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Economists tend to favor the trading of emissions permits across different regions, or countries, in order to help contain the costs of cap-and-trade programs for greenhouse gases. But are there any reasons why policymakers may wish to limit such trading, and if so, what might be the implications—environmental and otherwise—of such restrictions?

Politicians tend to see cap-and-trade systems (or tradable emissions permit markets) as difficult to implement, although economists generally consider these options cost effective compared to conventional regulatory approaches. The reason is that those with high marginal abatement costs will buy permits from those with low marginal costs. Both buyers and sellers will benefit from this and the total abatement costs will be lower than in the case without trading.

But this argument does not come down to black and white: the grey addresses what cannot be easily quantified. Are there good reasons for restricting permit trade even if monetary costs will be higher, and what would the environmental consequences of trade restrictions be?

First, some context setting: two types of permit trading exist—one between entities in different regions or countries that are covered by formal emissions trading programs; the other involves emissions offsets between firms that are formally regulated and entities in countries without emissions trading programs. In the former case, the general presumption has been that permit trading makes clear sense on economic grounds.

Only in the latter case have there been genuine concerns due to the possibility that emissions reductions in unregulated countries might have occurred anyway and the possibility of emissions leakage (for example, slowed deforestation in one region increases deforestation elsewhere via an increase in the global timber prices). This is evident under the Clean Development Mechanism (CDM), whereby countries that ratified the Kyoto Protocol can buy CDM quotas (that is, greenhouse gas pollution permits in countries that did not subscribe to binding emissions limits in the Kyoto Protocol).

However, some environmental organizations and governments have objected to permit trading. In fact, several existing multinational tradable permit schemes contain restrictions on permit trading. In the Kyoto Protocol for example, trade in pollution permits is allowed, but only as a supplement to national mitigation, meaning that countries have to do some abatement and not buy all their necessary emission reductions abroad.

Consequently, the cost of reaching a certain level of pollution reduction will be higher than it otherwise would have been, perhaps substantially so if restrictions preclude a large amount of trading.
It is tempting to suggest that reluctance to permit trading internationally is due to lack of understanding about how a cap-and-trade system would work. But might there be some valid reasons for imposing restrictions on permit trading, besides those related to the possible difficulty of validating emissions offset programs?

(Noneconomic) Arguments for Limiting Permit Trading

Countries or policymakers may want to restrict trade of pollution permits, on rational or moral grounds. These can be justified from a procedural view of justice (that is, the processes by which outcomes are reached are important, not just the consequences), or a consequentialistic viewpoint. For example, a common argument is that industrialized countries created the global warming problem and so it is their duty to reduce the consequences of it, even if this does not minimize overall costs of taking action. This argument may, however, have a declining relevance moving forward as carbon dioxide (CO2) emissions from developing countries are rising rapidly.

Another line of reasoning against permit trading is based on unfair background conditions. Even if two parties agree to trade permits, the trade may not be justified on ethical grounds. A voluntary agreement between two parties is not necessary fair if is entered into under conditions that are not fair. Background justice is not preserved when some participant’s basic rights, opportunities, or economic positions are grossly inferior. Examples include an agreement between a prostitute and her customer or a poor farmer selling a kidney to a rich person. Some may argue that a permit trade between poor and rich countries may not meet fairness conditions because of the very different economic positions.

Consequentialist ethics also comes into play. For instance, if countries set or suggest their own targets—a process that may describe the run up of the European Emission Trading Scheme (ETS), Kyoto Protocol, and the Copenhagen Accord—permit trading may actually lead to higher emissions. In particular, this can be the case for sellers of permits that may allocate more permits than in the case without permit trade; this “hot air” has occurred when several countries received allowances higher than their business-as-usual emissions. The idea is that if the permit price is not very sensitive to increases in permits and if the marginal damage of the country is relatively low, the benefits from overallocation are higher than the costs. It has also been pointed out that permit trading may reduce individual incentives to behave “green” because doing so simply frees up emissions permits for others.

Finally, abating domestic emissions instead of buying permits abroad may be perceived as a better policy based on consequences. Arguments that have been raised in this debate are the positive spillover effects of technology development by national abatement as well as the ancillary benefits (reductions in local emissions, traffic accidents, congestion, and so on) of domestic abatement. Related to this is the environmental justice argument that minority groups suffer from permit trading because they live close to polluting facilities and will, therefore, not benefit from the ancillary benefits of domestic emissions reductions.

Implications of Trading Restrictions

Moral arguments against trading will most likely lead to higher instead of lower global emissions in an international climate agreement with permit trading. The reason is that on average, permit-importing countries have a stronger incentive to overallocate their domestic industries to reduce permit purchases compared to the incentive of permit-exporting countries to underallocate theirs. However, if the concern of countries is based on a preference for domestic abatement and global responsibility, and not distaste for permit trading, global emissions will go down. This latter conclusion is based on an equal concern in all countries, which will probably not be the case. If only a few countries share this concern, the beneficial environmental effect may be rather small. Both these results show that good intentions do not always yield the desired results.

While restrictions on permit trading, as introduced in the Kyoto Protocol, may be bad for the environment as they increase the costs of reaching an emissions target, and therefore the incentive to join a treaty, such restrictions may on the other hand reduce global emissions when governments are morally concerned about trading permits. The reason is that the incentive of permit importers to overallocate to domestic industries to limit permit purchases would be reduced. Thus, if the restrictions result from reluctance to trade, they may actually be good for the environment.

To Trade or Not to Trade?

It is hard to draw implications for policy based on the discussion above as related decisions will depend on the preferences of policymakers. The case for trading permits is nuanced. There may be good ethical reasons to restrict permit trading, but such restrictions will increase the costs of a treaty and therefore the possibilities of it to fail. On the other hand, if the costs are not high, restrictions may increase total abatement in situations where policymakers have moral concerns. Thus, this is a case where there may be a tradeoff between economic and environmental efficiency.

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