Efficiency of Emissions Trading between Systems with Absolute and Intensity Targets

Emissions trading is regarded as a crucial instrument for a cost-effective implementation of climate policy. At the same time, the shape of global climate policy after the expiration of the Kyoto Protocol in 2012 is highly uncertain. Intensity targets, which limit the amount of emissions per output, have been proposed as an alternative to Kyotostyle absolute emission targets. In fact, the emergence of a fragmented regime in which one group of countries adopts the former and another group of countries the latter cannot be excluded. The question then arises of whether emissions trading between countries that are not subject to the same type of constraint would lead to an efficient outcome. Within a simple analytical framework, we find that permit trade between a country with an absolute and one with an intensity target never leads to a Pareto efficient equilibrium. Moreover, global emissions increase if the country with the intensity target is a net buyer of permits. We propose an ad valorem tax on traded permits in the intensity based regime, which restores Pareto optimality.