On the Design of Optimal Grandfathering Schemes for Emission Allowances

TL;DR: In this article, the authors determine central design rules for optimal grandfathering within a simple two-period model, and find that for (small) open trading systems, where allowance prices are exogenous, first-best second-period grandfathering schemes must not depend on firm-specific decisions in the first period.

Abstract: To meet its commitment under the Kyoto Protocol, the EU plans to implement an emissions trading system with grandfathering of allowances. Besides having distributional impacts, the choice of the grandfathering scheme may affect efficiency if firms anticipate how future allocations depend on upcoming decisions. In this paper, we determine central design rules for optimal grandfathering within a simple two-period model. We find that for (small) open trading systems, where allowance prices are exogenous, first-best second-period grandfathering schemes must not depend on firm-specific decisions in the first period. Second-best schemes correspond to a Ramsey rule of optimal tax differentiation and are generally based on both previous emissions and output. However, for closed emissions trading systems, i.e. endogeneous allowance prices, firstand second-best rules coincide and must not depend on previous output levels. They consist of an assignment proportional to the emissions in the first period plus a term which does not depend on firm-specific decisions in either of the two periods.

Summary

1 Introduction

• To meet its emissions reduction commitment under the Kyoto Protocol, the EU plans to implement a emissions trading system within the European Community (EU 2001) which covers large installations of energy-intensive industries.
• With respect to policy guidance, a key challenge from an economic point of view is to identify allocation rules that preserve overall economic efficiency.
• Dynamic incentives of grandfathering are studied by Laplante et al. (1997).
• The authors find that the design of optimal grandfathering schemes crucially depends on whether the emissions trading system is closed or open to a larger (the world) market: For open trading systems where allowance prices are exogenous, first-best second-period grandfathering schemes must not depend on firm-specific decisions in the initial period.
• The more inelastic output , the larger should be the weight to output in the grandfathering rule.

2 Analytical Framework

• 2 Firm i’s technology in period t (t = 1, 2) is given by its cost function cit(qit, eit) where qit denotes the output level and eit the emissions emerging from production.
• The firm sells output qit at a competitive consumer price pt, and must hold allowances for emissions eit.
• The assignment in period 2 might depend on firm’s decisions in period 1 and other non-firm-specific economic parameters: ēi2 = gi(ei1, qi1).
• In the following, the authors distinguish the cases whether the emissions trading system is open or closed to the world market.
• Ēt in both periods and the allowance price σt is endogeneous.

2.1 Socially optimal allocation

• The authors refer to this as the social optimum ((qit∗, eit∗)i,σ∗t )t.
• As well-known, in the social optimum the consumer price equals marginal production costs, and marginal abatement costs coincide for all firms.

2.2 The decentralized economy

• Next, the authors consider the decentralized economy in which firms can trade their emissions allowances and output on competitive markets.
• The competitive firm i maximizes its 3This reflects concrete policy concerns that the European emissions trading system might not be linked with trading schemes from other signatory countries under the Kyoto Protocol or allow for using credits obtained from Joint Implementation (JI) or Clean Development Mechanism (CDM) projects.
• Clearly, the openess of the system is a prerequisite for achieving emission reduction at lowest costs.

2.3 The open emissions trading system

• The first-best therefore coincides with grandfathering rules 6 that are independent of first period emissions and output.
• As an extreme case, a firm should not perpetually receive allowances although it already dropped out off the market.
• If, cross-price elasticities are small, optimal grandfathering is based on both emission and output levels, i.e. λiq,λ i e > 0.

2.4 The closed emissions trading system

• If the emissions trading scheme is closed, i.e. P i e it = Ēt, first period equilibrium again depends on the specific grandfathering rule and is given by (4) and (6).
• Instead of solving the social welfare maximization problem explicitly, the social optimum, which is given by (1) and (2), can be achieved without relying on lump-sum transfers.
• If lump-sum transfers are ruled out (λi0 = 0) in a closed emissions trading system, the sole grandfathering scheme that warrants efficiency assigns allowances proportional to first-period emissions.
• The proportionality factor is given by the targeted contraction factor of aggregate emissions, i.e. λe = Ē2/Ē1. 10.

2.5 Policy implications

• A major policy claim in the debate on allocation schemes is that an installation (firm) should not perpetually receive transfers via the grandfathering rule although it has already been shut down.
• The allocation rule could meet such concerns by choosing λi0 = 0, i.e. by using the discussed second-best allocations rules.
• In the closed system, economic efficiency, i.e. the decision to maintain or drop the installation, will not be affected since the effective costs of holding emission allowances do not depend on the choice of λe.
• Another key issue in the set-up of allocation schemes is the treatment of new market entrants.
• If the latter are not grandfathered, there is a distributional bias towards incumbent firm.

3 Conclusions

• From 2005, the EU will have the first international trading system for greenhouse gas emission allowances.
• Until then, Member States must have developed national allocation plans for emission allowances across large installations of energy-intensive firms.
• The authors have studied first- and 11 second-best allocation rules for dynamic grandfathering schemes with concretions to an open or a closed trading system.
• In real practice, implementation of even second-best rules across EU Member States may not be possible due to various reasons.
• Allocation rules typically addressed in the policy debate are either based on emissions or output.

Full text

ZEW
Zentrum für Europäische
Wirtschaftsforschung GmbH
Centre for European
Economic Research
Discussion Paper No. 03-08
On the Design of Optimal Grandfathering
Schemes for Emission Allowances
Christoph Böhringer and Andreas Lange

Discussion Paper No. 03-08
On the Design of Optimal Grandfathering
Schemes for Emission Allowances
Christoph Böhringer and Andreas Lange
Die Discussion Papers dienen einer möglichst schnellen Verbreitung von
neueren Forschungsarbeiten des ZEW. Die Beiträge liegen in alleiniger Verantwortung
der Autoren und stellen nicht notwendigerweise die Meinung des ZEW dar.
Discussion Papers are intended to make results of ZEW research promptly available to other
economists in order to encourage discussion and suggestions for revisions. The authors are solely
responsible for the contents which do not necessarily represent the opinion of the ZEW.
Download this ZEW Discussion Paper from our ftp server:
ftp://ftp.zew.de/pub/zew-docs/dp/dp0308.pdf

Non-tec hnical summary
To meet its emissions reduction commitment under the Ky oto Protocol, the EU plans
to implement an emission s trad in g syste m within the European Community which
co v ers large installations of energy-in tensive industries. An important element of the
Directive left open to Mem ber States is the grandfathering mechanism of allowances
across industries (installations). Several metrics hav e been proposed for the alloca-
tion of allowa nc e s across production facilities, most notably output-bas ed approaches
or emission-based approaches. Ho wev er, dynamic grandfathering schemes whic h take
production or emission levels as a bas is for allocation can lead to strateg ic behavior of
firms with adverse implica tion s for overall economic efficiency. With respect to policy
guidan ce, a key c h alle n ge from an economic point of view is to iden tif y allocation rules
that minimize efficiency losses.
In this paper, we study first- and second-best allocation rules for dynamic grandfather-
ing sc hem es with concr etions to an open or a closed emissions trading system:
• For (s mall) open tradin g sys tems where allowance prices a re ex ogen ou s, first-best
second-period grandfathering schemes must not depend on firm-specific dec ision s
in the initial period. Second-best schemes are based on a w eigh ted com bination of
first-period output and emission levels. They correspond to a Ram sey-type rule
of optimal tax differentiation: The more in elastic outpu t (em issions), the larger
should be the weight to output (emissio ns). This highligh ts the importance of
firm s’ (sectors’) characteristics when designing a grandfathering scheme.
• If the emissions trading system is clo sed , first- and second-best rules coincide. To
preserve efficiency, grandfathering m ust not depend on previous output levels.
Optim al grandfathering sc hem e s consist of an assignment proportional to the
emissions in the fir st period plus a term w hich does not depend on firm-specific
decisions in either of the two periods. The proportion ality factor m us t not differ
between firms (sectors).

On the D esign of Op timal Grandfathering Schem es
for Emiss io n Allowance s
by
Christoph Böhringer
∗
and Andreas Lange
∗, ∗∗
∗
Centre for European Economic Research (ZEW), M annheim
∗∗
In te rd iscip linar y Institute for En viro n m ental Economics , University of Heidelberg
Abstract: To meet its commitm ent under the Kyoto Protocol, the EU plans to imple-
men t an emissions trading system whith grandfathering of allow ances. Besides ha ving
distributional impacts, the choice of the grandfathering scheme may affect efficiency if
firms anticipate how future allocation s depend on upcoming decisions. In this paper,
we determ ine central design rules for optimal grandfath ering within a simple t wo-period
model. We find that for (small) open trading systems, where allowan c e prices are exoge-
nous, first-best second-period grandfathering schemes must not depend on firm -specific
decisions in the first period. Second-best schemes correspond to a Ramsey rule of opti-
mal tax differentiation and are generally based on both previous emissions and output.
However, ofr closed emiss ion s trading systems, i.e. en d oge n eo us allowance prices, first-
and second-best rules coincide and m ust not depend on previous output levels. They
consist of an assignm e nt proportional to the emissions in the first period plus a term
which does not depend on firm -specific decisions in either of the tw o periods.
JEL: Q28
Keyw ords: emissions trading, grandfathering, efficiency
Correspondence: A. Lange, Cen tre for European Econom ic Research (ZEW), P.O.Box
103443, D-68034 Mannheim, Germ any, tel: +49 (0)621 1235-208, fax: -226, em ail:
lange@zew.de, boehringer @zew.de
The authors would like to thank Heinz Welsc h and Michael Rauscher for v aluable comments.

1Introduction
To meet its emissions reduction co mmitmen t under the Kyoto Protocol, the EU plans
to implement a emissio ns trading sy stem within the European Com mun ity (EU 2001)
whic h cov ers large installations of energy-intensive industries. It is envisaged to link
the trading scheme with other (non-EU-)schemes and project-based mechanisms like
Joint Implemen tation (JI) and Clean Developmen t Mechanism (CDM) under the Ky oto
Protocol (UNFCCC 1997). Th e propo sed sch eme consists of several temporal stages:
a first phase from 2005 until 2007, a second one from 2008 until 2012, coinciding
withthelaunchoftheKyotoProtocol,andsubsequentfive-y ear-periods co vering P ost-
Kyoto commitment pe riods. M e mber States will allocate emiss ion allo wanc es for free
(grandfa th ering) until 2008 and can auction 10 per cent of the allowances in the second
phase.
An important eleme nt of the Directive left open to Member States is the gran d fath ering
mec hanism of allow ances across industries (installations). Sev eral metrics have been
proposed (Harrison and Radov 2002) for the allocation of allo wances across produc tion
facilities, mos t notably output-based approache s (e.g. kilowatt-hour s of electricity
production) or emission-based approaches (e.g. tons of CO
2
emissions). With respect
to policy guidance, a k ey challenge from an econ omic point of view is to identify
allocation rules that preserv e o verall economic efficiency.
Grandfathering schemes lead to efficien cy losses if firms can in crease their grandfa-
thered amount by choosing higher production or emission levels.
1
As a consequence,
the literature has stressed the importance of static grandfathering schemes which are
only based upon historical information. Abstracting from income and terms-of-trade-
effects, the diffe re nt metrics then simply hav e varyin g distribution a l impacts but leave
production plans of firm s unaffected. Grandfathering boils do wn to non-distortionary
lump-sum transfers of allowances (Laan and Nentjes 2001; Woerdm an 2001).
Howev e r, grandfathering sch eme s whic h tak e historical emissions as a basis for alloca-
tion within con tin uous planning cannot completely circumven t the problem of distor-
1
For example, initial allocation can be based on past emissions or on standards from a previous
command-and-c ontrol system. Within the European emissions trading scheme, Germany discusses to
use (re lative) emissions in 1990 as a basis for grandfathering, in order to not reward firms for “early
actions”.
1

Frequently asked questions

Q1. What are the contributions mentioned in the paper "On the design of optimal grandfathering schemes for emission allowances" ?

In this paper, the authors determine central design rules for optimal grandfathering within a simple two-period model. 

Q2. What is the key challenge from an economic point of view?

With respect to policy guidance, a key challenge from an economic point of view is to identify allocation rules that minimize efficiency losses. 

Q3. What is the main element of the Directive left open to Member States?

An important element of the Directive left open to Member States is the grandfathering mechanism of allowances across industries (installations). 

Q4. What is the purpose of the article?

To meet its emissions reduction commitment under the Kyoto Protocol, the EU plans to implement an emissions trading system within the European Community which covers large installations of energy-intensive industries. 

Q5. What is the way to grandfather emissions?

For (small) open trading systems where allowance prices are exogenous, first-best second-period grandfathering schemes must not depend on firm-specific decisionsin the initial period. 

Q6. What is the definition of a grandfathering scheme?

Optimal grandfathering schemes consist of an assignment proportional to the emissions in the first period plus a term which does not depend on firm-specific decisions in either of the two periods.