Tradable Carbon Permits and Emissions Reduction

A Case Study on the European Union Emissions Trading System

Background

Tradable carbon permits are a market-based mechanism that allows companies to buy and sell permits to emit a certain amount of greenhouse gases. This system is designed to provide incentives for companies to reduce their emissions and invest in cleaner technologies.

Case Study

The EU ETS is the largest carbon market in the world, covering around 45% of the EU’s greenhouse gas emissions. It operates in all EU countries and covers the power and industrial sectors, as well as aviation. Companies participating in the EU ETS are required to hold a permit for each tonne of carbon dioxide equivalent (CO2e) they emit. The total number of permits in the system is limited, and the cap decreases over time, leading to a reduction in emissions.

Table of data:

Task for Students:

  1. Draw a negative production externality diagram. Label all the curves, the equilibrium price and quantity without permits, and the socially optimal level of emissions.
  2. Using the same diagram, show how the introduction of tradable carbon permits can reduce the overall level of emissions. Illustrate the impact on the equilibrium price and quantity of emissions.
  3. Explain how the permits can be traded in the EU ETS and why this system incentivizes companies to reduce their emissions.
  4. Draw a diagram showing the market for permits. Show how a reduction in the emissions cap from 2021 to 2023 has increased the price for permits.
  5. Evaluate the effectiveness of using tradable carbon permits to reduce emissions. 

Hints:

  • Tradable carbon permits can be bought and sold in the market, creating a price for carbon emissions. Companies with low emissions can sell their unused permits to those with higher emissions.
  • The market price of a permit is determined by the demand for and supply of permits. As the cap on emissions decreases, the price of permits is expected to rise, making it more costly for companies to emit greenhouse gases.
  • Companies can reduce their emissions by investing in cleaner technologies and improving energy efficiency. This allows them to decrease their demand for permits or sell their unused permits for a profit.