient patitioning of national budgets, efficiency implications of cabon tade may be quite diffeent. It is no longe clea that the EU as a whole no individual Membe States will 17

23 benefit vis-à-vis domestic abatement policies (e.g. cabon taxes whee pat of tax evenues may be ecycled lump-sum to enegy-intensive industies fo compensation puposes). Scenaio NAP_Unity povides evidence on the potential magnitude of efficiency losses though hybid egulation: Unde NAP_Unity aggegate costs ae 10 times highe than unde an efficient tading scheme and 6 times highe than fo puely domestic abatement action. In this case, thee ae no efficiency gains that could be exploited in DIR sectos though egional flexibility because the implied cabon pice is zeo. All abatement is shifted to the NDIR sectos and must be achieved by domestic policies. Counties, thus, can not take advantage of sectoal flexibility ending up with highe maginal abatement costs fo the DIR sectos compaed to the NoTade scenaio and zeo maginal costs fo the NDIR sectos. 11 As a consequence thee occu substantial excess costs even compaed to the NoTade scenaio whee one assues at least equalization of maginal abatement costs acoss sectos within the domestic economy. This leads us to anothe cental insight fom ou stylized policy analysis. Hybid egulation may not only deteioate efficiency in a dastic way but also induce politically delicate buden shifting between DIR and NDIR sectos. Geneous compensations to DIR sectos ae diectly at the expense of NDIR sectos with potentially lage inceases in maginal and infamaginal costs (see e.g. Austia, Belgium, Denmak, o Finland). The NDIR sectos which do not eceive any compensation fom scacity ents in the fist place then bea the additional buden of diluting the pollute-pays-pinciple fo DIR sectos Counties which do not have a binding emission constaint unde NoTade (hee: Geece and Potugal) ae obviously indiffeent between NoTade and NAP_Unity because maginal abatement costs fo DIR and NDIR sectos ae zeo in both scenaios. 12 In fact, pefeential teatment including full exemptions of enegy-intensive industies is a common featue in envionmental policy pactise of all OECD counties (see OECD (2001), p. 78) but in geneal this is at the expense of envionmental effectiveness athe than moe stingent egulation fo othe sectos. In the case of the hybid EU tading scheme, howeve, the situation is diffeent as the envionmental taget is fixed. 18

24 Table 5 shows the lage diffeences in endogenous allocation factos fo the efficient NAP_Opt scenaio. They ange fom 0.34 fo Denmak up to 1.18 fo Geece and povide clea evidence that concens about competitive distotions between identical fims within the EU can be justified (when keeping with the objectives of oveall efficiency and fee allowance allocation). The coss-county diffeences in allocation factos eflect county-and secto-specific diffeences in the elative ease of cabon mitigation as captued by the cuvatue of calibated maginal abatement cost cuves. Finally, we tun to the induced pecentage emission eductions at the egional and sectoal level that ae epoted in Table 5. By definition, the aggegate egion s emission eduction must comply with the EU Buden Shaing Ageement fo the NoTade scenaio. Within egions, the DIR sectos will contibute elatively moe to the eduction equiement which means that cabon abatement options in enegy-intensive industies though fuel shifting o enegy savings is elatively cheape than in the NDIR sectos. 13 Fo efficient cabon tading the diection and magnitude of changes in autaky emission eductions ae diven by the diffeences between the autaky cabon value and the intenational pemit pice (the qualitative movements fo DIR and NDIR sectos within a single egion ae the same). Unde NAP_Unity, total emission eduction at the egional level will be the same as unde NoTade because egional flexibility acoss DIR sectos hasn t any effect. The implied shifts at the sectoal level ae, howeve, damatic: Unde NAP_Unity the NDIR sectos have to delive the oveall egional abatement duties implying vey high NDIR pecentage eduction fo seveal EU counties. 13 The one exception is Fance whose electicity secto is mainly based on cabon-fee nuclea powe wheeas in othe counties (e.g. Denmak o Gemany) powe and heat poduction is cabon-intensive and accounts fo a lage shae of oveall DIR cabon emissions. 19

25 Table 5: Allocation facto, allocation shae and emission eduction Allocation facto λ 1 Emission eduction (in % vis-à-vis 1997 base-yea emissions) NAP_Opt NAP_Unity NoTade NAP_Opt NAP_Unity Total DIR NDIR Total DIR NDIR Total DIR NDIR Austia Belgium Denmak Finland Fance Gemany Geece Ieland Italy Nethelands Potugal Spain Sweden U.K Allocation facto defined as λ = θe / e DIR 20,

26 5 Conclusions The fothcoming EU-wide cabon maket constitutes a milestone in intenational envionmental policy. It povides the fist multi-juisdictional emissions tading egime and will establish the wold-lagest maket fo tadable pemits. The concete implementation via National Allocation Plans entails a hybid egulation whee enegy-intensive sectos ae eligible fo emissions tading and othe segments of the economy must be constained by complementay domestic policy instuments. The hybid setting ceates tade-offs between oveall economic efficiency and othe objectives of the EU tading scheme, i.e. fee allowance allocation of tadable emission pemits and equal teatment of compaable enegy-intensive sites acoss EU Membe States. In this pape, we have developed a simple quantitative famewok that allows the non-technical eade to investigate these tade-offs in a flexible and use-fiendly way. Illustative simulations highlighted the need to e-conside the cuent guidelines fo National Allocation Plans in ode to avoid substantial excess costs of egulation and dastic sectoal buden shifting. The hybid egulation togethe with compensation (fee allowance allocation) of enegy-intensive industies may have been necessay in an initial stage to pomote maket-based egulation of cabon emissions. In the medium-un, compehensive coveage of all cabon emittes should mateialise the full potential of efficiency gains. 14 Futhemoe, the inheent conflict between compensation and hamonisation could be esolved by a gadual tansition to an auctioned pemit system. The latte simply implies the igoous adoption of the pollute pays pinciple which in tems of efficient esouce use should be the guiding pinciple of any maket-based envionmental policy. Finally, it should be stessed that ou analysis is of inteest beyond the scope of the cuent debate on National Allocation Plans. The deived insights may not be only useful fo the edesign of Allocation Plans acoss EU Membe States in futue peiods, but also with espect to the specification of any hybid egulation egime whee emissions tading fo some sectos is combined with complementay egulation in othe sectos. 14 Cabon emissions could be easily contolled upsteam via a athe limited numbe of fuel etailes. 21

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