This literature review compares the two main emission trade schemes: the cap-and-trade scheme and the performance standard scheme. The advantages and disadvantages are compared after which the author presents his view which of the two is more desirable.
Nowadays everyone is, to some extent, aware of the effect that greenhouse gasses and other forms of pollution have on our environment. This increase in awareness over the past few decades has led to increasing public pressure to reduce pollution, but at the same time to do so without harming the economy. This entails the need for a subtle instrument to coax polluters into reducing emissions without impeding economic growth. The solution that is currently favored by many nations is the ‘emission trading scheme’, mainly because it is less restrictive and damaging to the economy than other solutions. There are two main types of emission trading schemes: the so-called ‘cap-and-trade scheme’ and the ‘performance standard scheme’. The ongoing debate on this subject is centred on the two variations on the scheme and which of the two is more desirable on the whole. Questions that have been raised are, amongst others, which is more economically efficient, practical to implement and which will reduce emissions the most. This paper will examine available literature on the subject.
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In this review, we will start by providing the theoretical background to pollution regulation and emission trading. After this, a general introduction to emission trading schemes will be provided following which each of the two schemes will be examined more closely. During this examination we will explain the scheme’s particular features and then highlight the advantages and disadvantages that each scheme entails. Finally, the findings will be summarized in the conclusion and the author’s opinion will be offered as to which of the two schemes is more desirable.
In order to understand why one should prefer one system to another, it is first necessary to investigate the underlying theory on externalities, pollution regulation and emission trading. How would an emission trading scheme work? Our starting point is the Coase theorem, which is often described as the “fundamental theorem in the area of externalities.”
Pollution is a case of what some describe as ‘the tragedy of the commons’. Because the good that is being destroyed (the environment) cannot be identified as belonging to anyone, no one has an incentive to act. The obvious solution is to give someone the ownership of the good, but that is hardly practical in the case of the environment. We can however give someone the right to live in a pollution free environment or to pollute. This is described as ‘internalizing an externality’ and it is where the Coase theorem becomes important.
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