Emissions trading: permit market evolution

Blue Circle Industries has commissioned a report into just how stable a UK market for emissions trading permits might be. Volterra, in response, created an artificial economy and watched the market evolve.

The pace at which trading schemes are being developed is best illustrated by Canada and the United States, where trading in carbon is already underway. GERT – the Greenhouse Gas Emissions Reduction Trading Pilot – was established in Canada in June 1998. Since then there have been a number of trades in emissions reductions credits. These credits can be generated by: reducing existing emissions; avoiding an increase in emissions; or through carbon sequestration. In the United States a shadow market in CO2 is already up and running. This is without any rules or arrangements for carbon trading actually being in place. But there is proposed legislation in Congress which could formalise this carbon market.

Practical and workable

A set of proposals for a UK scheme has been developed which is practical and workable. Many details remain to be worked out – but now that the principles have been set, a new worry has emerged. It is clear that it is possible to set up a market, but this simply begs the question of whether the market itself will work. If only a few companies trade, or they are ignorant of how to assess costs and benefits, the market may be far too volatile or thin.

The model considers a simple situation in which identical firms produce one good and ‘pollution’. They have costs associated with producing their output and they can also reduce pollution by incurring costs. They have an initial allotment of pollution permits for one period which they may buy and sell befor making their production and pollution level choices. They learn about the profitability of their behaviour in the permit market and use their experience to modify their choices.

Next, the model is made more realistic, considering what happens when firms differ in size, in their allocation of permits, in their overall cost functions and in their costs of reducing pollution. A crucial finding is that the greater the number of ways in which firms differ, the greater the number of trades which are carried out in the permits market.

There are number of ways in which the model can be developed still further. The impact of arious types of taxes and/or regulations can be incorporated, for example. But the prototype system reported here generates some very interesting findings.

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