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6Emissions TradingPolicy Briefs

International Trade andCompetitiveness Effects

E m i s s i o n s T r a d i n g P o l i c y B r i e f s

International Trade and Competitiveness Effects

Objective and Audience

The overall objective of this series of Policy Briefs is to provide those in the policy system who deal with thedesign and implementation of emissions trading schemes with easy-to-read documents that allow them to under-stand some of the key issues, what theory and (especially) experience have to offer in clarifying choices and theirimplications. This Policy Brief deals with Competitiveness. As with other economic policy instruments, introduc-ing an emissions trading scheme is likely to affect more than just the internal allocation of goods and factors inan economy. In a globalising world, it will also influence the trade pattern of an economy and it will result inchanges in competitiveness. These indirect effects depend on a number of variables including the design of theemissions trading regime and also the form and degree of integration of an economy in the world economy.

The key audience will typically have little or no background in economics, but will be wise to the ways in whichpolicy evolves and is shaped. The text limits the use of technical language, of graphs and equations, and any mate-rial that might intimidate the non-specialist. Boxes are used to highlight case studies or interesting examples.

It is informed by the research papers presented at the Concerted Action on Tradable Emissions Permits (CATEP)workshops — these are available on www.emissionstradingnetwork.com and have been synthesised in Convery etal. (2003), Haites (2003), Lefevere (2003) and Peterson (2003). They will also be published in synthesis form bythe OECD in 2004.

The 5th Framework DG Research CATEP (Concerted Action on Tradeable Emissions Permits) network projecthas held a series of workshops over three years bringing together experts from policy, academic, research andindustry fields to discuss the latest thinking, research and experience on Emissions Trading as the EuropeanDirective came closer to fruition. The Network consisted of eleven partners and this series of policy briefsreflects and synthesises the results of the workshops organised by the following topics:

1. Issues in Emissions Trading - an Introduction 2. Allocating Allowances in Greenhouse Gas Emissions Trading3. Emissions Trading Regimes and Incentives to Participate in International Climate Agreements4. Institutional Requirements5. Linking Emissions Trading and Project-Based mechanisms 6. International Trade and Competitiveness Effects

A complete listing and links to all papers presented at the workshops and further details about the partners andthe CATEP network can be found on the website: www.emissionstradingnetwork.com.

We gratefully acknowledge the European Commision’s financial support of these Policy Briefs and the entireCATEP (EVK2-CT-2000-200003) project.



1. Introduction

This policy brief identifies the major elements that determine the trade and competitiveness effects of the intro-duction of an emission-trading regime. These effects depend most of all on the breadth of the emissions tradingsystem. One scerario is a national trading system that functions independently of other economies adopting sim-ilar policies. The effects of such a unilateral policy are similar to those of other unilateral economic policies suchas taxes on emissions. The American SO2 -trading or the Danish CO2 emissions trading system for electricity pro-ducers are examples of such systems. The second type of system is the EU-trading scheme or the proposedKyoto-trading scheme for greenhouse gases. They both involve a larger number of economies in the same trad-ing system and the policies will have repercussions on economies not participating, as opposed to the nationalscehemes where such repercussions are negligible. Lastly, a global emissions trading system would cover alleconomies. The trade and competitiveness effects of such a system are quite different from those of a unilateralsystem in a small economy. This policy brief will discuss these three cases consecutively and identify the differenttrade and competitiveness effects. It begins with an outline of some common reactions of an economy to theintroduction of emissions trading.

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2. Allocation Effects of Emissions Trading

The introduction of an emissions trading system — a ‘cap and trade’ or a ‘baseline and credit’ scheme (see PolicyBrief Number 2) introduces a limit on emissions for the first time. The allocation of permits establishes a legalright to emit but also an obligation to own permits for certain emissions. It thus creates a market for emissionsthat has not existed previously, and it establishes a market price for emissions.

This new market adds a new cost element for those subject to the emission-trading regime. Emitting GreenhouseGases (GHG) or SO2 , for example, will now have a cost, namely the price of the permit to be held if emissionsare to be legal. Firms or households subject to a permit requirement have two ways to avoid these costs: they canreduce the emissions by changing their activities towards lower emission intensity; or they can use alternativeinputs that are not subject to the emissions trading. In the case of CO2 , this is particularly clear since most CO2emissions are directly linked to the burning of fossil fuels. Avoiding CO2 emissions, therefore, means using lessfossil energy in the production process or switching to CO2 -free energy sources (e.g., energy from biomass, solaror wind energy) or to fossil energy with a lower CO2 content (e.g., from coal to gas).

Higher costs in the production processes will increase prices, especially of those goods that are most emissionintensive. Therefore, one of the most basic effects of an emission-trading scheme is the change in relative pricesof the goods produced. In the case of CO2 , energy-intensive goods become more expensive compared to goodswith low-energy intensity. In addition to this relative price effect, there will possibly be a small reduction in over-all production, as the limited emissions cannot be completely substituted by other factors of production.


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These effects in a closed economy will lead to a restructuring of demand towards less emission-intensive goods,and thus a restructuring of the economy. Emission-intensive sectors will shrink and production factors (capitaland labor) will move towards less emission intensive sectors. Such an economy with an emissions trading schemewill eventually have lower emissions and an industry structure oriented more toward low emission productionprocesses and commodities.

Such domestic adjustments will also have repercussions on the external affairs of an economy. Trade in goods andservices constitutes an important part of the exchange of an open economy. The other part is the movement ofcapital and labor, with a dominating role of capital as foreign direct investment (FDI). The impact of an emis-sion-trading scheme on an open economy depends, among other things, on the size of the economy relative tothe rest of the world, and the extent to which foreign governments follow a similar policy for regulating theiremissions.1 These two aspects define a number of cases, which need to be distinguished. Emissions trading canbe introduced unilaterally, multilaterally, or as a global scheme. The size of an economy only matters in the caseof a unilateral scheme. In the multilateral and global cases the group of countries is normally sufficiently largethat their ET-scheme affects world market prices. This situation cannot occur in the case of a unilateral emissionstrading system in a small country. Comparable effects can occur with respect to FDI. For a small country the rateof return on capital on world markets will remain unaffected, whereas in the ‘large country’ case world interestrates will respond to the ET-scheme and will thus lead to different trade and competitiveness effects. The differ-ent cases will be discussed in the following sections.

Whereas the changes in trade patterns and capital flows can clearly be defined, for example, by looking at tradeflows and market shares, it is not so clear how these changes affect the competitiveness of an economy.Competitiveness is a concept that has many different meanings to different people. In order to avoid confusionin the debate, competitiveness needs to be defined.

Defining Competitiveness

Among the many notions of competitiveness, three types should clearly be distinguished: The first concerns competi-tiveness of companies relative to their competitors in a particular market. The second is concerned with the competi-tiveness of different industries within an economy. In trade theory this type of competitiveness is also called compar-ative advantage. The major buzzword for industrial competitiveness in climate policy is ‘carbon leakage’, i.e., the degreeto which comparative advantage is shifted across economies by policy measures. Finally, there is the notion of interna-tional competitiveness, which is theoretically not well-founded and empirically hard to measure (see boxes 1 and 2). Thefocus of this policy brief will be on the second notion of competitiveness, i.e., the sectoral success on foreign markets,which is mainly concerned with the performance of producers. In addition, international competitiveness in terms ofproviding a satisfying per capita income for the citizens of an economy will be referred to.

1 This could happen within a multilateral emission-trading scheme or with similar measures such as emission taxes.




Choice of the Benchmark

The evaluation of emissions trading can only be done by comparing an emission-trading scheme with some coun-terfactual. This counterfactual situation could be a world without any policy, e.g., without any climate policy whichgoes beyond the current state of regulation. Such a comparison will identify the effects of the introduction of anemission-trading regime. An alternative approach is to assess the advantages of emissions trading by comparingit to a policy alternative that achieves the same result with a different policy instrument. This approach essential-ly assesses the replacement of one policy instrument by another one. This policy brief will concentrate on thefirst, but mention some results for the second approach.2

2 For a summary see OECD (1999).

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Box 1. Notions of Competitiveness

Competitiveness can be viewed on three levels: u Competitiveness of a firmu Competitiveness of an industry or a sector of the economyu International competitiveness, i.e., competitiveness of an economy

Competitiveness at the enterprise level concerns the success of an enterprise vis-à-vis its competitors in a market. This successis driven by two types of competitive advantages: lower costs and product differentiation (Porter 1985). These advantages overdomestic and foreign competitors essentially translate into a firm’s long-run profit performance. Hence an ex-post indicator forcompetitiveness at the firm level is sustained profitability.

Competitiveness at the industry level focuses on the performance of an industry on world markets. This is sometimes definedas the competitiveness of domestic industry in relation to the same industry in other countries (Jenkins 1997). Similarly to com-petitiveness at the firm level, industry competitiveness compares all firms in an industry of one country with those in the restof the world. This notion is often intended by representatives of firms and industries that are concerned with their own per-formance compared to that of their foreign competitors. The appropriate indicator for this interpretation of competitivenessare world market shares for the domestic industry in question.

A different idea of competitiveness at the industry level is derived from an economy-wide view as compared to an industry viewas above. In an open economy some sectors are more successful in exporting goods than others. This comparative advantagedepends on a number of factors such as relative factor prices, taxes, or prices of emission permits. From the point of view ofthe whole economy, the question is which sector is most successful in generating export revenues for financing the desired com-modities to be imported. The standard indicator for this sectoral competitiveness is the so-called ‘Revealed ComparativeAdvantage’ (RCA) (see Box 2). It measures the net exports of an industry relative to the export performance of the economyoverall.



As discussed above, the unilateral introduction of an emission-trading regime in a small country introduces a pricefor a service that has previously been supplied for free. A CO2 emission permit turns free CO2 emissions into atradable commodity. Restricting these emissions will lead to a positive price for permits. This, in turn, becomes acost factor for all firms that emit CO2 , with the result that the higher the emission intensity of a firm or an indus-try, the higher the expected costs of acquiring permits.

Emission-intensive industries will experience an increase in their cost of production, which would raise prices ina competitive environment. For example, if the CO2 -trading regime of the EU resulted in a permit price of 20€/tCO2 , then the unit cost in the metal industry is expected to rise by 3.6 percent, and by 1.4 percent in the chem-icals industry (Capros et al. 1999). This cost increase can in part be passed on to consumers who will adjust theirconsumption pattern towards less emission-intensive products. Hence, the domestic competitiveness of emission-intensive sectors will be reduced while that of low-emission industries improves.

The cost increase will also influence the competitive position of industries in the world market. In a unilaterally intro-duced emission permit system the cost changes are unlikely to affect world market prices. Therefore, domestic indus-tries faced with higher costs will need to compete with foreign competitors at unchanged world market prices. As a

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3. Unilateral Introduction of Emissions trading

Box 2. International Competitiveness

International Competitiveness is a controversial concept involving several aspects. The most pronounced negative statement oninternational competitiveness is from Paul Krugman (1996) who argues that ‘competitiveness is a meaningless word when appliedto national economies. And the obsession with competitiveness is both wrong and dangerous’. He argues that economies do notcompete with each other in a zero-sum game but engage in jointly beneficial trade in goods and services.

Another interpretation of competitiveness addresses the degree to which a country can, under free and fair market conditions,produce goods and services which meet the test of international markets, while simultaneously maintaining and expanding thereal income of its population in the long term. The OECD uses unit labour cost as the main indicator (OECD 2001). Similarly,the EU identifies competitiveness with high levels and rapid growth of productivity, along with high levels of employment(European Commission 1997).

There are no clear-cut indicators for measuring international competitiveness. The World Economic Council (IMD, 2003) classi-fies 286 criteria, which describe competitiveness. The EU focuses on productivity growth and employment. Essentially these indi-cators boil down to the level of per capita income that can be produced in real terms.

A different idea of international competitiveness (similar to the notion of firm competitiveness) is based on locational competi-tion. Countries compete for mobile factors of production— capital and labor —that tend to move to that economy where theyexpect the highest return (Siebert 1995). This concept refers to the productive environment that an economy can provide.Infrastructure, legal security, environmental quality, and many other factors contribute to this type of competitiveness. This con-cept is difficult to measure empirically, but long term capital flows and labor migration give an indication about possible changesin locational competitiveness.



5

5

0

2.5

b US$

Direct Regulation Emission Trading

Source: Johnstone (1999).

Figure 1. Annual Cost Estimates ofPhase II of SO2 Tradable Permits

($ US billion)

Range of Estimates

consequence, marginal suppliers who have been exporting may not be able to compete on world markets and reduceemissions simulataneously. Even industries that did not export to a significant degree will face more imports andincreased competition on domestic markets. Given the cost impacts of the EU CO2 emissions trading regime thesetrade impacts are likely to be small, although for some firms in highly price sensitive markets larger negative impactsare possible. However, compared to exchange rate volatility which also imposes a risk for competitiveness, theexpected effects are comparatively small as the cost effects above indicate.

Emissions Trading versus Direct Regulation

Thus far, the cost of introducing a permit system has been compared to a situation without any regulation. Insteadof having a benchmark without any emission controls, one can imagine a benchmark in which the desired emis-sion level is achieved by the use of direct regulation. The emission-trading scheme would then replace the com-mand and control policy. Theory already predicts that an emissions trading system should be less costly than directregulation since it enables an efficient allocation of abatement activities.

Empirical studies have confirmed this prediction, although the gains from substituting direct regulation of emis-sion sources by emissions trading vary widely (Johnstone 1999). Different studies in the USA for several pollu-tants found ratios of the costs of direct regulation to the costs of tradable permits in the range of 1.07 to 22.00.Compared to these studies (mostly from the 1980s) with a focus on planned emissions trading systems, studies ofactual systems have narrowed this range of numbers. For the SO2 tradable permit system in the USA estimatesof cost ratios are now in the order of about 2.5. Figure 1 illustrates the difference in the range of annual costsunder direct regulation to the range with trading.



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National trading schemes, such as the American programmes for SO2 or lead, focus on industries that serve pre-dominantly local markets without significant international competition, and as such they do not impose strongtrade or competitiveness effects. Emissions trading schemes in areas where international competition is strongtend to be schemes that are coordinated among several countries. Two prominent examples are the EU emissionstrading for energy-intensive installations which is to start in 2005 and the trading scheme which is planned for2010 among the Annex-B countries of the Kyoto Protocol. These multilateral approaches are both put forwardby the need for a coordinated action to combat global externalities and the desire to limit adverse competitivenesseffects to the lowest degree possible.

The basic allocation effects described in section 2 now hold for all economies within the multilateral tradingregime. In particular, all firms in all economies face the same permit price if cross border trades in permits areallowed. However, this does not impose the same cost effect on industries in different countries since, as in thecase of CO2 permits, the CO2 intensities of economic sectors vary widely between economies. Figure 2 illus-trates this for several sectors in Western Europe (WEU), the USA and China. Even in Europe and the USA —both developed market economies — emission intensities can differ significantly as is evident in the chemicals,pulp and paper sector or the transport sector. Hence, the economic impacts can differ within the same emission-trading regime.

4. Multilateral Emissions Trading Schemes

Non-energyIntensive

Iron, Steel,Metal

Agriculture TransportChemicals,Pulp and Paper

0.70

0.60

0.50

0.40

0.30

0.20

0.10

0.00

Source: World Bank (2002), IEA (2002).

WEU

USA

China

Fig. 2. CO2 Intensities in Selected Countries and Industry Sectors (1997, in kg Carbon/US$)



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Trade Effects

Changes in international trade structures take place within the group of countries participating in the tradingregime, and between the trading group and the countries outside the group. The dominant trade effect, however,will occur between the trading group and those outside. The permit trading system raises the prices of emissionintensive goods at the national level. Yet, higher prices in these countries will also create additional incentives forproducers not subject to the trading regime as they gain competitiveness in energy-intensive goods.

The changes in exports can best be illustrated for the case of CO2 emissions trading in the context of the KyotoProtocol. Simulation studies of a permit trading regime among the Annex B-countries lead to results that are similarto those shown in Figure 3.3 It illustrates the percentage change in exports of selected industries in Western Europe(WEU), the USA, and China for the case in which the Kyoto reduction targets are achieved with an emission-tradingregime. Exports of energy-intensive sectors such as the iron & steel industry, the chemicals and pulp & paper indus-try, and transport fall by 3 to 4.5 percent in both economies participating in the emissions trading regime. The moreexport-oriented Western European economies would be affected more strongly than the American one.

WEU USA China

6.0%

4.0%

2.0%

-2.0%

-4.0%

-6.0%

0.0%

Iron and SteelChemicals, Paper

Transport

AgricultureLow Energy Intensive

Figure 3. Change in Exports— Kyoto Protocol with Emissions Trading versus ‘No-Policy’

3 The results are based on simulations of the DART-model (Klepper, Peterson, Springer 2003) under the unrealistic assumptions of the USA participating, no supplies of hot air, and without terrestrial carbon sinks. Nevertheless, theyillustrate the basic mechanism at work.



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From an industry point of view it is also important to see how the market share of a given industry changes glob-ally. Figure 4 illustrates the change in market shares of selected industries. The Western European share of exportsof goods with a low-energy intensity on world exports of these goods rises by a little more than 0.1 percentagepoints whereas energy-intensive industries lose between 1 and 1.5 percentage points of world export marketshares. In contrast, the USA lose far less (0.2 to 0.3 percentage points) and China gains a little bit in energy-inten-sive goods. Overall, the effects are comparatively small if one considers that, for example, Western Europeanworld export shares in the energy-intensive sectors iron and steel, chemicals, and pulp and paper are between 35and 45 percent.

WEU USA China

0.5%

-0.5%

-1.0%

-1.5%

0.0%

Iron and Steel

Chemicals, Paper

Transport

Agriculture

Low Energy Intensive

Figure 4. Change in World Export Shares/Kyoto-Trading in 2010, in Percentage Points

Source: Simulation results from DART(Klepper, Peterson, Springer 2003).



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Competitiveness of Industry —Comparative Advantage

Changes in exports or changes in world market shares are not very helpful in identifying the effects of emissionstrading on sectoral competitiveness, or the comparative advantage. An indicator that simultaneously assesses theexport and import performance of a sector or industry is the so-called Revealed Comparative Advantage (RCA).It adjusts for the overall trade deficits or surpluses that are not relevant for competitiveness of industries. Figures5(a) and 5(b) illustrate the RCA for Western Europe and China. They both show the sectors in which each regionhad a comparative advantage, i.e., energy-intensive goods in Western Europe and labor-intensive (and simultane-ously less energy-intensive) goods in China, with no Kyoto commitment and no emissions trading. Emissionstrading will reduce that comparative advantage in both regions. At the same time, sectors with a disadvantage gainslightly. However, there is no drastic change in sectoral competitiveness, i.e., Western Europe remains a netexporter of energy-intensive goods and China a net importer. Apparently, the price effect of permit trading inWestern Europe and the additional cost advantages in China are not large enough to override the other advan-tages in terms of productivity and product quality that determine the competitiveness of these commodities inWestern Europe.

The trade effects of the Kyoto Protocol are not only driven by the permit prices they are also significantly influ-enced by repercussions on the markets for fossil energy. Since the Annex B-economies demand less fossil ener-gy, world market prices for coal, gas and oil will fall, giving industries in Non-Annex B-countries an additionalcost advantage. In fact, since the OECD countries tend to be net exporters of energy-intensive goods— mainlydue to their technological advantage — the Kyoto Protocol distorts international trade flows by giving the non-Annex B-countries an artificial gain in competitiveness in energy-intensive goods which they would not have if allindustries would face the true costs of energy. This distortion is often summarized by the above mentioned leak-age effect which measures the additional emissions in countries not subject to an emission constraint, which areinduced by the limitations on emissions e.g., in the Annex B-countries. The leakage rates have been estimated tobe around 20 percent for the Kyoto Protocol, i.e., 20 percent of the emissions reduced will be additionally emit-ted somewhere else (Klepper, Springer 2003).

International Competitiveness

The focus on comparative advantage in the previous section has revealed that the introduction of a multilateral emis-sions trading regime will result in winners and losers within an economy. In the example of GHG-trading, energy-intensive industries are likely to lose market shares on world markets as they are faced with higher energy prices thantheir non-participating competitors. At the same time low-energy industries within the GHG-trading regime gainfrom a reduced supply on world markets and a subsequent rise in prices of their commodities. Since there are alwayswinners and losers at the same time, the question remains as to how an economy is affected overall.



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Chemicals,Paper

Iron andSteel

0.20

0.15

0.10

0.05

0.00

-0.05

-0.10

-0.15Transport Agriculture Low

Energy

No Policy

Kyoto Trading

Chemicals,Paper

Iron andSteel

0.40

0.40

0.20

0.00

-0.20

-0.40

-0.60

-0.80

-1.00Transport Agriculture Low

Energy

No Policy

Kyoto Trading

Figure 5(a). Western Europe

Figure 5(b). China

Figures 5(a) and 5(b). Changes in Revealed ComparativeAdvantage (RCA) with and without Kyoto-Trading in 2010



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Box 2 shows that there is not a consensus on an appropriate indicator for international competitiveness. Studiesof emissions trading regimes usually focus on real income, real consumption or welfare when they try to assessthe overall effect on an economy. In a multilateral scheme like the Kyoto Protocol, the overall welfare effects ofan emissions trading regime that includes the United States amount to a loss of welfare of about one percent ifthe Eastern European surplus of emission rights is supplied only to a small extent (Klepper, Peterson 2002). Thisslightly negative impact on real incomes is accompanied by a very small slow-down in growth rates of theeconomies subject to the emission constraint. These income effects originate from two adjustment processes.Firstly, the emission constraint reduces the overall input of fossil energy sources, thus lowering total production.The second effect comes from the competitiveness effect in world markets. Most industrialized countries have acomparative advantage in energy and capital-intensive goods, whereas the economies not restricted by the KyotoProtocol usually possess a comparative advantage in labour-intensive goods. The impact of emissions trading inthe Kyoto context now shifts the specialisation of the economies away from their ‘true’ comparative advantage,i.e., the competitiveness of the capital- and energy-intensive sectors declines and that of the labour-intensive onesimproves in the industrialised countries. Hence, the emission constraint effect and the negative competitivenesseffect add up to the total welfare effect.

The above example illustrates how the impact of an emissions trading regime depends on international compet-itiveness effects and on the restrictiveness of the emission constraint. The international competitiveness effects,in turn, are influenced to a large degree by the geographic coverage of the emissions trading. A unilateral tradingscheme for a global externality can produce the largest distortions to international trade and thus the largest neg-ative income effects if the emission constraint is on those factors in which the economy has a competitive advan-tage. In multi-lateral trading regimes this remains true if— as it is the case in the Kyoto Protocol —the group ofcountries are driven away from specialising in their competitive sectors. Only a global trading regime could avoidsuch distortions and negative effects on international competitiveness. In fact, in a global emissions trading regimefor greenhouse gases, leakage towards the developing countries —mostly China and India— would not occur. Tothe contrary, they would be selling emission rights and would be specialising even further in labour-intensivegoods on international markets.



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5. Emissions Trading versus other Instruments

So far the analysis has compared international trading schemes with a situation without controls. For an evalua-tion of the competitiveness effects of an international trading scheme relative to other policy options that achievethe same emission target, one would need to compare the outcome of emissions trading with that of, for exam-ple, a command-and-control type of restriction. The Kyoto targets of the Annex B-countries without tradingwould constitute such a restriction. A system with quantitative targets for each country creates efficiency lossessince the marginal abatement costs are not equalised as is the case with emissions trading. Economies with a com-paratively strict target may face higher marginal abatement costs than economies with a soft target. Since theseabatement costs are not equalised in the absence of emissions trading, meeting the Kyoto targets will create dif-ferent impacts on international and on sectoral competitiveness. Economies with high economic costs for meet-ing their target will lose competitiveness while those with low costs will gain. Simulation exercises for the KyotoProtocol show that Japan and the USA would face the highest abatement costs (Klepper, Peterson 2003). This inturn would mean that moving from a no-trading situation to a trading scheme would lower abatement cost inJapan and the USA and it would enable the other Annex B-countries to sell emission rights, thus also gaining fromthe trading regime. In fact, moving from no trading to trading tends to lower the cost of the Kyoto Protocol toall participants.4

The welfare gain from a move from an inefficient emission policy to emissions trading is also found for theEuropean Union. The Greenbook on emissions trading indicates that extending the geographical and the sectoralcoverage of emissions trading lowers the cost of meeting the emission targets (European Commission 2000).Figure 6 illustrates the estimates of the cost of meeting the Kyoto target without trading, with EU-wide tradingand differing sectoral coverage and with full Annex B-trading. It clearly shows the efficiency gains that can beobtained by introducing trading and by extending the sectoral and geographical coverage. These cost savings willthen immediately influence the competitiveness of industries since the cost of production can be lowered byintroducing a trading regime.

4 There may be rare instances where in one country the costs savings from trading are more than offset by losses fromchanges in trade flows away from the true comparative advantage.


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No Trading amongEU Member States

EU-Wide Tradingamong EnergyProducers and

Energy IntensiveIndustries

EU-Wide Tradingamong all Sectors

Source: European Union (2000).

Full Annex BTrading

10

98

7

6

5

4

3

2

10

Figure 6. Cost of Meeting the Kyoto-Targets for the EU Member States (Year 2010 in Billion € (99))




Statements about trade and competitiveness effects of permit trading regimes often seem inconclusive or evencontradictory. This phenomenon is to a largely attributable to three oft-neglected aspects. Firstly, there are sever-al competing definitions of competitiveness. Competitiveness of companies, of industry sectors, or of nationshave very different meanings, and an assessment of these different types usually leads to answers that are not validfor competitiveness in general, but only to a particular notion of it. Secondly, an evaluation of trade and com-petitiveness effects of a permit trading regime needs to make clear the alternative to which this regime is com-pared. In this policy brief two alternatives are discussed with quite diverse results. Permit trading is compared toa situation without policy and to a situation where the permit trading regime replaces a command-and-controlregime that achieves the same environmental objective. Finally, the outcome is greatly affected depending onwhether a permit trading system is introduced unilaterally or multilaterally, and whether the country with a uni-lateral system is large or small relative to its trading partners.

It is beyond the scope of this policy brief to describe in detail all combinations of the underlying features forassessing trade and competitiveness effects, but a few of the more frequently discussed cases are addressed.Competitiveness for industry sectors are focused upon, and competitiveness effects for a nation briefly described.It reports more intensively on the comparison between permit trading and a no-policy environment since this isa more researched area, but is also shows some results of analyses that compare permit trading to other policymeasures. Finally, the differences between unilateral, multilateral, and global permit trading are illustrated.

In the case of a newly introduced environmental policy with a permit trading system it is clear that those indus-tries emitting the controlled substance most intensively will be faced with higher costs and will thus lose compet-itiveness with respect to other industries within the same economy but also with respect to the same industry inother countries that do not impose a comparable environmental regulation. This loss with respect to foreign com-petitors will be more pronounced the more important foreign competition and the larger the market share of for-eign producers. Hence, unilateral national permit trading in a small country with an open economy tends to havethe largest influence on trade flows and reduces industry competitiveness (comparative advantage) the most. Onthe contrary, the introduction of global permit trading will influence the costs of emission-intensive industries inall countries similarly and thus shows the smallest losses in competitiveness with respect to other industries athome and abroad.

6. Conclusions

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If the permit trading regime replaces another regulatory environmental policy regime the effects are quite differ-ent. The usually inefficient assignment of reduction requirements in the regulatory regime offers the opportuni-ty of efficiency gains for all parties. Those with high abatement costs can buy permits at lower prices than theregulatory abatement requirements and the suppliers of permits can profitably finance an expansion of theirabatement activities through the sale of permits. In the past such gains have turned out to be larger in practicethan were predicted by simulation exercises. These efficiency gains obviously reduce preexisting disadvantages incompetitiveness; they improve the competitiveness of the industries involved in the permit trading.

Whereas trade and competitiveness effects at the industry level tend to improve the competitive situation of someindustries (those not subject to additional costs) at the expense of others (those experiencing the additional envi-ronmental constraint), the competitiveness effects at the national level (sometimes called international competi-tiveness) are different. Imposing permit trading will lower overall output of the economy thus presenting a lossin income. If this reduction in output takes place predominantly in industries that are the most competitive oneson world markets, an additional negative effect occurs through leakage effects. Such an economy is forced to spe-cialise in activities that do not represent its true comparative advantage. This is in fact the case for most AnnexB-countries under the Kyoto Protocol. Such negative effects on international competitiveness can be avoided bymoving towards a global permit trading regime.

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Useful References

Capros, P., 1999. Analysis of Energy System Changes to Reduce CO2 Emissions in 2010 for Europe-14. NationalUniversity of Athens, Greece. [ http://www.europa.eu.int/comm/environment/enveco/capros_en_model/euco2out.pdf ]

European Commission, 1997. The Competitiveness of European Industry. Luxembourg.

European Commission, 2000. Grünbuch zum Handel mit Treibhausgasen in der Europäischen Union.

KOM(2000) 87 entgültig. Brussels.

IEA (International Energy Agency), 2002. Energy Statistics and Balances. Paris.

IMD (Institute for Management Development), 2003. The World Competitiveness Yearbook. Current Issues.Lausanne, Switzerland. [ http://www02.imd.ch/wcy/ ]

Jenkins, R., 1997. Environmental Regulation and International Competitiveness: A Review of Literature and SomeEuropean Evidence. United Nations University Discussion Paper Series #9801, Maastricht.

Johnstone, N., 1999. Tradable Permit Systems and Industrial Competitiveness: A Review of Issues and Evidence.In: OECD Proceedings: Implementing Domestic Tradable Permits for Environmental Protection. OECD, Paris.

Klepper, G. and S. Peterson, 2002.Trading Hot Air. Kiel Working Paper No. 1133. Kiel Institute for WorldEconomics.

Klepper, G.and S. Peterson, 2003. On the Robustness of Marginal Abatement Cost Curves: The Influence ofWorld Energy Prices. Kiel Working Paper No. 1138. Kiel Institute for World Economics.

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Institutional Requirements

Authors

Gernot Klepper Sonja PetersonKiel Institute Kiel Institute

Booklet design and cover illustration by Flying Squirrel Graphics, Dublin

Series Editors: Frank Convery and Louise Dunne © 2003 Environmental Institute

CATEP active partners

Environmental Institute, Universtity College Dublin, www.ucdenvironmentalstudies.comDublin, Ireland (Co-ordinator)

C-SERGE Economics, University College London www.ucl.ac.uk/economics/cserge/site/Centre for European Policy Studies, Brussels (CEPS) www.ceps.beCentre International de Researche sur l'Environment www.centre-cired.fr/

et le Developpement (CIRED)Department of Economics, Stockholm University www.ne.su.se/eindex.htmlFondazione Eni Enrico Mattei (FEEM) www.feem.it/The Centre d'Economie et d'Ethique pour www.c3ed.uvsq.fr/

l'Environment et le Developpement (C3ED)Climate Action Network Europe www.climnet.org/UNEP Collaborating Centre, www.uccee.org/

Risoe National LaboratoryKiel Institute Of World Economics www.uni-kiel.de/ifw/homeeng.htmCentre for International Climate and www.cicero.uio.no/index_e.asp

Environmental Research (CICERO)Foundation for International Environmental www.field.org.uk/

Law and Development (FIELD)Organisation for Economic Co-operation www.oecd.org

and Development (OECD)Joint Research Centre, Instituto de www.jrc.es

Prospectiva TechnologicaBP Amoco www.bp.com

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