What is... | March 26, 2019

What is emissions trading?

The world is going more green, but there are still heavy polluters. How are they incentivised to reduce their emissions?


Every day people look at the price of a good or service before deciding whether to buy it. If it’s too expensive for their budget they will say no. But when it comes to pollution, people have traditionally not had to pay for that cost, such as the smoke from the power plant creating the energy to go into their electricity supply.

This is beginning to change thanks to emissions trading, which is a markets-based approach to controlling pollution. Rather than slap a tax on the offending factory or product, governments in 31 European countries have put a price on emitting carbon dioxide gases.

In the United States, the Acid Rain Program does the same for sulphur dioxide and nitrogen oxides. Major polluters such as electricity producers and steelmakers as well as cement, paper and glass manufacturers are either given emission rights, called allowances, or have to buy them. They trade them with other emitters in the market, giving them an incentive to find ways to operate more efficiently and leaving them with spare permits that they can sell to other, less efficient producers.

As more efficient producers will be able to pass on the savings in the form of lower prices, consumers will be more likely to buy from those producers, adding an extra incentive for the companies to become more efficient.

Market power
How does it work? Imagine that the government sells emissions permits (per tonne of CO2) for £100. A company will have to pay this additional cost for each tonne of CO2 emitted. Alternatively, it can save £100 by reducing its emissions by a tonne.

Because company managers suffer from loss aversion – feeling the pain from a loss rather than a gain – as much as consumers do, they will prefer not to pay the extra £100 up front. However, this impact will weaken if companies are given emissions permits for free. While they have an incentive to make money by cutting emissions and selling the permit as a profit, they can choose to do nothing and just use their free permit.

This is known as status quo bias and can lead people to lose out from future gains by ignoring potential opportunities to save or make money. One study found examples of this in action among European manufacturers earlier this decade. About 30 percent of firms did not see the permits as financial assets while most of the firms surveyed did not trade on the EU allowance market. Much like a stock market, companies and private individuals can trade through brokers.

Energy bills
At the moment consumers don’t pay any direct costs under the emissions permits system but are affected by the indirect impact through rises in prices of goods and energy they consume that are supplied by inefficient suppliers or their industrial customers. For example, if a power station has to buy extra permits to offset its pollution, it is likely to pass those on to electricity companies that buy its power who in turn may pass that on in the form of higher energy bills.

One study found that between 20 percent and 100 percent of the permit costs were being passed on to electricity consumers. If households can see their bills go up because of charges from inefficient suppliers, they may switch supplier. However, households may not know that this is the reason for a rise in their bills that can be driven by other factors such as domestic taxes and fluctuations in oil and gas prices.

One idea that would make households have to account for the direct cost of emissions would be a personal carbon trading system. This describes the idea of an individualised carbon budget, which people could spend or trade just like money. But it does not exist yet other than in an experiment in the Norfolk Island in the Pacific Ocean. The British government looked at the idea 10 years ago but concluded it was “ahead of its time” because of problems with low levels of public acceptability and the need for technology to bring down the costs.

Social norms
Social norms can influence people’s behaviours as well as price triggers. One Swedish experiment found that people would be more willing to buy carbon allowances from the European scheme and to retire them permanently when they knew that others were doing the same.

Households in countries such as the UK where they can switch supplier can also use their power as consumers to choose companies that use renewable energy that does not produce emissions. One survey found that as of August 2018 half of the top 10 cheapest tariffs were green ones. These suppliers will by definition not be affected by emissions trading.

Emissions trading uses market prices rather than one-off taxes to try to change the way that companies and people behave by offering carrots to those that reduce their polluting output and sticks to those that don’t. Although consumers are one-step removed from that process, they should over time benefit by choosing suppliers who follow the money.

EconomicsSustainabilityEnergy costs

Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics