Liability rules for international trading of greenhouse gas emissions quotas

To reduce the costs of mitigating greenhouse gas emissions in accordance with the Kyoto protocol, international trades of emissions quotas are allowed. The revenue from the sale of quotas may exceed the sanctions for non-compliance if these penalties are weak or poorly enforced. Under these circumstances emissions trading enables a country to benefit financially through non-compliance.

To counter non-compliance due to trading a range of liability proposals have been suggested. Using a simple global model, we analyze the economic and environmental performance of these proposals for the first commitment period. In addition, the proposals are tested for their sensitivity to national circumstances and to market power.

We find that penalties are sufficient to deter non-compliance if they are high enough and are effectively enforced. If the non-compliance penalties are weak or poorly enforced, the permanent reserve proposal is best able to ensure compliance by sellers at a cost similar to the competitive market equilibrium.

While not sufficient to ensure compliance on their own, eligibility requirements and annual retirement of AAUs equal to actual emissions contribute to compliance at little or no cost. Hence, such provisions could complement other liability proposals.