How carbon permit markets can lead firms to capture surplus rents

Executive Summary

The threat of climate change due to anthropogenic emissions of greenhouse gases has led policymakers around the world to implement a growing number of carbon pricing schemes to reduce emissions, either through carbon taxes or market-based cap-and-trade programs. In general, market-based approaches for emissions reductions are favored by experts due to their theoretical economic efficiency.¹ As a result, we have witnessed a substantial rise in carbon markets around the world at the subnational, national,² and supranational level.³

Carbon markets based on cap-and-trade programs are entirely created by regulators, which makes market design and implementation essential to avoid potential market imperfections.⁴ Moreover, it is important to examine how firms actually behave in these markets in response to the regulations to better understand how well such programs work and to identify any inefficiencies that can be corrected by policymakers.

In this paper, I investigate how the linkage between the carbon market in the European Union ETS (EU ETS), the first large-scale multi-national regulatory program for greenhouse gases, together with carbon offset credit markets created an opportunity to capture rents in the early years of the EU ETS. The EU ETS initially required firms to submit sufficient emissions permits issued by EU regulators to cover all their carbon emissions from within the EU, either through permits freely allocated to them or by purchasing them from other firms. However, in a later phase, it allowed the use of offset credits purchased from outside the EU ETS to be used for compliance. These different permits traded at a lower price than EU emissions permits, and at the same time there was a significant surplus of freely-allocated EU permits in many sectors. This allowed firms to sell their initial allocation of EU emissions permits at higher prices in the market and buy cheaper (but identical in terms of meeting compliance obligations) offset permits from developing and emerging economies to comply with the regulation. The exploitation of this opportunity allowed firms to profit off the EU ETS.

I leverage a novel dataset of companies from the iron and steel and refining sectors, covered by the EU ETS, to investigate the extent and characteristics of the exploitation of this rent-capturing opportunity. Firms with operations in multiple EU countries engaged in this opportunity to a greater extent than those with operations in a single country, suggesting that multi-country firms benefited from information and knowledge advantages as well as higher organizational capacity, allowing them to better exploit this opportunity. Further, the stringency of regulations reduces the heterogeneity among firms in exploiting the arbitrage opportunity by incentivizing firms to engage strategically with carbon markets. Finally, I find a significant correlation between the use of the rent-capturing opportunities and the proximity of firms to market institutions, suggesting that the diffusion of knowledge and information can play a decisive role for environmental regulations based on complex and dynamic market instruments.

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