The Impact of Informational Costs in Quantity Regulation of Pollutants: The Case of the European Emissions Trading Scheme

The Kyoto Protocol mandates a reduction of greenhouse gas emissions to countervail climate change. As a consequence, the EU has introduced the European Emissions Trading Scheme (EU ETS) to achieve a reduction of CO2 emissions of 21% on average among energy producers and energy intensive industries until 2020. The regulated firms are heterogeneous in terms of annual emissions levels and employed technology. Since there are currently no end-of-pipe technologies available for CO2 abatement, firms have to optimize processes or invent new technologies in many cases to achieve emission reductions. If emissions occur as a byproduct of complex processes as it is often the case in the EU ETS, firms will face informational costs when searching for abatement options or when evaluating costs for abatement. This is in contrast to other regulatory schemes, like the US SO2 trading scheme. Within the US SO2 trading scheme one specific technology was regulated, namely the combustion of fossil fuels for energy production. Moreover, when the SO2 trading scheme was introduced there were mature end-of-pipe technologies available on markets (i.e. scrubbers), offering abatement options at low informational costs. In this paper we present a model that highlights the importance of technological complexity and firm-size in environmental regulation. If regulated firms emit a relatively small amount of pollutants, possible efficiency gains from abatement are also relatively small. If there are high informational costs for abatement options and costs to be identified because of complex technology, small emitters might face a threshold for searching for abatement technology. This could effectively hamper the implementation of existing abatement technologies and the invention of new ones. The model presented in this paper has several implications for the optimal design of environmental regulation, i.e. if regulated technological processes are complex, as in the case of greenhouse gas abatement. Induced technological change can be hampered if regulated sources emit only small amounts of pollutants. The problem can be resolved if informational costs for abatement options and the discovery of abatement costs are reduced, e.g. by strengthening collaboration in research and development, fostering and incentivizing technological transfer, strengthening markets for abatement technologies or promoting basic research. Reducing uncertainty with regard to future regulation can also reduce informational costs, e.g. by announcing price-floors in quantity based regulation. Alternatively, smaller emitters could be opted-out of regulation. Further research has to be conducted with regard to the optimal mix of additional measures to environmental regulation in situations where a complex technology is employed and to the optimal coverage of firms and technology.

Heindl, Peter (2011), The Impact of Informational Costs in Quantity Regulation of Pollutants: The Case of the European Emissions Trading Scheme, ZEW Discussion Paper No. 11-040, Mannheim.