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This paper assesses the economic impacts of linking the EU emissions trading scheme (ETS) to emerging schemes beyond Europe in the presence of a post-Kyoto agreement in 2020. Numerical simulations with a multi-country equilibrium model of the global carbon market show that linking the European ETS induces only minor economic benefits. As trading is restricted to energy-intensive companies that are assigned high initial emissions, the major compliance burden is carried by the non-trading industries excluded from the linked ETS. In the presence of parallel government trading under a post-Kyoto Protocol, the burden of the excluded sectors can be substantially alleviated by international permit trade at the country level. However, the parallel carbon markets of linked ETS companies and post-Kyoto governments are still separated here. From an efficiency perspective, the most desirable future climate policy regime is thus represented by a joint trading system facilitating international emissions trading between ETS companies and post-Kyoto governments. While the Clean Development Mechanism is not able to attenuate the inefficiencies within linked ETS, in a parallel or joint trading regime the economy-wide access to project-based abatement options in developing countries induces large additional cost-savings.

By the initiation of the European greenhouse gas emissions trading scheme in January 2005, for the first time international trading of carbon emissions allowances became feasible for energy-intensive companies at the installation level. Introducing the largest multi-country emissions trading scheme (ETS) world-wide, the EU aims at cost-efficient compliance with the reduction commitments of its Member States under the Kyoto Protocol (UNFCCC, 1997). In the future, carbon trading will however not be limited to Europe: The EU ETS directive proposes that “agreements should be concluded with third countries listed in Annex-B to the Kyoto Protocol which have ratified the Protocol to provide for the mutual recognition of allowances between the Community scheme and other greenhouse gas emissions trading schemes” (EU, 2003). At the same time, countries beyond the EU are contemplating the set up of domestic ETS with the intention of linking up to the European scheme — which would enable companies outside the EU to trade emissions with European firms. From 2008 on, company trading among linked schemes would however occur in parallel with trading among countries, as the Kyoto Protocol facilitates international government trading of emissions between Annex-B parties at the country level. To quantify the economic implications of these overlapping future climate policies is the goal of this paper. Developments of domestic ETS outside the EU have already made substantial progress in Norway and Switzerland who are designing schemes similarly to the European system. Since discussions on linking are already underway, chances are high that these countries will already be linked to the EU ETS until 2010 (Sterk, 2005). In the medium-term perspective up to 2020, further candidates for linking to the EU ETS appear on the stage: Canada has promoted the Large Final Emitter System to cover energy-intensive companies which account for almost 50% of total Canadian greenhouse gas emissions (CEPA Environmental Registry, 2005). The scheme aims to be based on intensity targets and to include a “Price Assurance Mechanism” capping allowance costs at 15 Canadian dollars. Japan has started the Pilot Project of Domestic emissions trading scheme on a voluntary basis, with about 30 private companies participating in the program (Japanese Ministry of the Environment, 2004). Russia – having ratified the Kyoto Protocol – could have incentives to develop a domestic emissions trading system in order to be linked to the European scheme and exploit a larger market for the sale of excess emissions permits – so-called “Hot Air” – due to lower Business-as-Usual (BAU) than target emissions committed to. Although the United States and Australia have not ratified the Kyoto Protocol, individual states in both countries are promoting emissions trading schemes: In the U.S. the Regional Greenhouse Gas Initiative, aiming at a regional ETS, is pushed by several Northeast and Mid-Atlantic states (RGGI, 2006). In Australia the New South Wales Greenhouse Gas Abatement Scheme is already operating at the state level (NSW government, 2006) and more recently, Australian state premiers have released early proposals for a national cap and trade system starting in 2010 (Point Carbon, 2006). Also these schemes could quickly arouse interest in EU-ETS decision makers, as “the Commission should examine whether it could be possible to conclude agreements with countries listed in Annex-B to the Kyoto Protocol which have yet to ratify the Protocol” (EU, 2004). In summary: There are strong signs for future ETS to be established in non-EU countries and potentially linked with the European scheme by 2020. At the same time, three flexible mechanisms proposed by the Kyoto Protocol will facilitate various emissions market operations by Annex-B parties from 2008 on: International emissions trading makes government trading of Assigned Amount Units (AAUs) possible at the country level; the Clean Development Mechanism (CDM) enables project-based emissions reductions in developing countries in order to generate Certified Emission Reductions (CERs), and Joint Implementation (JI) facilitates project-based abatement in other Annex-B regions, generating Emission Reduction Units (ERUs). However, the use of the project-based mechanisms will not be restricted to governments: The amending directive linking the European ETS with the Kyoto Protocol's project-based mechanisms (EU, 2004) allows European companies to generate emissions reductions by means of the CDM or JI. Imports of CDM and JI credits may serve as substitutes for ETS allowances since they are interchangeable with the European allowances. Moreover, EU ETS allowances are simultaneously labeled as Kyoto units (AAUs). Consequently, four types of emissions reduction credits – ETS allowances, Kyoto units, CDM and JI credits – may be used by countries to comply with their reduction commitments under the Kyoto Protocol. This paper analyzes these parallel climate policies due to regulation at the country and installation level by both emissions trading and project-based crediting. Previous studies have assessed the economic aspects of international emissions trading schemes both in theoretical and applied model frameworks. Rehdanz and Tol (2005) consider the coordination of domestic carbon permit markets in which countries determine their own emissions reduction targets. Using a theoretical two-country model they find that linking such schemes benefits both countries but may cause the exporting country to decrease its emissions reduction target and increase permit exports. Quantitative studies have on the one hand focused on efficiency aspects of segmented carbon markets under the current European ETS in partial or general equilibrium frameworks (see Böhringer et al., 2005 or Peterson, 2006), and on interactions between the European ETS and the project-based Kyoto mechanisms (Klepper and Peterson, 2006b). These studies find that hybrid emissions regulation (i.e. EU emissions trading in energy-intensive sectors and complementary domestic emissions regulation for the remaining segments) may lead to substantial excess costs — as compared to a comprehensive emissions trading system covering all segments of the economy or an emissions tax imposed unilaterally by each Member State. Moreover, they find that unlimited access to emissions abatement via CDM and JI substantially contributes to reducing the costs of meeting the European Kyoto targets. On the other hand, economic impacts of country-level trading under the Kyoto Protocol have been assessed through multi-model evaluations (see Springer, 2003 or Weyant and Hill, 1999), partly focusing on the economic potential of the CDM and associated investment barriers (Anger et al., 2007). While these studies focus either on the present EU ETS or government trading in the first commitment period of the Kyoto Protocol, a comprehensive simultaneous assessment of these parallel regulations in a future climate policy regime is still lacking. Against this background, the contribution of the present paper is threefold: In a quantitative approach it (i) addresses the economic impacts of company-based emissions trading beyond the European ETS by linking to emerging non-EU schemes, (ii) analyzes the efficiency implications of linkage in the presence of parallel country-level trading and the CDM under a post-Kyoto regime, and (iii) introduces a possible joint future trading system between ETS companies and Kyoto governments. Based on a numerical multi-country, two-sector partial equilibrium model of the world carbon market economic impacts are assessed quantitatively. 1 The model features explicit marginal abatement cost functions for 2020 calibrated to energy-system data and considers transaction costs and investment risk for CDM host countries. The remainder of this paper is organized as follows. In Section 2, the theoretical background for the analysis is derived. Section 3 lays out the numerical framework for the subsequent policy assessment. Section 4 specifies illustrative scenarios of climate policy in 2020. Quantitative simulation results are presented in Section 5 and Section 6 concludes.

Linkage of the EU Greenhouse Gas emissions trading scheme (ETS) to emerging schemes beyond Europe is a central strategic issue of current EU climate policy. At present, non-European countries like Canada, Japan or Australia are contemplating the set up of domestic ETS with the intention of linking up to the European scheme. From 2008 on, company trading among linked schemes would however occur in parallel to trading among countries, as the Kyoto Protocol facilitates international government trading of greenhouse gas emissions at the country level. Moreover, both companies and governments may undertake project-based emissions reductions in developing countries via the Clean Development Mechanism (CDM). The present paper assesses the economic impacts of linking the EU ETS in the presence of a post- Kyoto agreement in 2020. Based on a numerical multi- country, two-sector par tial equilibrium model of the world carbon market the economic impacts of pa rallel climate policies are assessed quantitatively. The model covers explicit sectoral marginal abatement cost functions for the year 2020 calibrated to energy-system data, and considers transaction costs as well as investment risk for CDM host countries.The simulations show that in the absence of post-Kyoto government trading, linking the European ETS induces no or only marginal economic benefits for the EU: Total compliance costs decrease no more than one percent in all linked schemes. As where-flexibility of international emissions trading is restricted to energy-intensive industries that are assigned generous initial emissions, the major compliance burden is carried by sectors excluded from the linked ETS (i.e. non-energy-intensive industries). These non-trading segments of the economy are not able to benefit from an enlarged trading scheme. Moreover, the economic impacts for non-EU countries from linking to the European scheme are very heterogeneous: Linking to Canada, Japan and the Former Soviet Union implies drastic compliance costs for Canada due to domestic inefficiencies, while Japan is benefiting and the Former Soviet Union is even net-benefiting from joining the EU scheme. A further linking process to Australia and the USA is not beneficial for any participant except for the Former Soviet Union which profits from an increased demand and price for its excess emissions permits ( “ Hot Air ” ). In the presence of parallel government trading under a post-Kyoto agreement, international emissions trading is not only feasible among energy-intensive sectors of linked ETS, but also among non-energy-intensive industries (represented by their governments). Linking the European economies to non-EU regions then leads to a much stronger fall in adjustment costs: By linking to Canada, Japan and the Former Soviet Union total EU compliance costs can be reduced by more than 60%. Here, it is the non-energy-intensive sectors that benefit from cost attenuation through enlarged international government trading of the same countries. A further linkage to Australia and the USAyields increased benefits from a larger emissions market, especially for non-energy- intensive sectors, further cutting EU compliance costs by almost 30%. Also for non-EU regions these parallel trading regimes would result beneficial. However, emissions markets are still separated – and where-flexibility still restricted – as international trading is feasible only among the same sectors of the linked economies. From an efficiency perspective, a desirable future climate policy regime represents a joint trading system that enables international emissions trading between ETS companies and governments under a post-Kyoto agreement. Such a joint regime is de facto equivalent to full where-flexibility, establishing international trading activities between all regions and sectors. Via such a joint regime the formerly separated markets can be interconnected, generating large efficiency gains: Linking the EU economies internationally in a joint trading system causes an even stronger fall in EU compliance costs than under a parallel-regime, since now all sectors can benefit jointly from extended trading activities. Here, the cost decrease is most substantial when linking to Canada, Japan and the Former Soviet Union, as the latter region is able to decrease the international permit price by supplying excess permits to a large extent. The CDM is not able to alleviate the inefficiencies of linked ETS, since also project-based crediting is restricted to energy-intensive industries of ETS. By contrast, in a parallel trading regime government access to low-cost abatement options of developing countries induces large efficiency gains. Here, the CDM provides additional cost-savings of more than 90% within the European scheme, largely reducing the compliance costs of non-energy-intensive industries. By providing access to project-based crediting for both energy-intensive and non-energy-intensive sectors, the CDM establishes an indirect link between the two segments of the economy and assures full where-flexibility. Due to this provision of an international credit pool for all sectors the CDM levels out the economic impacts under parallel and joint trading regimes. A restriction of CDM activities via a supplementarity criterion does not significantly decrease the economic benefits from project-based crediting, as the respective thresholds of CDM imports are generally not yet reached under unlimited CDM access.While representing a fairly transparent model framework, the present partial market analysis clearly can only provide a restricted description of economic reactions to international climate policy. One limitation of partial analysis is the neglect of market interactions and spillovers (for related studies see Böhringer and Rutherford, 2002, Bernard et al., 2003 or Klepper and Peterson, 2006a ). Moreover, the direct costs of abatement may be altered by terms-of-trade effects on fossil fuel markets. However, these effects depend on the extent of global cuts in demand for fossil fuels as well as the level of regional fossil fuel supply elasticities, and may only be addressed in a multi- market, i.e. general equilibrium framework. This paper laid out the efficiency implications of internationally linked emissions trading schemes, as well as alternative country-level compensation mechanisms for the expected inefficiencies of future schemes. In the long run however, uncertainties about future post-Kyoto agreements and the exhaustion of low-cost abatement options in developing countries raise concerns about the availability of such mechanisms. The projected large economic potentials of the CDM could also be substantially downscaled by the existence of implicit investment barriers such as incomplete information. Moreover, given the large number of participants it is company- based trading that provides a fertile ground for developing a competitive market for emissions. Considering the potential for efficiency improvements of future ETS – such as a stricter allowance allocation to covered installations or an enlarged sectoral scope – linking emissions trading schemes beyond Europe may thus become not only a fall-back option for a lacking international agreement, but a vital option for future climate policy at the global level.