Emissions Trading: ERCs or Allowances

There are two principal choices of the baseline from which emissions trading may take place: 1) emission reduction credits (ERCs) in which the baseline is existing regulations which are often activity-based; and 2) cap-and-trade which specified the total allowable emissions. This paper examines the effects of these two tradable permit systems on marginal and average costs for the firm, using electricity generation as an example. The ERC system subsidises the activity level to which it is tied, failing to incorporate the full cost of external harm into the product price. The cap-and-trade system is more efficient.