### 3. Taxonomy of transaction costs in the EU ETS

We define transaction costs for firms under the EU ETS as the sum of administrative costs and trading costs. More explicitly, by ‘transactions costs’ we mean those costs the firms incurred in preparing for, and setting up systems to comply with the regulations required by their participation in the EU ETS, and by engaging with the market. The experience of previous emissions trading schemes shows that impediments from regulatory side help to explain frictions in pollution trading markets. Betz (2005) points out that while trading (market) transaction costs are shifted from seller to other agents like brokers in the economy, administrative costs are a loss to society, since they are real resource losses that do not affect traded volumes.

For our purposes, transaction costs can be grouped into three categories: (1) early implementation costs, i.e. costs that were incurred before 1 January 2005; (2) monitoring, reporting, and verification (MRV) costs, i.e. costs that were experienced annually; and (3) trading costs. The first two categories are relevant for all firms in the scheme, whereas the third category is only incurred by firms that participated in the market. Early implementation costs are almost all fixed costs, MRV costs are periodic costs, so the variable costs would be trading costs $ ^{25} $ .

Early implementation costs are costs incurred by firms before the official start of the scheme. During this time, the familiarisation with the rules and guidelines of the scheme had to be achieved, baseline emissions had to be calculated, an operator holding accounts for each installation had to be established, and any necessary capital equipment had to be purchased. These costs can be considered as one-time fixed set-up costs and divided into three categories: (i) internal costs incurred by the firms in terms of additional management and staff time and training; (ii) consultancy costs incurred in terms of consultancy services taken on; and (iii) capital costs, meaning the additional monitoring, recording, and data storage equipment needed to comply.

Costs related to MRV activities were incurred annually since MRV procedures are mandatory on an annual basis for all installations in the EU ETS. At the end of the year each company had to prepare an annual emissions report which must then be verified. The EU ETS requires all annual emissions reports and monitoring to be verified by an independent accredited verifier. We assume that MRV costs are a combination of internal company costs, mainly management and staff time, and consultancy costs, where a firm buys in the necessary capacity to be MRV compliant (e.g. charges for external consultancy services and for accredited verifiers).

Trading costs were incurred only by those firms that chose to trade on the market. These costs depended on: the number of transactions conducted; the volume of allowances traded; and any search or other fee costs incurred (the costs of the allowances themselves are not included). Any installation could trade with any other installations within the same business group (internal trade), or with other installations outside the business group and financial institutions (external trade). Likewise, companies could trade either directly or indirectly, i.e. via a third-party.