A critical issue in dealing with climate change is deciding who has a right to emit carbon dioxide (CO2), and under what conditions, when those emissions are limited. The European Union Emissions Trading Scheme (EU ETS) is the world's first large experiment with an emission trading system for CO2 and it is likely to be copied by others if there is to be a global regime for limiting greenhouse gas emissions. This paper provides the first in-depth description and analysis of the process by which rights to emit carbon dioxide were created and distributed in the EU ETS. The main objective of the paper is to distill the lessons and general principles to be learned from the allocation of allowances in the EU ETS, i.e. in the world's first experience with allocating carbon allowances to sub-national entities. We discuss the lessons and unifying observations that emerge from this experience and provide some insights on what seem to be more general principles informing the allocation process and on what are the global implications of the EU ETS.

Main Report: We consider the cost of meeting emissions reduction targets consistent with a G8 proposal of a 50 percent global reduction in emissions by 2050, and an Obama Administration proposal of an 80 percent reduction over this period. We apply the MIT Emissions Prediction and Policy Analysis (EPPA), modeling these two policy scenarios if met by applying a national cap-and-trade system, and compare results with an earlier EPPA analysis of reductions of this stringency. We also test results to alternative assumptions about program coverage, banking behavior, and cost of technology in the electric power sector. Two main messages emerge from the exercise. First, technology uncertainties have a huge effect on the generation mix but only a moderate effect on the emissions price and welfare cost of achieving the assumed targets. Measured in terms of changes in economic welfare, the economic cost of 80 percent reduction by 2050 is in the range of 2 to 3% by 2050, with CO2 prices between $48 and $67 in 2015 rising to between $190 and $266 by 2050. Second, implementation matters. When an idealized economy-wide cap-and-trade is replaced by coverage omitting some sectors, or if the credibility of long-term target is weak (limiting banking behavior) prices and welfare costs change substantially.

Appendix B: This note provides an overview of different measures of costs of climate policy. While in our studies we stress emissions prices and welfare changes, here we illustrate the measures in most common use, showing results for the 167 bmt scenario from the main report (MIT Joint Program Report 173). Similar results for the other scenarios can be derived from Appendix A. These are studies of mitigation costs only and do not consider climate benefits and potential ancillary non-climate benefits of greenhouse gas mitigation, e.g., through reduced urban air pollution.

Appendix C: The American Clean Energy and Security Act (H.R.2454) passed the House of Representatives after the completion of the main report (MIT Joint Program Report 173). In this Appendix we provide an analysis of the Act's provisions as they relate to key features governing the cap-and-trade system, the renewable electricity standard (RES), limits on new coal power plants and support for carbon capture and storage(CCS), applying the Emissions Prediction and Policy Analysis (EPPA) model used in the main report. While the overall economy-wide target in H.R. 2454, of no more than 161 billion metric tons of CO2-equivalent released through 2050, is similar to the 167 bmt case analyzed in the main report, other features of the Bill significantly affect projections of its cost. We find that the large allowance for outside credits could reduce the cost if indeed these are forthcoming (and inexpensive). Other provisions, such as how the revenue and allowances will be distributed, will have important distributional consequences as well, but their analysis is beyond the scope of the study presented here.
  Our central estimate shows the CO2-e price starting at $21 per ton in 2015 and rising to about $84 by 2050. We decompose the welfare costs into a total cost including H.R. 2454 and recent legislation that was motivated in part for its GHG benefits (the Energy Independence and Security Act of 2007 and American Recovery and Reinvestment Act of 2009) vs. the additional cost of H.R 2454 itself given these preexisting measures. The national welfare cost of reaching the emissions targets outlined in H.R. 2454, attributable to the bill itself, rise from about 0.1 percent to 1.45 percent over the period 2015-2050. We estimate average annual net present value cost of H.R. 2454 of about $400 per household over this horizon, but given different assumptions about the availability of offsets this estimate ranges from as low as $180 to as high as $470. A rough comparison of costs with analyses by the CBO, EIA and EPA shows results in the same general range, though our estimates are higher. [Appendix C issued: September 2009]

Appendix A: Data Tables (MS Excel file: 88 kB)
Appendix B: Measuring the Cost of Climate Policy (PDF: 83 kB)
Appendix C: Cost of Climate Policy and the Waxman-Markey American Clean Energy and Security Act of 2009 (H.R. 2454) (PDF: 260 kB)

A common assertion in public policy discussions is that the cost of achieving the SO2 emissions reductions under the acid rain provisions of the Clean Air Act ("Title IV") has been only one-tenth or less of what Title IV was originally expected to cost. Initial cost estimates are cited in the range of $1000 to $2000 per ton of SO2 reduction and contrasted to SO2 allowance prices of about $100 per ton. Unfortunately, these are "apples-to-oranges" comparisons, leading to erroneous conclusions that greatly overstate the true divergence of actual costs from initial cost estimates. When the facts are viewed in a conceptually appropriate, "apples-to-apples" context, one finds that actual costs for SO2 reductions have been and are likely to remain near the low end of the initial range of estimates.

We all must learn to recognize conceptual pitfalls in these assessments of the SO2 program, to avoid unrealistic expectations of major new regulatory initiatives. For example, many regulatory advocates are now using the erroneous characterization of Title IV costs being one-tenth or less of their originally projected levels to argue that the new market-based regulatory approaches render ex ante cost estimates meaningless or at least much too high. This fundamentally incorrect line of reasoning already has been used to dismiss concern over cost estimates for new regulations, such as the PM2.5 and ozone air quality standards. These and other major policy initiatives deserve to be debated in light of appropriate and realistic assessments of their likely costs. This requires correcting the current misunderstandings about the actual costs of the Title IV SO2 emissions allowance market.

The following paper leads the reader through an interpretation of the facts regarding the estimated and actual costs of the SO2 program. Some of the key points include:
(1) Initial cost estimates for the Title IV SO2 program were not over $1000 per ton.
(2) Initial cost estimates for a fully-implemented Phase II cap ranged from $225-500 per ton, and costs were projected to be lower than this until the Phase II cap would be fully achieved, about ten years from now.
(3) Much confusion has arisen from comparing different cost and price concepts that become important in an allowance trading system, such as average and marginal cost, and the price of an allowance.
(4) When a market has a temporary oversupply (which has been true of the SO2 allowance market), spot market allowance prices will fail to reflect the capital cost portion of control costs, which can be a large part of the total costs.
(5) The allowance price may reflect future control costs, but regulatory uncertainty may cause future costs to be highly discounted.

The average control cost actually experienced in Phase I has been about $200 per ton. This is within the range that was initially projected. Today's most up-to-date estimates for Phase II (future) average costs are about $185 to $220 per ton. This is at the low end of the initial range of estimates. Allowance prices have been much lower, but we explain how they are consistent with actual average costs of $200 per ton.

Given the large uncertainties regarding potential damages from climate change and the significant but also uncertain costs of reducing greenhouse emissions, the debate over a policy response is often framed as a choice of either acting now or waiting until the uncertainty is reduced. Implicit behind the "wait to learn" argument is the notion that the ability to learn in the future necessarily implies that less restrictive policies should be chosen in the near-term. I demonstrate in the general case that the ability to learn in the future can lead to either less restrictive or more restrictive policies today. I also show that the initial decision made under uncertainty will be affected by future learning only if the actions taken today change the marginal costs or marginal damages in the future. Without this interaction, learning has no effect on what we do today, regardless of what we learn in the future. Results from an intermediate-scale integrated model of climate and economics indicate that the choice of current emissions restrictions is independent of whether or not uncertainty is resolved before future decisions, because the cross-period interactions in the model are minimal. Indeed, most climate and economic models fail to capture potentially important cross-period interaction effects. I construct a simple example to show that with stronger interactions, the effect of learning on initial period decisions can be more important.