...effect of these provisions on agent behavior in output and emissions markets assuming profit maximization. The main conclusion is that the principal effect is on capacity. The effect of the resulting over-capacity on output markets is to reduce output price and to increase output. The effect on emissions markets is more ambiguous in that it depends on the emission characteristics of the new capacity, existing capacity, and the capacity not retired, and the distribution of the excess capacity among these categories.

1. INTRODUCTION

As a person whose life began in England and ended in North America and who maintained academic affiliations in the United Kingdom, Canada and the U.S., Campbell Watkins had a fine appreciation for the subtle differences that mark the two sides of the North Atlantic. He embodied the cross-fertilization that trans-Atlantic exchanges imply and I have no doubt that that was one of the reasons the IAEE received so much of his attention and benefited so grandly from it. This essay concerns one of those trans-Atlantic exchanges and one of which Campbell would have enjoyed the irony: An American innovation that goes to Europe and becomes bigger than anything yet seen in North America. The transplant is the cap-and-trade form of emissions trading and the European application is the European Union C[O.sub.2] Emissions Trading Scheme (EU ETS). More specifically, this paper focuses on a particular feature of the allocation process in the European variant, the endowment of new entrants with allowances and the forfeiture of allowances when facilities are closed.

The European Union Emissions Trading Scheme (EU ETS) is the world's first cap-and-trade program for C[O.sub.2]. It has been implemented by the twenty-seven Member States of the European Union (EU) as one of the measures to fulfill their obligations under the Kyoto Protocol. It applies to stationary sources larger than 20 [MW.sup.th], generally fossil-fuel-fired electricity generators and C[O.sub.2] emitting industrial facilities and it covers approximately 52% of the C[O.sub.2] emissions of the entire EU. The first stages of implementation occur in two distinct periods: a first "trial" period encompassing calendar years 2005-07 and a second period corresponding to the first commitment period under the Kyoto Protocol, 2008-2012.

Although modeled after the U.S. S[O.sub.2] cap-and-trade system, the EU ETS is much larger in all dimensions. It includes about four times as many installations, approximately 11,400 installations as compared to about 3,000 in the US S[O.sub.2] program. The volume of annual emissions covered is a thousand times greater: approximately 2.2 billion metric tons of C[O.sub.2] compared to about 18 million short tons of S[O.sub.2] (before the 50% reduction imposed by the initial S[O.sub.2] cap). Finally, although prices per allowance and per ton of emissions have been much higher in the S[O.sub.2] program than in the EU ETS (from $70 to $1600 compared to 8 to 30 euros), the value of the allowance assets distributed in the EU ETS is about ten times that of the US S[O.sub.2] program, about $50 billion compared with $5 billion at current prices of 18 euros/metric ton and $600/short ton, respectively.

Cap-and-trade programs create allowances, which are explicit limited rights to emit the specified substance, and all programs face the initial problem of allocation: deciding how to distribute these limited and prospectively valuable rights. In the U.S. program, allocation was decided centrally by the U.S. Congress as an integral part of Title IV of the 1990 Clean Air Act Amendments. In the EU ETS, allocation is delegated to the 27 member states, each of which is responsible for developing its own National Allocation Plan (NAP) subject to review by the European Commission. Despite this fundamental difference in allocation approach, both programs are alike is distributing nearly all of the allowances for free to the incumbents on whom the liability to surrender allowances equal to emissions is imposed.

One of the notable differences between the EU ETS allocation of C[O.sub.2] allowances and the U.S. allocations of either S[O.sub.2] or N[O.sub.x] allowances concerns the treatment of new and closed facilities. Generally, new entrants in the U.S. do not receive allowances and therefore must purchase whatever they would need from the market. (1) Moreover, closed facilities are allowed to retain the initial endowments. In the EU, all 27 Member States have set aside a certain percentage of the total number of allowances for new entrants and most Member States require the owners of closed facilities to forfeit future allowance endowments at closure. Some Member States have also developed transfer rules whereby the allowances from a closed facility can be transferred to a new facility under certain well-specified conditions. (2) A further important condition of the new entrant endowments, like those to incumbents, is that once determined they are fixed in keeping with the criteria of no ex post adjustment of allowance endowments.

This paper concerns the effect of these new entrant and closure provisions and specifically the means by which efficient resource allocation is distorted. A considerable literature has already developed about these provisions generally within the context of over-all treatments of the allocation procedures in the EU ETS. Although all of these contributions recognize that the new entrant and closure provisions are distorting, the focus is as often on the diversity of these provisions among member states, and on the additional distortion thereby introduced into EU-wide investment by the carbon market, as it is on the more fundamental nature of the distortion. Moreover, many (Matthes et...

NOTE: All illustrations and photos have been removed from this article.



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