Modeling the European Directive Establishing a Scheme for Greenhouse Gas Allowance Trading and Assessing the Market Power of Firms

It has long been acknowledged that market mechanisms may decrease the welfare cost of an environmental policy and, in the case of the Kyoto Protocol, three instruments have been designed, Tradable Permits (TP), Joint Implementation (JI) and Clean Development Mechanism (CDM). European Union long-standing position has been to claim that these flexibility mechanisms may only be supplemental to domestic action, but at the same time to favor trade between firms within Europe, especially among firms belonging to highly energy intensive sectors. This endeavor lead to the vote of a Directive (2003/87/CE) establishing a scheme for greenhouse gas allowance trading. Trading is limited, at least in a first stage, to some industrial sectors, precisely defined in the Directive. Two important features characterize the Directive: on the one hand, the almost free of charge allocation of allowances to firms (only 5% may be sold or auctioned) and on the other hand the responsibility given to each Government to determine the total amount of domestic allowances and to allocate them among sectors and among firms. This scheme appears to favor the electric generation sector and particularly the German utilities, which are the biggest emitters of GES in Europe. Using a simple representation of the market of tradable allowances calibrated on a General Equilibrium Model (GEMINI-E3), the topic of the paper is to assess the working of the trading scheme, its likely inefficiencies and the possible market power given by Governments to domestic firms. The main results are twofold: on the one hand, it can be demonstrated that, though it is partial (i. e. concerns only a limited set of sectors), the trading scheme can be as efficient as a generalized European market of permits provided that each country allocate the right quantity of quotas to the firms belonging to the trading sector and that the latter behave competitively; on the other hand, there is a real market power of German firms, which of course depends on the quantity of quotas allocated to them by the Government. But purchasing countries, mainly Italy and The Netherlands, also have the possibility to restrict demand and exert a symmetric market power. The welfare cost of non–cooperative strategies is assessed and shown to be of a very limited magnitude, compared to the gain accruing from the Union-wide trade of emission permits that the European Directive makes possible.