Designing environmental market instruments

This project was part of the Environmental Economics Research Hub (EERH) (2007-2009) and was funded under the Commonwealth Environment Research Facilities (CERF) Program of the Commonwealth Department of Sustainability, Environment, Water, Population and Communities (SEWPAC). The project aims to develop environmental policy options that deliver efficient, effective and operational outcomes taking imperfections of the real world into account. Given the political developments in 2007-2009 the project has been focusing mainly on the design of greenhouse gas emissions trading schemes, since the Carbon Pollution Scheme was on the top of the policy agenda. 

Emissions trading schemes are designer markets – governments create and can change the rules. There is an enormous amount of flexibility in the chosen design of such markets and this poses both opportunities yet risks for system designers. It is possible to create extremely complex schemes which might limit or even totally diminish the efficiency gains of the market.

Given the limited experience with emission trading schemes to date, there are many unanswered questions about key design issues for maximising their effectiveness. Therefore the aim of this project is to assess different design options and assess their impact on the efficiency and effectiveness of reducing greenhouse gases. The project included different case studies which are as follows:

  • The first topic is related to initial allocation of permits. We developed a short-run and long-run model (Calford, Heinzel and Betz, 2010) and found that initial permit allocation may have an impact on the efficiency of the emissions trading market when market power in both permit and output market do exist. We show that in the Bertrand case higher pass-through profit rates (similar to those which could be observed for the electricity industry under the EU ETS) are generated. We also show that in the short run under free allocation, permit-market efficiency is likely to increase with the strength of the emissions target. Further efficiency increases could be achieved by auctioning permits instead of handing them out for free. In an experimental study (Restiani and Betz 2010c) we demonstrate that auctioning provides higher compliance incentives than the free allocation taking a loose price cap and price floor into account. Furthermore, auctioning evidently generates higher static efficiency due to stronger price signals. What options of auctioning emissions permits do exists and what the advantages and disadvantages of the different auction designs are was another focus. We show that a set of ascending clock auctions are the preferable auction type to distribute permits (Betz et al., 2010). 
  • The studies of the second topic were related to the impact of different penalty designs on market performance and were based on theoretical and experimental approaches (Restiani and Betz 2010a and 2010b). We included the Australian proposal under the CPRS of tying the penalty rate to the auction price. We find that a make-good provision penalty provides stronger compliance incentives compared to fixed penalty rates. Most importantly we observe a trade-off between investment incentives and efficiency of the permit market with related to different penalty types, thus policy makers need to decide if they favour higher compliance rate instead of a high efficiency of the permit market. The Instructions for these experiments can be found here.
  • Our third topic was focusing on linking options for the CPRS with other international markets (Jotzo and Betz 2010). Our major findings show that there is a risk to public budgets and economic efficiency due to the price cap of the CPRS, because it can override the scheme cap but not the national emissions commitment. The price cap was seen as an important obstacle to bilateral linking with other schemes.
  • Another topic was around the efficient coverage of an emissions trading scheme when transaction costs are included in the analysis (Betz, Sanderson and Ancev, 2010). We show that the approach of “partial coverage” based on benefit–cost analysis can achieve the same emission reduction outcome compared to a “full coverage” approach at lower social cost.