4.4 Recommendations for defining permits
4.4.1 Permits defined for one use or in-perpetuity/eternal
By “one use” we mean that the permit is defined as the right to emit one tonne of carbon once. For example a permit might state “This permit gives the holder the right to emit one tonne of carbon dioxide equivalent after January 1999.” A permit in perpetuity gives the right to emit a flow of permits. For example the permit might state “The permit gives the holder the right to emit one tonne of carbon dioxide equivalent each year from the year 1999 to perpetuity.”
We recommend permits should be one-use, infinitely divisible, defined as proportions of the target rather than in tonnes. Defining permits for one use only, as opposed to several uses or “in perpetuity” has the advantages of administrative simplicity relative to the several-uses definition, and increased homogeneity. Homogeneity makes trading more efficient, reduces complexity and makes compliance easier to monitor. With one-use permits, it would be easier to phase grand-parenting out over time. This could have enormous revenue recycling benefits.
In addition, it is harder to define bankability with an “in perpetuity” permit. With a normal property right it is not possible to use it twice in one period, e.g., with land it is not possible to not farm in one period and use the same piece of land twice in the second period. In many environmental tradeable permit markets the timing of emissions is critical and bankability is not allowed. In this situation, a permit in perpetuity can make sense because it is the right to emit a flow of emissions each year. In the carbon market, however, we are concerned with the accumulation of emissions. A permit in perpetuity that was not used one year would have to be convertible into a permit that allowed those emissions to be used in a later year. This becomes a “one use” permit system.
Infinite divisibility benefits market liquidity by removing some of the lumpiness of transactions and encouraging small trades. If very small trades are possible, the number of market participants will increase, and small emitters will not be penalised by having to buy more emission rights than they wish to use.
Defining permits as proportions of the target rather than in tonnes has the effect of shifting the cost of reducing the country’s target from the government to private agents. The country’s target would only change between commitment periods, thus during each commitment period the permits would behave as if they were defined in tonnes. However, firms that banked their permits beyond the end of one commitment period would face the risk that their value in terms of emissions could decrease.
Each permit would need to be marked with a date before which it cannot be used. This would ensure that the country is cumulatively in compliance up to any given date. Domestic permits would be directly convertible to assigned amount units (AAUs – the internationally tradeable permits created by the Kyoto Protocol). One option would be to simply use AAUs as domestic permits. This would create problems however if a hybrid system were used and the trigger price was reached. The government would want to be able to freeze convertibility to AAUs.
4.4.2 Length of bankability of permits
By “bankability” we mean that a permit dated January 1999 does not need to be used in January but could be saved (banked) and used in a later period. The government may want to define a limit on how long the permit can be banked. Thus the permit may be defined as “This permit gives the holder the right to emit one tonne of carbon dioxide after January 1999 and before January 2009.”
Bankability should probably match any international rules on banking of AAUs. The advantage of long allowances for bankability is that it allows businesses individually and the private sector as a whole to find the optimal path for emissions.
However, given uncertainty and the relatively short horizons of most businesses, it is probably not necessary to make the bankability infinite to achieve most of the gains from intertemporal optimisation. In actual markets most banking has been for the purpose of short run smoothing so that permits are banked for only one or two years at most. This is more a response to limited liquidity and short-term individual shocks than an overall constraint on permits in the market. When the market is actually operational, if there is too high (much more than rising at the rate of interest) a value on future rights relative to current rights, this would be an indication that the limit on bankability is a real constraint and should be reconsidered. The specifications of the Kyoto Protocol allow for permits allocated in the first commitment period to be banked into the second commitment period, so a domestic system in which the same was permitted would seem sensible, and would aid New Zealand’s compliance with Kyoto.
4.5 Allocating permits
4.5.1 Auctioning vs grand-parenting
Auctioning permits is economically preferred to grand-parenting because it is less distortionary. However, some grand-parenting may be required for political feasibility. The transition to a permit system would be eased if firms covered by NGAs were to receive grand-parented permits in quantities based on best practice levels of emissions at a given date.
It is important to require that at least some firms buy emission permits for two main reasons. First, the revenue gained by the government would allow the economy to enjoy some of the benefits of revenue recycling. Second, equity would be increased because those bearing the cost would be more widely spread through the economy. Most importantly, this would set a precedent that would make it possible that in the long run, emitters would pay for emissions and revenue would be recycled.
It may be desirable to phase the grand-parenting out over time, so the government should ensure that this option is not precluded by the design of the permit system.
4.5.2 How to auction permits
In a perfect market with perfect information all permits could be auctioned immediately. The government could invest the money gained and if it needed to buy back permits simply repurchase them with the return from the investment. Alternatively, the government could require firms to purchase permits on the international market and sell its own surplus in the same way, essentially using the international market as its auction mechanism. However, given that markets may not be perfect, the government needs to take into account issues of market power, liquidity and maximizing government revenue.
If we use ”one use” permits we have a series of permits dated for years out into the indefinite future. The later permits cannot be used for many years but could be sold in advance. One option would be to sell all permits with all dates immediately. Alternatively, the permits for each year could be sold at the time they can be used. We propose a mixed system where all current permits are sold, as well as a percentage of the permits from each future year with the percentage declining for more distant dates. Thus there would be annual auctions of a variety of different types of permit.
We recommend that annual auctions sell the remaining current permits and some for each future year out for about 25 years sold at each auction. For example, in 2005, all permits that are dated for use only after January 2005 would be auctioned. In addition 75% of the permits dated January 2006, 50% of those dated 2007, 25% of those dated 2008, 15% of those for 2009 and so on would also be auctioned. In the year 2006, the remaining 25% of permits for 2006 would be auctioned together with an additional 25% from 2007 etc. The percentages chosen here are purely for illustration. The idea would be to have a sizable percentage of permits for each of the current year and immediate future years traded every year.
Market power can only arise if one small group gains control of most permits that are available for use in a given year. If not all permits are allocated in advance, the government can always counteract the market power by auctioning permits and thus making them available to new entrants. With annual auctions of all different types of permits (i.e., with different start and end dates), a minimum level of liquidity will be guaranteed in the market. Finally, gradual auctions will allow experience to develop in the private sector, so the uncertainty about permit values will decrease, probably allowing the government to sell them for higher values and make more revenue. This prevents private companies that have good information about the value of permits from making large speculative gains early in the market and buying many permits cheaply.
4.5.3 Fully define rights - minimize restrictions and uncertainty
If when or how permits can be used is limited, the permits are less valuable to firms. Some restrictions are necessary to maintain the integrity of the system but each restriction should be evaluated to ensure that it is strictly necessary. Uncertainty increases the risk associated with holding a permit and makes it less valuable. Some uncertainty is unavoidable and cannot be controlled by government. This risk should not necessarily be absorbed by the government to raise prices, because risk bearing has a real cost to the government as well as to the private sector. However the government can create unnecessary uncertainty if it does not design the permits clearly and if it makes the value of those permits overly vulnerable to political changes.
