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HOW to regulate carbon emissions
Mads Nørgaard Jørgensen & Tobias Rune Caspersen, Institut for Statskundskab, Københavns Universitet
Analysing the principles of THE EU EMISSION TRADING SCHEME AND THE CARBON REDUCTION LABEL
List of Contents
1. Introduction 3
2. Analytical approach 4
2.1 Defining regulation 4
2.2 Case selections 4
2.3 Defining the mind of companies 6
2.4 Structure 7
3. Regulating in theory 8
3.1 Standards 8
3.1.1 High or low standards? 8
3.1.3 Process standards 9
3.1.4 Uncertainty 9
3.2 Sanctions 10
3.3 Marketing potential 10
4. Carbon Reduction Label 12
4.1 Presentation 12
4.1.1 PAS 2050 12
4.1.2 Carbon Reduction Label 13
4.2 CRL analysis 15
4.2.1 Logic of rationality 16
5. EU Emission Trading Scheme 20
5.1 The system in action 20
5.2 Analysing the European approach 21
6. How to regulate carbon emissions 25
6.1 Perspectives on regulating carbon emissions 25
7. Conclusion 28
8. References 30
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1. Introduction
The concept of climate change is a relatively new problem faced by global policymakers,
business leaders, and NGOs, and consequently, the proposed regulative solutions diverge
greatly. How to cope with climate change is perhaps one of the most relevant questions today
as the time of the Kyoto Protocol is running out and an heir is sought.
Climate is something widely different from most other political problems in the sense that for
once, it is actually a necessity to reach agreement internationally if the notion of the nation-
state as the effective political unit is to be maintained with some creditability. It is an
international problem and national public solutions are simply not enough (Reinicke, 1998;
Kaul, 1999: 464). Even though the severe limits of the Kyoto treaty and the difficulties of
obtaining a new one might suggest that public regulation by nation-states is ineffective on
global issues, the European Union does show that international binding public regulations can
be accepted and implemented by the countries involved through the EU Emission Trading
Scheme.
On the other hand, academia and the private sector suggest that this might not be the most
efficient way to deal with the problem (Reinicke, 1998: Chapter 2; Cutler et al., 1999: 3). Private
regulation is a radically different approach to achieve the goal of cutting carbon emissions, but
the economical incentives of good public relations might just let the market forces do the trick;
an approach such as the Carbon Reduction Label has its own advantages and disadvantages
vis-á-vis intergovernmental regulation. To acquire knowledge of how to regulate carbon emissions,
we analyse the problem case wise through the following question:
What are the advantages and disadvantages of regulating carbon emissions through the
European Union’s Emission Trading Scheme and the Carbon Reduction Label?
The arguments for this approach are outlined in the next chapter. In answering the problem
three preliminary questions stand before us: first, how do we define regulation; second, to what
extent can our findings of the two cases be used in general; and third, how do we define the
mind of companies, which the regulation seeks to influence. These questions will be answered
consecutively followed by a structuring of the paper.
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2. Analytical approach
2.1 Defining regulation
It is our understanding that for a regulation to be effective it has to exercise power. Robert Dahl
describes power as: “A has power over B to the extent that he can get B to do something that B would
not otherwise do” (Dahl, 1957: 203). We therefore define regulation as containing both a specific
goal or rule and influencive means to make companies comply with it.
Furthermore we focus on regulation approaches that are general in scope, even though we see
a tendency for sector-specific regulation as more common (Gunningham, 2007: 223. The
distinction is important because the general approaches are faced with somewhat more
complex interaction of their policy content, while the sector-specific assumable can specialise
their approach, due to a more thorough following of the sector stakeholders and companies.
Further, as we want to shed light on some of the differences in advantages and disadvantages
of intergovernmental and private regulation approaches, sector-specific cases simply would be
less possible to compare.
2.2 Case selections
The main focus of this chapter is to consider how well the selected cases are representative of
the present landscape for regulating carbon emissions, which is important to be able to
generalise our findings. In doing so it is necessary to clarify the selection process of the Carbon
Reduction Label and the EU Emission Trading Scheme as our cases.
The selection is carried out according to three criteria, derived from our definitions:
- Significant elements of either private or intergovernmental climate regulation.
- The ability of the regulation approach to enforce the policies chosen.
- General and not sector-specific in scope.
Starting with the first of the criteria, it stems from a consensus in the literature on the subject
that these are the only types of regulation capable of handling global problems (Kaul, 1999,
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464). According to Reinicke, national regulations would lead to a race to the bottom (Reinicke,
1998). Even though it is said that neither intergovernmental nor private regulation are pro-
active by nature, they stand out as the solutions since climate change is upon us now.
Purely private or intergovernmental climate regulation is of course ideal types, and we cannot
hope to find real world examples hereof. As a consequence, the criterion is merely used to
focus on significant elements of each type and strive for cases as close to the ideal types as
possible. Excluded are therefore national climate regulation approaches, private-public
partnerships and similar hybrids on the grounds that to use our conclusions outside the specific
cases at all, we will need to be as close to the ideal types as we can.
The second criterion is a necessity based on our definition of regulation from Dahl’s
description of power. Hence, regulation approaches that do not contain an ability to enforce its
decision either directly or indirectly have no real power and would be meaningless to include in
the analysis.
The third and final criterion directly follows our choice of analysing general regulation
approaches. Even though general and sector-specific approaches differ in scope, we find it
reasonable that many of the methods of general regulation approaches can be used on sector-
specific regulation approaches, as least more so, than the other way.
As a consequence of these criteria, other regulation approaches have been left out. These
include as an example the UN Global Compact, which is a private/intergovernmental hybrid
with no real power to enforce itself (UN Global Compact, 2009), and the solemnly vision-
declaring Nairobi-declaration of the African Union (African Union, 2009: 9).
By these criterions, the European Union’s Emission Trading Scheme and the originally British
private initiative of Carbon Reduction Label stood out as prime examples. They are both
general in their scope and the two cases with the least mix of public and private regulation
within the same approach even though the Carbon Reduction Label were originally initiated
by the British government. Hence, the cases are not ideal types but they are as close as we can
get in a complex real world and the advantages and disadvantages of each can within reason,
following the arguments above, be used outside this context as estimates of intergovernmental
and private types of regulation.
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2.3 Defining the mind of companies
Companies are assumed to be rational actors. We find this choice to be reasonable based on
the very short timeframe available if we are to successfully react to climate change as pointed
out by the IPCC (IPCC, 2007: 775). Norm and sociologically determined acts requires a longer
learning process to influence patterns of actions significantly (Cutler et al., 1999: 9). As stated
before, according to the UN climate council, there is not enough time to wait for these
processes to effect incentive structures and thus emissions. If we were to include norm and
sociologically determined acts, we would have to moderate and restrain our conclusions even
further. Such additional precautions lower the validity of the analysis. Even though reliability
in principle would suffer by looking at the problem from only a single theoretical perspective,
the relatively short timeframe provide some leverage to our choice of focussing on rationality.
Through the lenses of rationality, regulation is an attempt to correct the failures of the free
market. Being a non-excludable public good the environment is a collective action problem,
because the cost of polluting is not paid by the polluters (Prakash & Potoski, 2006: 43). The
invisible hand of Adam Smith simply does not take these externalities into account (Smith,
2003: section 2.3). This market failure needs to be corrected by the public to maintain correct
market terms where the huge cost to the environment caused by pollution is somehow
minimised through less pollution, or strictly economically speaking, through sanctions that
makes up for the cost to the environment.
Because we assume companies to be rational, the otherwise fairly distinct types of regulation
become much more blurry. Regulation can be seen as either hard or soft regulation; determined
by whether the policies punishes companies if they are not acting as desired (in this case
polluting excessively), or if the policies try to change the direct incentive structures by making
it profitable to act as desired; the stick (hard regulation) and the carrot (soft regulation),
respectively. However, the assumption of rational actors and the focus on economic incentive
structures make these ideal types to a graduation of no real practical importance. If everything
is seen in terms of economic incentives then both direct sanctions (fines, confiscations etc.) and
indirect ones (image amongst clients, experts, competitors, industry organisations etc.) work in
exactly the same way.
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2.4 Structure
First, we cannot measure the exact outcome of each approach by how much reduction of
carbon emissions it produces. Second, we cannot obtain valid quantitative data concerning the
economic implications on each identified parameter, singling out what is caused by each
approach. As a consequence, the analysis will position itself on a purely theoretical platform,
the only empirics being the cases themselves. In answering the question we therefore look at
advantages and disadvantages of the regulation approaches through their economical
implications for the companies, their rational incentive structures, on a qualitative level.
Doing so the next chapter will clarify which parameters to be looked at and the precise
theorems for what these parameters mean for the differences in economical incentives.
Through our assumptions we will deduce three main parameters which arguably contain the
essential elements for an objective, qualitative evaluation of the regulation approaches.
The Carbon Reduction Label and the EU Emission Trading Scheme is analysed in chapter 4
and 5, respectively. Before the actual analysis and assessment of advantages and disadvantages
of each regulation approach, each chapter briefly outlines the current policies and mechanisms
of the case in question. The analyses is concluded by recapitulating the advantages and
disadvantages to deduce some general perspectives on how to regulate carbon emissions.
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3. Regulating in theory
To be able to creditably analyse and compare the two regulation approaches, addressed later,
this chapter presents the advantages and disadvantages of varying regulatory methods. The
presentation is divided into three distinct parameters: Standards, sanctions and marketing
potential. Following our definition of regulation, drawn on Dahl’s idea of power, regulation
includes some sort of rule or goal, here called standards. Furthermore, the definition requires
the regulation to influence the companies to comply with the standards. Our assumption that
companies act rationally according to economic incentives, opens two ways to compliance:
Punishment or reward. The punishment is presented as sanctions and reward as marketing
potential. To cover both intergovernmental and private types of regulation the presentation is
sought to be general in scope.
3.1 Standards
3.1.1 HIGH OR LOW STANDARDS?
First of all, the regulator needs to consider the degree of regulation: Should it have high or low
standards? Of course the regulator would prefer as high a standard as possible, but the
consideration is important since the degree of regulation is negatively correlated with the
degree of compliance. If the standards are two high the compliance will tend to be low,
because of the associated high costs of complying (Prakash & Potoski, 2006: 56).
3.1.2 SPECIFICATION OR PERFORMANCE STANDARDS?
Roughly speaking, there are two types of standards: Specification or performance standards. A
specification standard is a standard that tells the companies exactly what to do. It defines one
specific method and therefore requires virtually no interpretation. It does however include
some disadvantages; to be effective the guidelines need to be extremely detailed, which makes
it difficult for companies to comprehend and difficult for the regulator to keep up to date.
Furthermore it inhibits innovation and does not encourage individual best practice
(Gunningham, 2007: 212).
A performance standard, on the other hand, sets a general goal and lets the company decide
how to comply. The backside here is first of all the additional administrative cost associated
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with the necessity of control by the regulator. Secondly, it may be burdensome for small and
medium-sized enterprises to develop their own methods for compliance. In such cases it is
preferable that the regulator provides technical advice (Gunningham, 2007: 214).
3.1.3 PROCESS STANDARDS
The central element in process standards is an encouragement to go beyond the minimal
standards by providing incentives for companies to make continuous improvement
(Gunningham, 2007: 214). This is achievable by making different standard-levels and thereby
different levels of compliance. Process standards are therefore a way to include both low and
high performers and can be used with both specification- and performance standards.
3.1.4 UNCERTAINTY
When evaluating the use of standards, it is also important to consider the uncertainty that rests
about future regulations. If this uncertainty is too high companies will be reluctant to lead the
way and invest time and money in complying.
Being the first in a new market means the possibility of a price premium as you receive a short-
term monopoly status, as well as the longer-term profitability of learning the new techniques
and accumulating experience here within before your competitors. The latter means that the
competitors would have to pay a higher price at any given time for a comparable product since
the experience curve makes it continuously cheaper to produce any particular good, including
non-polluting goods (Johnson et al., 2008: 336). However, within the sphere of politically
controversial matters, such as the environment, first mover’s advantage is somewhat reduced as
regulation can change very fast making expensive investments less certain and thus less
worthwhile. In such cases, the literature on microeconomics tend to favour a fast second
approach instead, meaning that the rational solution would be not to take the risk of being the
first to invest in something uncertain but always be ready for fast investments when regulation
seems to be relatively certain (Johnson et al., 2008: 338). In that way one tries to maximise the
benefits of learning new techniques fast making it cheaper to produce these new goods faster,
but without taking the potentially very unprofitable investments in completely new and
politically uncertain territory.
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3.2 Sanctions
One way to encourage companies to meet the regulation standard is to threaten with sanctions
in the case of non-compliance. For this to be effective third party monitoring is of vital
importance, due to a general lack of public scrutiny in companies and consequent information
asymmetries (Prakash & Potoski, 2006: 58).
3.2.1 COMMAND AND CONTROL OR INFORMATION REGULATION
The type of sanctions can be divided between command and control- or information
regulation. Command and control regulation is the classical type, with clear guidelines for
compliance, which if not met, are followed up by economic or legal sanctions. For private
regulations, carrying out these sanctions requires a mandate given by the regulator. The state
has a monopoly on the use of legitimate violence, which means that all intergovernmental
regulation besides the EU needs states’ acceptances in all cases of sanctions (Cutler et al.,
1999: 359).
In information regulation there is not necessarily any direct demand for change. Instead the
approach relies upon the public opinion and the economic market as the mechanisms to bring
about cuts in carbon emissions. The logic is that firms care about their reputation: By naming
and shaming the laggards will lose reputation and consequently be punished in the market
(Prakash & Potoski, 2006: 62). This logic is further examined below.
3.3 Marketing potential
Marketing potential is a reward to compliers. By marketing that the company is socially
responsible it enables itself to differentiate its products, which attract costumers and/or allows
it to charge a price premium.
The reason for this marketing potential is related to the fact that regulation of carbon emissions
induces companies to undertake costs to produce a public good. In return for cutting carbon
emissions, companies receive goodwill from external stakeholders, such as consumers, interest
organisations and the government (Prakash & Potoski, 2006; 49).
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Marketing potential however, requires that the design of standards makes it possible for firms
to differentiate themselves from each other. In general, this could be accomplished by using
process standards, as discussed above. For voluntary regulations it would be possible to
differentiate between members and non-members.
Taking the same action unilaterally would be less credible, because it is non-institutionalised
(Prakash & Potoski, 2006: 53). Moreover achieving good reputation is less costly when
affiliated with a credible regulative program due to economies of scale, a dynamic akin to
network effects: one company’s progressive environmental activities generates positive
reputational and goodwill externalities for other companies within the regulative program
(Prakash & Potoski, 50-51).
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4. Carbon Reduction Label
After having defined the parameters necessary for an assessment of regulation policies, we turn
to the actual analysis of our two cases; beginning with the Carbon Reduction Label. Initially,
we will present a brief introduction to the concrete nature and regulation mechanisms before
proceeding with the assessment.
4.1 Presentation
The Carbon Reduction Label is a regulation approach that labels product’s carbon emissions. It
is managed by the Carbon Label Company, which is a subsidiary of the Carbon Trust. The
Carbon Trust is a private organisation tasked with creating practical business-focused solutions
and advising organisations on how to reduce their carbon emissions (The Carbon Trust, 2008:
10). The organisation is funded by the UK Government and is therefore providing its services
to businesses free of charge (The Carbon Trust, 2007: 7). The organisation is however not
limited to the UK but targets companies around the world.
4.1.1 PAS 2050
The Carbon Reduction Label builds on the Public Available Specification (PAS) 2050, which is
an approach to assessing carbon emissions developed by the Carbon Trust among others (The
Carbon Trust, 2008: 8). The PAS 2050 differs from other standards in view of the fact that it is
aimed at measuring products and not entire companies (The Carbon Trust, 2008: 1). The
advantage hereof is the ability to label products according to their carbon emissions.
To develop the PAS 2050 it was important to consider the balance between consistency, to
ensure the measurement reliability, and practicality, to ensure business support. To make the
assessment consistent it is essential that the whole life cycle of the product is included in the
calculation. The distinct stages identified are listed in the figure below.
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Figure 1: Product life cycle
There is however some practical difficulties involved. First, companies producing more than
one product need to divide up their emissions. Secondly, the producer of the end product
might not be in control of the whole life cycle. It is, as an example, very common that the
manufacturing company is not involved in the procurement of raw materials. The solution
provided by the PAS 2050 is for the companies to provide the information up to their point in
the chain (The Carbon Trust, 2008: 12). Thirdly, the ‘use phase’ is difficult to measure, because
there is no certainty over how any product will be used, and lastly how to grasp with recycled
materials. With the last two issues, PAS 2050 draws on existing standards, like the ISO 14044
(International Organisation for Standardization) and the Greenhouse Gas (GHG) Protocol
(The Carbon Trust, 2008: 12-13).
Furthermore, for the PAS 2050 to be practicable, it has set a de minimis limit. According to
their publication it ‘allows any one source contributing less than 1% of the total footprint to be excluded,
provided the total exclusions do not exceed 5% of the overall product carbon footprint’ (The Carbon
Trust, 2008: 12).
Because the PAS 2050 has tried to find a middle ground between consistency and practicality,
it is, as shown, not possible to be completely prescriptive. The Carbon Trust has therefore
written a Code of Good Practice, which, however, will not be discussed here.
4.1.2 CARBON REDUCTION LABEL
Building on the PAS 2050, the Carbon Reduction Label ‘offers companies a way to display their
products’ carbon footprint information consistently, credibly and with a commitment to reduce the
footprint over time’ (The Carbon Trust, 2008: 7). It is set up to meet the market needs for carbon
emission visibility demanded by both producers and consumers. With their own words it
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“addresses businesses’ need to better understand how their products and supply chains impact carbon
emissions and to respond to growing consumer demand for carbon information and low-carbon
products” (The Carbon Trust, 2008: 2).
For companies to use the label they have to be certified by the Carbon Label Company.
Furthermore, the Carbon Label Company requires that companies reduce their carbon
emissions over a two year timeline. If not, the companies will loose their certification (The
Carbon Label Company, 2009)
The graphics of the Carbon Reduction Label includes at least the carbon emissions per unit
and the statement “We have committed to reduce this carbon footprint”. Apart from this there are
three optional elements:
“An educational element explaining how the footprint is created. This could explain whether the
measurement includes GHG emissions associated with food preparation or the washing of a
garment, for instance.
Product comparison information between different items produced by the same company and
within the same category.
Customer action tips on appropriate products, empowering consumers by showing them how they
can reduce emissions when using, preparing or washing the product, for instance.”
(The Carbon Label Company, 2009)
At the moment there are a only 21 companies publicly displaying their carbon footprint (The
Carbon Trust, 2008: 19). The figure below shows an example of a Carbon Reduction Label.
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Figure 2: Continental Clothing (The Carbon Trust, 2008: 27)
4.2 CRL analysis
Looking at the description above, with the presented theory in mind, it is clear that the Carbon
Label Company puts to use the logic of information regulation to influence companies to
reduce their carbon emissions. The Carbon Reduction Label makes it possible for the
consumer to make an informed choice based on products’ carbon emissions. Assuming
consumers prefer low carbon products, it will affect companies towards reduction of carbon
emissions.
This logic, however, presupposes almost universal use of the label, which is at present not the
case. It is therefore pivotal to deduce the rationale for companies to join the Carbon Reduction
Label. First, calculating carbon emissions specific to every stage of the products enables
companies to locate ways to reduce their carbon emissions, and thereby also reduce their costs
of production. Second, the Carbon Reduction Label provides the means for companies to
credibly display their efforts to reduce their product’s carbon emissions. The carbon Reduction
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Label serves as a symbol of the company’s commitment to reduction. Third, and most
importantly, the label makes it possible for companies to differentiate themselves form each
other, and thereby produces a race to the top, where companies strive to lower their carbon
emissions as much as possible, to have the product with the lowest carbon footprint.
These marketing benefits necessitate high credibility of the Carbon Reduction Label. The
Carbon Label Company has therefore set a standard requiring companies to reduce their
products’ carbon emissions. Companies not complying is sanctioned though expulsion, which
ensures credibility.
Contrary to the marketing benefits the method for measuring, the PAS 2050, causes
administrative costs conflicting the rationale for joining. Measuring product carbon emissions,
as described by the PAS 2050, is a challenging task, compared to measuring a company’s
overall carbon emissions, as used in the EU ETS. In the overall measure you simply sum up the
onsite fuel and electricity consumption and the use of transport and convert the figures to CO2.
On the other hand, to calculate the carbon emissions of a single product, as described above,
you need to divide your emissions between your products and include indirect emissions
discharged by your suppliers and the consumer. This is not only difficult and costly, it might
also be unattainable, because it requires the willingness from all parts in the supply chain to
cooperate, which might not be in their individual rational interest. Even though the PAS 2050
in some instances draws on existing codes, ISO and GHG, the conclusion stands that the PAS
2050 is very comprehensive and costly for companies to adopt.
Following this, it is essential to determine the uncertainty of the associated costs. If the label
does not become prevalent the marketing potential will be lost and the only use of calculation
is an internal search for carbon efficiency.
4.2.1 LOGIC OF RATIONALITY
In summery, joining the Carbon Reduction Label rests on a cost-benefit analysis of the costs of
measuring compared to the marketing potential it might bring. The cost-benefit analysis,
however, differs in accordance to the phase of the label: Start-up phase compared to complete
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phase. Furthermore, the cost-benefit analysis is influenced by the specific product’s level of
public attention (high or low) and its degree of measurement complexity (high or low).
In the start up phase, characterized by few members, simply using the label is a marketing
benefit, because it symbolises a company’s good intentions. Another benefit the ‘first movers’
receive is valuable knowledge of measuring. However, with only a few members it is difficult
for the consumer to analyse whether the specific amount of carbon emissions is high or low,
because of the relatively few opponents to compare with. This reduces the overall marketing
potential. Furthermore, if the label does not succeed, the costs of being a first mover will be
lost. Being a ‘fast second mover’, on the other hand, you still receive a great share of the initial
benefits, but greatly lower the uncertainty of loss.
In the complete phase, characterised by many members, it would be rational either to lower
your carbon emissions as much as possible, or not at all and thereby exit the Carbon Reduction
Label. If you undertake costs to reduce your carbon emissions, the highest payoff in marketing
potential will be obtained by being the lowest polluter. Looking at the opposite logic, if you are
at the bottom of the list in your specific category, you would be better off not displaying your
carbon emissions at all. In the long run the Carbon Reduction Label will therefore not be
efficient in regulating the low performers; they are better off outside the label.
Looking at different products, it is irrefutable that high complexity of the product greatly
increases the costs of measuring its carbon emissions. The figures below show the life cycle of
a complex and a simple product, respectively. For some sectors of products, the costs of
measuring might greatly exceed the marketing potential the label brings. It is therefore not
evident that the Carbon Reduction Label is suitable for regulating all sectors.
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Figure 3: Boots Botanics shampoo (The Carbon Trust, 2008: 11)
Figure 4: Innocent’s smoothie (The Carbon Trust, 2008: 11)
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Lastly, the public attention, determining the marketing potential, is not a fixed size. There may
be sectors with low public attention such as raw material extraction. In such cases it would be
irrational to undertake the costs of measuring and reducing carbon emissions; at least if based
only on the Carbon Reduction Label.
In conclusion, the Carbon Reduction Label is best suited at regulating companies, whose
products are of low complexity and high public attention. Furthermore its great force lies in
providing incentives for the high performers, but, because the label is voluntary, there are on
the contrary little incentives for low performers to join the label in the long run.
It is therefore obvious that the Carbon Reduction Label is not able on its own to regulate all
possible polluters.
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5. EU Emission Trading Scheme
As with the Carbon Reduction Label above, we will start with a short presentation of the
characteristics of the Emission Trading Scheme before moving on to the analysis.
5.1 The system in action
The European Union’s Emission Trading Scheme (ETS) is a regulation approach that allows
companies to trade emission allowances with each other and thus provide an attempt towards
an efficient allocation of emissions to the industries where change would be most costly. It is
by far the largest emission trading scheme in the world and currently covers more than 10,000
installations in the energy and industrial sectors1 which are collectively responsible for close to
half of the EU's carbon emissions and 40% of its total greenhouse gas emissions (Wagner,
2004: 12; European Commission, 2008).
To compensate for emission variances from year to year caused by changes in weather, the
emission allowances under the ETS are given as part of a series of years at a time; the so-called
trading period. The first part of the scheme, the very first trading period, took place from
January 2005 to December 2007, the second from January 2008 to December 2012. Within
each of these trading periods, the affected companies can also bank and borrow, meaning that
a unit of allowance in 2009 can be saved (banked) and used in 2010 or borrowed and used in
2008. In general, interperiod borrowing is not allowed, but it is accepted to save allowance
units from one period to be used in the next (Stauffer, 2009).
5.1.1 ALLOWANCES
The actual granting of allowances to the specific operators is done by the national governments
of the EU, but the overall emission cap and the proposed national allocation plans (NAP) on
an industry level do need to be approved by the commission (European Commission 2009).
The governments are also responsible for the tracking and validating of the actual emissions
against the assigned amounts. The companies may reassign or trade their granted allowances
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1 As per part I of the scheme the following are covered: combustion installations with a thermal input above 20MW, mineral oil refineries, coke ovens, production and processing of ferrous metals, mineral industry (cement clinker, glass and ceramic bricks) and pulp, paper and board activities.
in a number of ways: First, they can move them between operators still within the same parent
company (this includes cross-border reassignments). Second, they can trade privately using a
broker as mediator, or third, they can use one of the climate exchanges in Europe. The latter
works in much the same way as a stock exchange; buyers and sellers are matched by the
current market price. Further, the regulation allows companies to trade projects that reduce
carbon emissions in completely the same way as the actual emissions; this includes projects in
developing countries. As the EU ETS is designed to be more or less compatible with the Kyoto
Treaty, this means that if a project reducing 1 tonne of CO2 is certified by the UNFCCC
(supervisors of the Kyoto Treaty) it will count as a EU Allowance Unit of 1 tonne of CO2 and
can be traded as such on a one-to-one basis (Carbon Finance, 2008; COP7, 2001).
The aforementioned allocations have changed somewhat as the ETS regulation has matured.
The phase 1 allocations were higher than the actual emissions in 2005 (Parker, 2008: 6).
However, the objectives here were quite modest in terms of reduction (only 1-2% in the EU) as
the main goal was implementation (Ellerman & Joskow, 2008: 7). Further, even with over-
allocation of allowances the emissions were lower than forecasts by 3-4%, which at least
partially was caused by the ETS’s putting an additional price on carbon although it was still
very little (Buchner & Ellerman, 2007). By phase II, the general emission cap was 6% lower
than 2005 levels (European Commission, 2006).
5.2 Analysing the European approach
The Union’s Emission Trading Scheme provides a regulation scheme based on distinct
command-and-control sanctions. By demanding that the companies of the sectors included do
not pollute more than the emission allowances allocated to them or acquired through purchase
or emission-reducing initiatives, the scheme face problems very much different from the private
scheme of Carbon Reduction Label introduced in the previous chapter.
Two major critical concerns have been raised about the ETS; volatile prices and windfall
profits. The first of these emerges from the fact that the price of emission permits rose by a
factor of three within half a year of phase I, and declined to almost zero a year later (Cozijsen,
2009). This is very problematic as the system was unable to deliver stable incentives to the
companies involved (Ellerman & Joskow, 2008: 15). However, the energy sector has always
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been fairly volatile and it is expected that minimum prices on emission permits and a more
widely used system of banking and options for future emissions will moderate some of the
volatility (European Commission 2009).
The concern of windfall profits is to some extent related to the price volatility. As electricity
prices skyrocketed in 2005, some consumers found it unfair that even though companies
received permits for free, the consumers were charged extra, the windfall profit (European
Commission 2009). Studies have shown that companies actually were able to pass on a
significant part of the market cost of their free permits to the consumers (Sijm et al., 2006; The
Carbon Trust, 2006), and consequently it has been much debated whether the permits should
be auctioned off instead of given out for free. To further push some of the costs on to the
producers, thus giving them incentives to cut emissions, it has been suggested to advance
deregulation of the European electrical market to let market forces push the fraction of costs
passed on to consumers towards the efficient market equilibrium (Ellerman & Joskow, 2008:
25, National Bank of Belgium, 2006).
The main point from these two critical reviews of the ETS is the fact that the regulation is very
much uncertain on future changes. This is extremely problematic for the possibility of a
successful cut in emissions since the strict command-and-control scheme with its specification
standards already limits the degree to which companies can outperform the market on
reducing pollution. Of course they do have the option of investing in greener technology to
reduce their spending on carbon allocations, but with highly volatile prices and very low prices
on carbon allocation, the incentives to do this have been more or less not-existing. This was
shown very vividly when, Ecofys, an independent consultancy, in an assessment of the NAPs
waiting to be approved for phase II found that the majority were not sufficiently strict as the
suggested caps were higher than independently estimated business-as-usual emissions and only
really cut emissions compared to the higher official business-as-usual projection (Rathman et
al, 2006). After this report, eleven of the first 12 NAPs were rejected. Further, the commission
started infringement proceedings against six countries2 for not submitting their NAPs within
deadline; an example of a market with too many carbon allocations and too volatile and low
prices on carbon to really induce companies investing in green technology.
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Mads Nørgaard Jørgensen & Tobias Rune Caspersen
2 Austria, Czech Republic, Denmark, Hungary, Italy and Spain.
Further, as the scheme has an inclusion of every single company within the chosen sectors, the
possibility to get a price premium through differentiating the company from its competitors in
the sector is very little. Again, the option of investing in greener technology and carbon
reducing projects other places is present but without a reassurance from the regulators on how
the scheme is to develop, such investment is simply not rational for companies; the risk of
investing in expensive technology that will put you worse off than your competitors who
simply buys cheap allocations permits, is to high.
Another point of interest in an assessment of the ETS from our parameters is the choice of
reference for reducing emissions. As the ETS is designed at least partially as the European
response to the Kyoto Protocol the base year of 1990 is predominant. This does bias the
country allocation slightly towards punishing the countries initially not polluting very much in
1990, but the Kyoto Protocol does incorporate most of these issues and the alternatives with
continues new reference year would have been far more biased (The Carbon Trust, 2006: 8).
However, the actual allocation of carbon permits still needs to be based on individual plants,
which is a very bureaucratic process. Several countries uses benchmarking in the sense that
allocation of permits are done according to the least polluting plant of that particular sector.
This does provide an ability to intervene for the regulators to include special characteristics of
all sectors, but as mentioned it is a very tiresome and intrusive process that renders the
companies at the mercy of bureaucrats who might not have sector experience. The result in the
Netherlands was an abandonment of the benchmarking attempt after 125 different benchmarks
had been developed (Wagner, 2004). The workload was simply not cost-effective and the
scheme has yet to show such a thing as an efficient and objectively fair carbon allocation to
individual plants. So far member countries of the EU are still protecting their own economies
where possible (Buchner & Ellerman, 2007: 18).
As mentioned above, the commission has proposed a number of changes to the regulation.
Among these are centralised allocation of permits by the EU and a higher proportion of these
to be auctioned instead of given away for free. The objective is to minimise intra-union
differences and price volatility as well as pushing for even higher economic incentives for
complying with the policy of non-pollution investments (Kanter, 2008; European Commission,
2007). However, the changes have not been passed as legislature and the effects can take place
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from January 2013 at the earliest. More recently three non-EU members have joined the ETS3
and the airline industry has been included which is expected to be in effect from 2012
(European Commission, 2005; EU Business, 2007). The long-term goal is to include all
industries and all greenhouse gases (Dimas, 2005).
This last notion might not be consistent with the desire to create an objectively and efficient
trading scheme without unnecessary uncertainty about future changes and interventions. In
general, the more the commission interferes and changes the regulatory framework the more
uncertainty it creates within the companies and the fewer long-term green investments will be
rational. But several of the sectors involved are absolutely critical for the functioning of states.
So even though market efficiency would make it most profitable to reduce emissions in the
sectors where it is cheapest to do so, some sectors simply need to be of a certain size no matter
the polluting effects. It is a strong statement, but sectors such as energy are vital for the
infrastructure and security of modern states. The point here is that sectors need to be
differentiated by the commission and member states to exclude the risk of jeopardizing security
even though it does limits the perfect allocation of emission permits on a purely environmental
and economic basis.
The main conclusion here is that the huge number of emission permits available during the
first trading periods, the uncertainty of which sectors faces intervention by commission
regulators, which sectors in which countries can pollute how much and the extreme volatility
in prices (even for a normally volatile product) make it very difficult for companies to plan and
profit from the expensive long-term green investments (Ellerman & Joskow, 2008: 42).
However, the ability to trade permits does provide for some room for innovation and product
differentiation if the aforementioned problems are solved.
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3 Norway, Iceland and Liechtenstein.
6. How to regulate carbon emissions
Following the two analyses we find it important to reassess the key challenges in order to
deduce some general guidelines for how to regulate carbon emissions, which is the topic of the last
section.
The analysis of the Carbon Reduction Label clearly showed the great potential of information
regulation. The label is however still to show its capabilities. The race to the top, where
companies strive to outperform each other on low carbon products require a high company
participation. To achieve this, it is important to further lower the costs of compliance or
increase the benefits of participation, in view of our assumption of rationality. Further the
analysis concluded that the label would not be able to restrain all carbon dischargers, because
of different circumstances.
On the contrary, the ETS draws on the principles of command-and-control regulation and is
therefore in a position to demand reduction of carbon emissions. However, as the analysis has
showed the ETS faces other problems, the greatest being how to distribute the carbon
allowances to provide incentives to lower the carbon emissions instead of buying cheap
permits. To do so the Commission has declared that more allowances will be auctioned instead
of given away for free. The most important, as far as our argument goes, is however to provide
a stable platform for the companies to act upon. If the uncertainty about future regulation is
too high, the companies will be reluctant to invest in low carbon technology.
6.1 Perspectives on regulating carbon emissions
Looking on from the conclusions of the two separate cases, we still need to be mindful of the
assumptions forming the foundation of the theories and our causal claims. Based on the
theoretical background and the concrete rational incentives for companies involved in the
Carbon Reduction Label, public support for first movers is a necessity if technological
breakthroughs and green investments are to be profitable. And if a certain type of action is not
profitable, either by direct income or a more valuable image, these investments simply will not
come. As the theoretical basis for this is fairly general in scope and the Carbon Reduction
Label exemplifies this lack in a concrete private regulation scheme, we feel confident that this is
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in fact a general tendency for private approaches within climate regulation. Whether such
public support should be in the form of direct economic incentives or a very long-term legal
framework is not a question to be answered by this analysis; both approaches fulfil the
requirements, and both would be a step in the direction of a more hybrid regulatory framework
taking in elements from the other side of the private/public continuum of regulation power.
If we turn to the ETS there are some conclusions, which seem to be somewhat more general in
scope than just an application on the European continent. Even though it is primarily a public
regulation scheme, and an intergovernmental one of those, it does possess trends towards
setting up the framework for companies to make their own decisions on whether it is profitable
to cut emissions or buy redemption through allowances from elsewhere. However, as the ETS
seems to be the only comprehensive command-and-control scheme within intergovernmental
climate regulation and it still bases itself on setting up rational incentives for companies,
certain lessons are apparent for ETS as well as other intergovernmental schemes trying to
commit members on different levels. The market functions of such schemes are clever in the
sense that too much bureaucratic morass is expensive, inefficient, straining on inter-members
relations and simply unnecessary. As we have seen, the problems of the ETS are mostly in the
form of balancing market versus government interference. It is a dilemma and as concluded
above, some sectors are so critical that market regulations are not good enough. Further, even
though some of the slow diplomacy is removed, we still see fierce arguments over allocations.
Fixing these problems in intergovernmental regulation in general will, based on theory and the
ETS case, result in a trade-off with market efficiency. Elaborate specifications as regulation
standards are not necessarily the answer to this trade-off; the quest is for consistency so the
market knows what to expect from regulators and thus can invest accordingly. Looking only at
the effectiveness of regulation, deciding whether to allocate centrally or maintaining it at
member state level is not that important; the critical point is to make a decision, doing it fast
and sticking to it.
To sum up, intergovernmental regulation probably will need the use of incentives to regulate
private action since no intergovernmental body so far has been capable of merely trying to
solve the climate regulation problem in any other way. Learning from the private schemes,
market incentives are critical for the success and a part from the aforementioned public support
for first movers in climate investments, the best thing the intergovernmental regulatory body
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Mads Nørgaard Jørgensen & Tobias Rune Caspersen
can do to create the efficient framework they aim for is to agree on long-term policies and stick
to them. Security for green investments above all else.
In this way publicly induced frameworks for private initiatives can take the form of either the
all-including type, as the ETS, covering everything and regulating the big picture, while the
same basic thinking also is behind the Carbon Reduction Label type of regulation. In the latter,
there is just the opportunity to differentiate even more by much looser standards and thus
bigger room for innovation; a greater reduction and a marketing potential not available at the
ETS type regulation. The two types can learn from one another as mentioned above, but they
still serve different purposes; one based on clear standards in production and one based on the
informed consumer choice. They do seem fairly complimentary with regards to climate
regulation (Reinicke, 1998: 219; Prakash & Potoski, 2006, 74; Gunningham, 2007: 207).
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7. Conclusion
To answer the question of how to regulate carbon emissions our analysis has studied two
contrasting regulative approaches. The first being a private regulation and the second an
intergovernmental one. The reason for this follows our argument that the nature of climate
change as a world wide problem, which delimits the regulative approaches to either private or
intergovernmental regulation.
The analysis builds on a theoretical platform of advantages and disadvantages of regulative
methods, derived from our assumptions that companies are rational, and therefore act
according to economic incentive structures, and that a regulation, to be effective, needs to
enforce its strategy. The theoretical parameters deduced are: standards, sanctions and
marketing potential. With these in mind the advantages and disadvantages of the two
regulative approaches have been assessed.
Our analysis has clearly showed that climate change is a relatively new field of policy. Both
regulative approaches show signs of being in a start up phase, and therefore have some critical
aspects to improve.
The Carbon Reduction Label, representing a private approach, labels product’s carbon
emissions and thereby puts to use the logic of information regulation to influence companies
to reduce their carbon emissions. The biggest force of the label is its possibility of producing a
race to the top, where companies strive to outperform each other by lowering their carbon
emissions. This requires high participation, which is not the case at the moment, due to three
obstacles. First, high costs of measuring a products carbon emissions; second, high uncertainty
about future public regulation; and third, some sectors may not benefit enough from the
marketing potential.
The EU Emission Trading Scheme, representing an intergovernmental approach, is based on
command-and-control regulation. It demands companies not to pollute more than their
allowances for carbon emissions allocated to them or acquired through purchase or emission-
reducing initiatives. In theory this opens possibilities for the market forces to find the most
efficient ways of cutting carbon emissions, but with too high uncertainty about future
regulation the reductions have been relatively modest. This is very problematic as the system is
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unable to deliver stable incentives to the companies involved making them reluctant to invest
long-term.
Owing to the fact that the cases in question are both general in scope and not sector-specific
regulations, we have argued, that our finding within reason can be used outside their own
specific context. The last chapter has therefore put forth some general lessons. However, we do
not argue that the two cases are the only suitable regulative approaches, but together they cover
many of the basic elements of regulating a policy field such as climate change.
We recommend that public support for first movers in climate investments are needed to cover
their disproportionate costs. Other than this, the best thing the intergovernmental as well as the
private regulatory body can do to create the efficient framework they aim for is to agree on
long-term policies and stick to them; certainty for investments are by far the most pressing
issue given our focus on companies’ rationality and the power of regulation.
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