Silviase/jgov_v1.4_full_ann huggingface dataset:
“…we have to take into account the costs involved in operating the various social arrangements (whether it be the working of a market or of a government department), as well as the costs involved in moving to a new system. In devising and choosing between social arrangements we should have regard for the total effect. This, above all, is the change in approach which I am advocating.”

Coase (1960, p. 44)

### 1. Introduction

The European Union’s Emission Trading Scheme (EU ETS), like any other pollutant-trading system, is expected to produce efficiency gains in reaching the $ CO_{2} $ emissions target. Firms with the lowest abatement costs should abate most, and sell their surplus of allowances to firms with higher abatement costs. As abatement occurs where costs are lowest, abatement targets should be met at least cost. Montgomery (1972) argues that this efficient equilibrium is independent of the initial allocation, suggesting that regulators can distribute permits as they wish $ ^{21} $ . These key features – cost-effectiveness and irrelevance of initial allocation – of trading schemes are the main arguments why trading schemes are favoured over other alternative environmental instruments to mitigate climate change.

Stavins (1995) uses a simple theoretical framework to show that the potential costs savings from trading systems might be compromised by the presence of trading transaction costs. The nature of transaction costs can determine whether the initial allocation matters for the achievement of the efficient equilibrium. Along similar lines, Tietenberg (2006) argues, that a complete ex-post evaluation of the degree of cost-effectiveness of any trading programme needs to address total compliance costs – abatement costs, as well as trading and administrative costs. This comprehensive evaluation approach can be especially useful in the early stages of the trading programmes, as it can provide insights for the development of the existing scheme, or for the design of other new schemes.

These theoretical findings on transaction costs are supported by empirical analyses of the pioneering US trading systems. Kerr and Maré (1998) find that the presence of transaction costs in the lead permits programme caused efficiency losses of 10-20 percent. Gangadharan (2000) shows that the effect of transaction costs on the choice to participate in the Regional Clean Air Incentives Market (RECLAIM) was significant: without such costs the probability of trading would have increased by 12-32 percent.

Based on this evidence, and considering the fact that the scale and complexity of the EU ETS are unprecedented, it is clear that to understanding the transaction costs incurred over its trial phase (2005-2007) is of paramount importance.

This study addresses the transaction costs incurred by firms, but it must be remembered that governments also incur transaction costs. The European Commission (EC) faced transaction costs associated with the creation and maintenance of an EU ETS team in Brussels. Similarly, each member state had to establish complex organisations to facilitate the EU ETS implementation.
### 4. Research Methods

Our survey of Irish firms consisted of two stages: (1) a mail survey and (2) face-to-face interviews. In Stage 1, a questionnaire was sent to all 72 firms (106 installations) that were covered in the first phase of the EU ETS $ ^{26} $ . According to the Ireland’s national allocation plan (NAP) 2005-2007 (EPA, 2005), Ireland’s Environmental Protection Agency (EPA) allocated these installations with 66.96 million tonnes of allowances (see Annex 2). These allowances were distributed to the following sectors: brick and ceramics (0.2%), cement and lime (18.1%), glass (0.1%), paper (0.1%), refining (1.9%) and energy activities (power generation (66.3%) and other combustion (13.4%)). Over 92 percent of allowances were allocated to the 21 larger installations. Consequently, the share of allocations received by the remaining installations is very small.

Twenty-seven firms $ ^{27} $ completed and returned the questionnaire over an eight-week period (7 July, 2008–1 September 2008), with an understanding that the responses of individual firms would not be identifiable in the research results (see Annex 3 for a summary of firms contacted). These twenty-seven respondents represented around 40 percent of all Irish firms in the EU ETS, and 70 percent of the total Irish allowance allocation, during 2005-2007. According to the level of the respondents’ verified emissions, they were grouped into three categories: large (with an allocation share larger than 2% of the Irish total allocation), medium (0.1% - 2%) and small (up to 0.1%) (see Figure 4). In Stage 2, representative responses were identified, by sector and scale, and face-to-face interviews were conducted (see Annex 4 for the interview profiles).

□ Number of companies, total ■ Number of companies, respondents

Sources: CITL, EPA and author’s calculations.
Before presenting the results, it is important to understand to what degree these results based on the Irish case study can be generalised and used for providing some insights for further policy implementation in the context of transaction costs. Heterogeneous participants and institutions, differences in scale, and variation in monitoring, reporting and verification requirements across member states are the main reasons suggesting that the findings below may not hold for each member state. One could expect some divergence between the participants in the new member states and those in the EU15. However, Trotignon and Ellerman (2008) find little difference between these participants in their analysis of the monetisation of allowance surpluses in the EU ETS during 2005-2007. As the compliance framework for the EU ETS procedures was the same for all participants and each member state had a similar composition of participants in terms of allocation size $ ^{28} $ , we are confident that the sources of the transaction costs and their distribution, if not their magnitudes, would be comparable across member states.

### 5. Findings

### 5.1 Early implementation costs

Twenty-five of the respondents (92.6%) experienced some internal costs consisting of time and staff commitment. Twelve firms (44.4%) incurred consulting costs and seven (25.9%) incurred capital equipment costs. Only five firms responded that they experienced all three kinds of costs, while only two firms answered that they incurred none of these costs in implementing the EU ETS rules.

## I nternal costs

To measure the opportunity costs of time, the firms were asked to report the number of staff members involved and their time spent for the early implementation activities. The firms had two choices: (1) to partially or fully reallocate the existing staff from their regular duties (implicit costs); or/and (2) to hire additional staff (explicit costs). In most of the firms (23 respondents) only internal staff was involved in the early implementation process (in most of the cases only one person), and only in two companies both existing and newly hired staff were working on the launch of the EU ETS. In the firms with multiple installations, more than one staff member were committed to implementing the EU ETS $ ^{29} $ .

In terms of the total time required to engage with the scheme, the firms were asked to provide an estimate of the time commitment for implementing the EU ETS. Three respondents (12.5% of 24 respondents) estimated that the time required was less than one year, but more than nine months. Another five (20.8%) estimated that it took between three and six months. Seven (29.2%) estimated that it required from one to three months; while nine (37.5%) estimated that it only required one working month of effort, or less. It is worth noting here that companies with larger volumes of
allowances spent more time on the early implementation procedures, than companies with smaller shares of the total allocation.

## Consultancy costs

Twelve respondents incurred some consulting costs for implementing the EU ETS. The costs for such services vary from €3,000 to €50,000 per firm (€17,000 on average). Again, the companies with higher allocations tended to incur higher consultancy costs than the companies with smaller allocations. This was quite surprising as we would have expected an opposite outcome, i.e. that firms with lower allocation would have lower in-house capacity and, hence, would be willing to engage with external consultant.

## Capital costs

About one third of respondents incurred some capital costs. These costs vary from €5,000 to €880,000 and, again, reflect the size of the respondents in terms of allocation. Most often meters had been bought for quantification of fuel usage. One firm reported that necessary changes were implemented not only on the tangible capital side, but also on the intangible capital side as necessary updates were made on the information technologies for collating and reporting $ CO_{2} $ emissions data.

## Summary of early implementation costs

The respondents ranked their early implementation activities according to the costs they experienced. The measurement of their baseline emissions and learning about the functioning of the EU ETS were judged by most as the two most costly early implementation procedures, while applying for allowances and delivering a monitoring and reporting plan were the least costly.

Figure 5 and Figure 6 below summarise the early implementation costs faced by respondents expressed as Euros per firm, and per tonne of verified emissions over the three years of the trial period $ ^{30} $ .
Figure 5 Early implementation costs per respondent across different respondents' categories

Figure 6 Early implementation costs per tonne of $ CO_{2} $ emissions emitted across different respondents' categories

Figure 5 shows that the total early implementation costs tended to be higher for large firms than for medium and small firms. On average, large firms faced costs that were 10 times or 30 times higher than those faced by medium and small firms respectively. However, this pattern is reversed when costs are expressed per tonne of $ CO_{2} $ emissions emitted (see Figure 6): costs per tonne of emissions are significantly higher for small firms. For instance, the early implementation costs were €0.03/t $ CO_{2} $ on average for large firms, while they were 17 times higher (€0.51/t $ CO_{2} $ ) on average for small firms.

These results are not unexpected, and are consistent with other research studies (Schleich and Betz, 2004, Betz, 2005) and with concerns expressed by the European Commission about the unequal distribution of administrative costs across EU ETS participants of different sizes (CEC, 2008).

There is also a difference among firms by size in the composition of the early implementation costs. As described in Figure 7, capital costs were the major component of the total early implementation costs for large firms, while internal costs among small and medium firms were larger than their capital and consultancy costs combined.

Figure 7 Composition of total early implementation costs across different respondents' categories

The high capital costs among large firms may be explained by the fact that large firms often have multiple and complex points of emission, which may have required the installation of expensive monitoring equipment. Large installations were also subject to more stringent monitoring and reporting requirements than small installations, which may have required the deployment of costly new technology. Small and medium firms, on the other hand, have fewer, less complex emissions points, and may have been able to track emissions from these points using low-cost fuel meters. The relatively low consultancy costs faced by firms in all size categories may imply that sufficient consultation support was acquired at no cost from the governmental bodies responsible for the scheme’s
implementation $ ^{31} $ or that there was no need to engage with external consultants. However, the former reason is unlikely, as most firms reported that learning about how the EU ETS worked was the most costly process.

### 5.2 Monitoring, Reporting and Verification (MRV) costs

As monitoring, reporting and verification procedures were mandatory for all operators in the EU ETS, all respondents incurred some MRV costs in the first period of the EU ETS. MRV costs consist of the internal (staff) costs and the consulting costs (e.g. verification and consulting costs), and are generally assumed to accrue annually, as MRV procedures were compulsory on an annual basis.

## I nternal costs

In twenty-four firms, only internal staff members were involved in the MRV procedures (in most cases only one person), while in the remaining three firms both existing and newly hired staff was involved in these procedures.

The annual time commitment for the MRV procedures is not significantly different from the total time commitment for the early implementation procedures. Only one respondent estimated that the time required was less than one year, but more than nine working months. Another three estimated that it took between three and nine months. Four estimated that it required from one to three months, while the remaining fifteen estimated that it only required one working month of effort or less. Companies with higher share of allocation spent more time on the MRV procedures, than companies with a smaller volume of allocation.

## Consultancy costs

Over three-quarters of respondents incurred some consulting costs for their MRV procedures, with such costs per annum varying from €1,000 to €100,000 (€12,200 on average). Firms with higher allocations and multiple installations tend to incur higher consultancy costs than companies with smaller allocations. It should be noted here that the definition of consultancy costs encompass verification costs too, which were incurred annually on a mandatory basis by all operators $ ^{32} $ .

## Summary of MRV costs

What was the most costly part of the MRV procedure for companies? As evident in Figure 8, large firms with multiple emission points spent relatively more on monitoring. While firms were required to report their emissions only on an annual basis, large and medium firms appear to monitor their emissions more frequently, on a weekly or monthly basis. This may explain why the share of costs for monitoring is higher for large and medium firms. Likewise it reveals that participation in the scheme
influenced most of the firms’ day-to-day operations, since during the interviews most of the firms noted that they had not monitored their emissions before the launch of the EU ETS.

Figure 8 The breakdown of the total MRV costs across different respondents' categories

To understand the magnitude, the distribution and the composition of the MRV costs across the firms of different sizes, the internal and the consultancy costs were calculated per firm and per tonne of $ CO_{2} $ emitted in the trial phase of the EU ETS $ ^{33} $ . These costs are presented in Figure 9 and Figure 10.

Figure 9 Three-year MRV costs per respondent across different respondents' categories

Figure 10 Three-year MRV costs per tonne of $ CO_{2} $ emissions emitted across different respondents' categories

As in the case of the early implementation costs, the 3-year MRV costs were significantly higher for large firms than for medium and small ones. When costs are expressed per tonne of $ CO_{2} $ emissions emitted, this pattern reverses: the 3-year MRV costs per tonne of $ CO_{2} $ were significantly higher for
small firms than for large and medium ones. For instance, as shown in Figure 10, MRV costs were €0.02/ tCO $ _{2} $ for large firms and more than 75 times this level (€1.51/ tCO $ _{2} $ ) for small firms.

The composition of the MRV costs differs from that of the early implementation costs (see Figure 11). The share of consultancy costs in the total MRV costs is much larger than in the early implementation costs. For large companies, the shares of internal and consultancy costs were approximately equal, while internal costs dominated consultancy costs at medium and small firms.

Figure 11 Composition of MRV costs across different respondents' categories

Several insights may be drawn from these observations. First, the small share of consultancy costs in total MRV costs for small firms may imply that these firms incurred consultancy costs only for verification purposes. Small firms may have had little financial capacity to hire consultants for other purposes, or they may have been concerned only about compliance. The larger share of consultancy costs among large firms might suggest that these companies were concerned not only about compliance but also how to reduce compliance costs. For instance, one large company noted during an interview that the same external consultant helped not only to perform the necessary MRV procedures, but also to identify potential abatement opportunities.

### 5.3 Trading costs

In contrast to early implementation costs or MRV costs, trading costs are variable, as they depend on the volume of allowances traded $ ^{34} $ . As pointed out by Stavins (1995), this form of transaction costs can influence firms' trading decisions, and create inefficiencies.

There were some early concerns about the liquidity of the European allowance market. According to a recent survey’s results, a lack of understanding of how to trade and the fact that participants with long position did not free-up their allowances in the market were indicated by EU ETS participants as the most important reasons preventing the allowance market from further improving liquidity (European
The fact that the EU ETS comprises heterogeneous participants in terms of core business, initial emission permit allocation size, in-house trading and technical capabilities, etc. raises the question whether companies with small and single installations have the same capability as big multiple installation companies to deal with the scheme requirements. The concern that transaction costs (especially administrative ones) might be excessive for smaller installations has been raised by the European Commission too (e.g. see CEC (2008)). These concerns are supported by the findings of our study.

Figure 12 and Figure 13 below summarize the burden of transaction costs borne by firms with small, medium and large emissions allowance in the pilot phase. The cost distribution reveals that while in absolute terms transaction costs were highest for large firms, the transaction costs per tonne of $ CO_{2} $ emitted were much higher for the smallest operators. Additionally, the composition of transaction costs shows that while early implementation costs were more significant for large respondents, on-going MRV costs were more considerable for medium and small firms.

Figure 12 Total transaction costs per respondent across different respondents' categories

Figure 13 Total transaction costs per tonne of $ CO_{2} $ emissions emitted across different respondents' categories

Early implementation costs are fixed costs (or sunk costs) that were incurred only once before trading started. If these costs were distributed across the life-span of the programme, they would be significantly lower than other transaction costs components for most of the scheme’s participants (however, it remains true that the initial costs are unlikely to be negligible). Hereafter, we refer to the costs incurred before the start of the trading period as ‘fixed costs’, and MRV and trading costs as ‘transactions costs’. Over time, the MRV component of transactions costs should diminish as a result of learning-by-doing and increased competition among verifiers. For instance, one quarter of respondents in the Irish survey claimed that their overall transaction costs decreased over the three years of the EU ETS pilot phase. In the future, when the trading market matures, a special attention should be given to understanding the trading transaction costs, their nature and distribution across different participants.
Although these transaction costs are extra costs that are incurred as a result of implementing the programme, they are more appropriately seen as the costs of implementing a program of limiting emissions to the cap level.

The results, expressed as average costs per tonne of $ CO_{2} $ emitted, were as follows: the costs of price discovery and trading were negligible - there is no evidence that they inhibited the efficiency of market operation; the average costs per tonne of $ CO_{2} $ emitted for all firms for set up and MRV amounted to €0.08, which is less than one per cent of the current allowance price of €11.60 on January 23, 2009 (see: http://www.pointcarbon.com/news/1.1042750). For the largest firms – accounting for over half the emissions - these costs are still lower, amounting to just €0.05 per tonne. However, for the small firms, while they contribute a very small share of emissions, their costs per tonne – at €2.02 - amount to over 18 per cent of current allowance price. We conclude that the costs overall are so low that they are unlikely to impose a drag on firm or overall performance, but that for small firms, who typically already face major challenges in meeting other input costs, this may not be the case.

The immediate policy implications are that attention to the transaction cost implications of thresholds and scale are important considerations in the design and implementation of trading schemes.

The easiest way to reduce transaction costs for small operators would be to exempt them from the scheme. This ‘opt-out’ possibility of small operators was considered at the EC level too. However, this goes against the ‘polluter pays’ principle, which is the core of the EU ETS. The European Commission notes that “an exclusion of small emitters from the EU ETS on the grounds of cost-effectiveness cannot mean, however, that these installations do not need to contribute to the overall emission reduction targets of the EU. It would just mean there would need to be other more cost-effective measures to ensure the same objective” (CEC, 2008, p. 24).

The harmonisation and an increase of efficiency of the MRV activities, and an increase in competition of verification services are other ways to guarantee the reduction and the equalisation of transaction costs in the EU ETS across 27 EU member states and its participants. No doubts, alongside the reforms on bureaucratic side, the learning will be a key in achieving the successful reduction in these costs. This leaning might be considerably facilitated through information provision and training process.

As regards the taxes vs. trading debate, since $ CO_{2} $ taxes would also require the same level of MRV costs, and some set up costs, our evidence does not support the proposition that carbon taxation would be better than emissions trading from the perspective of transactions costs, although we recognise that there are also other considerations involved.