Emission Trading Scheme: A Brief Overview and Indian Perspective

By Abhishek Mohanty, WBNUJS

Editor’s Note: The concern for controlling the level of pollution in the world has been growing steadily with the increasing urbanization and industrialization. This paper presents an overview of the Emissions Trading Scheme. This scheme become successfully in the early 80’s in America and this became even more successful when emissions trading became a part of the Clean Air Act of 1990. This paper further presents the positives of this scheme and also its criticisms and problems. It ends by providing an Indian perspective to this scheme.


 In 1920, Arthur C. Pigou introduced the concept that there are ‘externalities’ involved in any transaction which don’t usually show up. Like an industry can go on polluting and not have to pay for it and neither would the customer. So he proposed that these sort of externalities can be internalized by introducing corrective taxes or Pigouvian taxes where the firm has to pay a per-unit tax for a polluting activity.[1] This would force the firms to control their own costs and would simultaneously minimize the costs the society has to bear in terms of pollution. However, there continued a debate between quantity-based and price-based regimes. During this period, legal regulations existed since these taxes were not very widely accepted.[2] Ronald Coase in his famous work ‘The Problem of Social Cost’[3] showed that how these externalities could be removed with ‘market-based’ instruments instead of a traditional ‘command-and-control’ regime if the property rights are explicit.


Baumol and Oates showed that a ‘cap-and-trade’ system can minimize the cost of meeting a emissions cap.[4] Under perfect competition, the permits would achieve their highest value since a trade between two parties with different costs of abatement would be beneficial to both. This study was further validated by Montgomery who showed that these permits result in benefits to both parties to a trade regardless of how the initial allotments are made.

Under the marketable permits system, instead of government fining the firms for polluting the environment, it makes the right to pollute tradable. It allows the firms to buy and sell the right to pollute among themselves. The government just sets an emission cap i.e. the amount of pollution it is willing to allow.

Suppose initial level of pollution is 300 tonnes which the government intends to bring down to 120 tonnes. Assuming there are only two firms(Firm A and Firm B), it gives the two firms 60 tonnes worth of permits. When both the firms bring down their pollution to 60 tonnes, we assume that firm A has higher marginal cost than firm B. In this case, firm B will decide to sell some permits to firm A. Firm B can abate more and firm A can pollute more. Hence, the total abatement remains unchanged but the price of abatement falls.


In the 1980s, American power plants were releasing huge amounts of sulphur dioxide which was resulting acid rain, damaging lakes, forests and buildings. The erstwhile command-and-control approach required scrubbers to be installed which was seen as a regressive step as it would have increased cost of production by a huge amount. When George H.W. Bush came to power in 1988, attorney Boyden Gray sought to break impasse over acid rain and wanted to employ the marketplace approach.

There were a lot of early objections and apprehensions over whether there would exist a market for emissions. Many of the environmentalists saw this as a way for firms to buy their way out to pollute the environment.[5] But ultimately all these objections were overruled by President Bush and emissions trading became a part of the Clean Air Act of 1990. It was included as part of the US Acid Rain program in Title IV of the Act. That year saw a three-million tonnes cut in acid rain emissions. This resulted in wide appreciation for the new tool.


Further in December 1997 at Kyoto, 149 countries agreed to reduce emissions of greenhouse gases. 39 industrialized countries pledged to reduce emissions of greenhouse gases by 5.2%.[6] One of the several approaches to this challenge was the acceptability of emissions trading between Annexe B countries(smaller and developing economies)[7].  Under the protocol, between 2008 and 2012, nations emitting lesser than their allotted quota could sell their assigned amount units to nations that exceed their quota.[8] Tradable carbon credits could also be made by sponsoring carbon projects that reduce greenhouse gases in other countries.

In the European Union, a 31-member participation was seen in a carbon dioxide reduction programme.[9] The European Union Greenhouse Gas Emission Trading Scheme (EU ETS) commenced which is the largest multi-country and multi-sector collaboration with respect to a greenhouse gas ETS. Close to Europe’s half emissions of carbon dioxide was covered by covering over 11,500 energy-initiative installations. The system covered emissions from power plants, wide-range of energy intensive industry and commercial airlines. Nitrous oxide from from the produce of certain acids and emission of perflurocarbons from aluminum production was also included.

These programmes have spawned up similar programmes in parts of Australia and New Zealand. The NZ ETS was legislated in September 2008.[10] The NZ ETS covers forestry, 43.4% of energy, industry and waste. The scheme created a specific domestic unit’ New Zealand Unit’ which was issued by free allocation. The number of units to be allocated was decided on a per-sector basis. This has been criticized saying that giving away such units as free damages the government’s revenue and also does not penalise the firms for the pollution that they generate.

After the success of the emissions trading scheme under the Clean Air Act in the US, many other such legislations were brought into place in different states. In 1997, the State of Illinois adopted a trading program for volatile organic compounds in most of the Chicago area, called the Emissions Reduction Market System.[11] Over 100 major sources of pollution began trading pollution credits. In 2003, New York State proposed and attained commitments from nine Northeast states to form a cap-and-trade carbon dioxide emissions program for power generators, called the Regional Greenhouse Gas Initiative (RGGI). This program launched on January 1, 2009 with the aim to reduce the carbon “budget” of each state’s electricity generation sector to 10% below their 2009 allowances by 2018.[12] All US corporations were allowed to trade carbon dioxide on the Chicago Climate Exchange under a voluntary scheme. Trading in carbon emission has steadily risen from 11 billion $ in 2005 to 30 billion $ in 2006 to 64 billion $ in 2007. [13]


As opposed to a carbon emissions trading scheme which relies on the market to value the cost of  a permit itself, a carbon tax approach seeks government’s discretion in setting a corrective tax. This causes a significant problem because deciding the tax rate or amount can only be done optimally when complete information is available. The marginal social damage per unit of each pollutant needs to be assessed. But lack of such information can lead to either over or under taxation. Over taxation results in too many resources to be devoted to pollution control which would in turn make firms unprofitable. A low tax rate will not effectively curb pollution.

An inflation in the cost of pollution cannot be effectively gauged by a regulatory body whereas in an open marketplace approach, the market will adjust itself thus setting the ‘correct’ price for each unit of permit.

Command-and-control regulations can take a variety of forms and are much less flexible. It places the burden on the producer to reduce its emissions by a certain number or percentage. But this kind of system does not give economic incentive to the producer. The producer can easily pass on the costs to the consumers and not worry about reducing any pollution. A vast majority of studies have found that command and control mechanisms turn out to be significantly costlier than other alternatives.[14]

Hence, in a way emissions trading scheme is the most cost effective way of reducing pollution. Moreover, marketable permits provide us with more certainty about the level of pollution.


One of the most basic arguments regarding marketable permits is that formalising emission rights effectively gives firms a right to pollute. Although it might sound as a very elementary argument, however fact remains that the basic purpose of any pollution controlling mechanism is to cut the amount of pollutant in the environment in the most effective way. Firms can balance their cost of abatement and cost of production in an open market and in turn the society benefits.

Traditional theory regarding emissions trading presumes that the pollutant is homogenous. But in reality, there are other externalities which come into effect and do not result in net benefit. One of the factors affecting this is the location of the source of pollution. In theory, we can set a cap on the emissions but in practice this cap might not result in the most fruitful outcome because the source of pollution might play a bigger role than expected.

Although empirical evidence proves that market-based approach has made it easier to limit emission outputs, a very basic issue is what kind of caps are feasible in an economy. Setting very stringent caps can result in the non-compliance to the norms and thereby degrading the environment further more. One of the desirable aspects about marketable permits is the ability to raise income levels for participants. This also raises the incentive for non-compliance. A weak enforcement system could result in illegal activity for higher profitability.

Initial allocations of permits also affects how effective the system becomes. Even though the basic impulse is to give firms, permits as a fraction of their current levels of pollution, it poses some challenges. Firms which have spent large amounts on pollution control are given fewer permits. Free distribution of permits has also been advocated. However, studies have shown that auctioning permits is a better option since the revenue generated can be used in future to reduce distortions which are very likely to arise.[15] But advocates of free distribution point out that feasibility of implementation of emissions trading programme has increased when permits are distributed freely. They argue that the revenue generated by auctions is a fraction of what the environment loses.[16]

In contrast to a taxation regime, a permit trading programme does not provide any insular protection against ‘shocks’. An emission cap can lead to politically unacceptable permit price increases. This was seen in the Los Angeles RECLAIM(Regional Clear Air Incentives Market) where a very large unanticipated rise in power could only be accommodated by increasing power production from the older, more polluting plants.[17] The large increase in demand for power along with fixed supply of permits caused the price of permits to soar.[18] The RECLAIM programme was suspended temporarily until a solution was found. One of the solutions suggested to this problem is to include a ‘safety valve’ in form of a predefined penalty which shall be imposed uniformly over the cap once prices exceeded a threshold.[19]


In 2009, India was world’s third largest carbon dioxide emitter. [20]There has been wide acknowledgement that developing economies of China and India are increasingly becoming contributors to climate change problems.[21] In area of environmental politics, developed countries exert a lot of pressure on developing countries to curb their emissions. Developed countries have two responsibilities : first, to reduce their own emissions and secondly to facilitate the migration efforts of developing nations by providing financial and technical assistance.[22]

Accepting an emissions trading scheme means that India would also have to agree to a emission cap for itself. However, this might turn out to be counter-productive for India since being a rapidly developing economy with large incremental rise, its emissions might rise above the cap for which it would have to face severe consequences.[23] India has viewed climate change as a problem due to developed countries and has steadfastly refused to accepted any mandatory emission reductions.[24] This was a moral stand taken by the developing nations who participated in the Kyoto protocol that developed countries should first reduce their own emissions since they were responsible for most of the emissions.

For sustainable development, India committed to a voluntary Copenhagen Accord to reduce emissions intensity by 20-25% of 2005 by 2020. India has adopted several measures itself to meet this target. These include increased use of renewable energy, nuclear energy, afforestation and solar energy. A carbon tax of Rs 50/ton has also been imposed on coal produced and imported since July 2010.[25]

The 2008 National Action Plan on Climate Change set up the ‘Perform, Achieve and Trade’ (PAT) which is congruous to an Emissions Trading Scheme.[26] The distinguishing feature of PAT from a cap-and-trade system is that whereas cap-and-trade systems specify absolute caps, PAT specifies energy targets that are intensity-based. [27] Mandatory efficiency targets were set for 478 facilities which together constituted 60% of India’s 2007 emissions.[28] India also has Renewable Energy Certificate trading system. Under this scheme, an industry will be provided with Energy Saving Certificates which it can sell to another industry which is unable to meet its mandatory target. The certificates purchased will be deemed to be a certificate of fulfillment of compliance requirement for the underachiever and avoid non-compliance. Amendments to the Energy Conservation Act in 2010 gave the necessary legal permission for the Certificates.[29]

However, the Ministry of Environment has decided to try out pilot projects of emission trading schemes in the states of Tamil Nadu, Maharashtra and Gujarat.[30] The pilot systems for the three included states will cover 1,000 industries. The cities of Aurangabad, Tarapur, Chandrapur, Jhalna, and Kohlapur will be covered by the Maharashtra pilot program. The industries should be of medium or large size, high emitters of particulate matter and have at least one CEMS(Continuous Emissions Monitoring System) suitable stack. The Tamil Nadu pilot system will encompass the cities of Ambattur, Chennai, Maraimalai, Sriperumpudur, and Tiruvallur. Covered industries must lie within a 50 KM radius of Chennai City. The Gujarat pilot ETS will encompass the cities of Surat, Vapi, and Ahmedabad. A covered industry must lie within a 20 KM radius of one of these three cities, be a high emitter of PM, or have at least one CEMS suitable stack. [31]

A Ministry of Environment Concept Note[32] laid down the concerns and challenges that India needs to overcome to implement such a scheme. It emphasised that introducing such a scheme would make it a leader among developing economies and possibly help in better regulation of pollution. The paper argues that a system in line with world standards would help bring in more foreign investment and also boost the economy.


In the course of the essay, we have looked at the effectiveness of market-based instrument Emissions Trading Scheme in curbing emissions and reducing pollution. The global climate change crisis will not however be solved by such simple steps and requires innovation on clean energy, transportation and various other sectors.

Taxes and trading schemes are important policy instruments which should be seen to be complementary with environmental regulations, informational campaigns, subsidies etc. Even if a emission trading scheme comes with several benefits, due diligence needs to be done if such a scheme is implemented in India. An emission trading scheme would require an absolute emissions cap which India could do well to avoid to keep its economy growing and competitive. It needs to be understood that India’s contribution to stock of emission is only 2% of the world’s emission. Although the incremental rise in emission is large, the contribution to cumulative emission will remain lower than that of developed countries in the business-as-usual case.[33] Hence the issue is not only moral but also economical. A system of absolute caps could prove be to be very expensive for a developing economy like India.[34] Given its impressive record of domestic schemes, India could also opt out of such a scheme and continue in the pursuit of energy efficiency targets and the PTA system.

Edited by Hariharan Kumar

[1] G. Metcalf & D. Weisbach, ‘The Design of a Carbon Tax’ (2009) 33 Harvard Enviornment Law Review < http://www.law.harvard.edu/students/orgs/elr/vol33_2/Metcalf%20Weisbach.pdf> accessed 07 March 2014

[2] Coniff, Richard ‘The Political History of Cap and Trade’ (Smithsonian Magazine, August 2009) accessed 06 March 2014

[3] Ronald H. Coase, ‘The Problem of Social Cost’ (1960) 3(1) Journal of Law and Economics1

[4] Baumol, W. J. and Oates, W. E. ‘The Use of Standards and Prices for Protection of the Environment’ (1971) 73, Swedish Journal of Economics 42

[5] Ibid. 2

[6] Kyoto Protocol 1997

[7] Ibid, Article 17

[8] United Nations, ‘International Emissions Trading’ (United Nations Frameword Convention on Climate Change ) <http://unfccc.int/kyoto_protocol/mechanisms/emissions_trading/items/2731.php> accessed 06 March 2014.

[9] European Commission, ‘The EU Emissions Trading System (EU ETS)’ (European Union Climate Action) <http://ec.europa.eu/clima/policies/ets/index_en.htm> accessed 06 March 2014

[10] David Parker, ‘Historic climate change legislation passes’ (New Zealand Government 2008) < http://www.beehive.govt.nz/release/historic-climate-change-legislation-passes> accessed 07 March 2014

[11] In 1997, the State of Illinois adopted a trading program for volatile organic compounds in most of the Chicago area, called the Emissions Reduction Market System.

[12] Memorandum of Understanding – Regional Greenhouse Gas Initiative

[13] World Bank, ‘Climate Finance ‘ (The World Bank 2009) <http://carbonfinance.org/docs/State___Trends–formatted_06_May_10pm.pdf> accessed 07 March 2014

[14] Tom Tietenberg, Environmental Economics and Policy (5th, Addison Wesley, London 2006)

[15] Lawrence H. Goulder & Roberton C. Williams , ‘The Usual Excess-Burden Approximation Usually Doesn’t Come Close’ [1999] NBER Working Papers 45

[16] Lawrence H. Goulder, ‘Environmental Taxation and Regulation in a Second-Best Setting’ [1998] Journal of Applied Economics 279

[17] Tom Tietenberg, ‘The Ecolutions of Emissions Trading’ (AEA Web 2008) <http://www.aeaweb.org/annual_mtg_papers/2008/2008_90.pdf> accessed 07 March 2014

[18] ibid

[19]H. D. Jacoby and A. D. Ellerman , ‘Safety Valve and Climate Policy’ [2004] Energy Policy 32(4) 481

[20] The Guardian, ‘World carbon dioxide emissions data by country: China speeds ahead of the rest’ (DataBlog 2011) <http://www.theguardian.com/news/datablog/2011/jan/31/world-carbon-dioxide-emissions-country-data-co2> accessed 07 March 2014

[21] Richard Green, ‘Carbon Tax or Carbon Permits: The Impact on Generators’ Risks ‘ [2008] The Energy Journal 29(3)

[22] ibid

[23] Steffen Kallbekken and Hege Westskog , ‘Should Developing Countries Take on Binding Commitments in a Climate Agreement? An Assessment of Gains and Uncertainty’ [2005] The Energy Journal 26(3)

[24]Prabbat Upadhyaya ‘Is Emission Trading a Possible Option for India?’ [2010] Climate Policy 5(10)

[25] Sapna Dogra, ‘India sets $1/mt clean coal tax for domestic producers/importers’ (Platts International Coal Report 2010) <http://www.lexisnexis.com.offcampus.lib.washington.edu/hottopics/lnacademic/> accessed 07 March 2014

[26] Anthony Mansell and Peter Sopher, ‘India The World’s Carbon Markets: A Case Study Guide to Emissions Trading’ (Environmental Policy Overview 2013) <http://www.ieta.org/assets/Reports/EmissionsTradingAroundTheWorld/edf_ieta_india_case_study_may_2013.pdf> accessed 07 March 2014

[27] Climate and Development Network, ‘Creating market support for energy efficiency’ (CDKN 2013) <http://cdkn.org/wp-content/uploads/2013/01/India-PAT_InsideStory.pdf> accessed 07 March 2014

[28] ibid

[29] Saurabh Kumar, ‘India’s own emissions trading scheme ‘ (The Hindu Business Line 2011) <http://www.thehindubusinessline.com/opinion/indias-own-emissions-trading-scheme/article2726531.ece> accessed 06 March 2014

[30] Padmaparna Ghosh, ‘Tamil Nadu, Gujarat to have pilot emissions trading scheme’ (Live Mint 2010) <http://www.livemint.com/Politics/stnlPYzumLErSKxGAyD5WI/Tamil-Nadu-Gujarat-to-have-pilot-emissions-trading-scheme.html> accessed 07 March 2014

[31]RN Jindal , ‘A Case for a Pilot Emissions Trading Scheme in India’ (Ministry of Environment and Forests 2011) <at http://www.hks.harvard.edu/var/ezp_site/storage/fckeditor/file/pdfs/centers-programs/centers/mrcbg/programs/ssp/docs/events/conferences/2011/harvard/Jindal_Harvard_Sust_Science_Forum_110919.pdf> accessed 06 March 2014

[32] Esther Duflo, Michael Greenstone, Rohini Pande & Nicholas Ryan, ‘Towards an Emissions Trading Scheme for Air Pollutants in India:A Concept Note’ (Ministry of Enviornment and Forests 2010) <http://www.moef.nic.in/downloads/public-information/towards-an-emissions-trading-scheme-for-air-pollutants.pdf> accessed 07 March 2014

[33] Daljit Singh, Girish Sant and Ashok Sreenivas, ‘Climate Change: Separating the Wheat from the Chaff ‘ [2009] EPW 44(5)

[34] Steffen Kallbekken and Hege Westskog, ‘Should Developing Countries Take on Binding Commitments in a Climate Agreement?: An Assessment of Gains and Uncertainty’ (2005) The Energy Journal  26(3)

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