Including Aviation in the European Union Emissions Trading Scheme : Impacts on Industries , Macroeconomy and Emissions in China

In October 2008, European Union (EU) announced that it would include the international aviation in the European emission trading system (EU ETS). This paper builds a static computable general equilibrium (CGE) model based on the 2007 input-output table, and estimates the impacts from this policy on China’s macro-economic, residents' welfare, aviation industry, and carbon dioxide (CO2) emissions. Our results indicate that the implication of this policy has negative effects on China’s economy and residents’ welfare; nevertheless, it also reduces the outputs of industries especially that in aviation industry.


Background
In recent years, the aviation industry keeps growing fast with the average annual growth rate of 5% and stimulates the economic growth.However, the international aviation is also responsible for about 2%-3% of anthropogenic greenhouse gas emissions (Wang, 2010).With the increasing of the air transportation's greenhouse gas emission, its accumulated contribution to climate change becomes larger over time.In order to cap CO2 emissions of the aviation sectors, the European Commission, the European Parliament and the European Council decided to include international aviation in the existing European Union's CO2 Emissions Trading Scheme (EU ETS) in December 2008.According to this policy, more than 2000 airlines whose flights will land at or depart from any airport in the EU should be included in the EU ETS since 2012, including Air China, China Eastern, China Southern and other 33 airline carriers from Mainland China.This policy causes controversies globally.Different interest groups exhibite different attitudes over it (Guo, 2010).The first group, including Thai and Korean airline carriers, welcomes the policy, and is ready to join the EU ETS.The second group is somehow supportive, including Brazil and Middle Eastern airline carriers, believing they would benefit from the EU ETS in the long term because of their advantages in developing new bio-fuel.However, the third group, including airline carriers from China, United States, and many other countries, protests that the policy is not fair and has potential negative impacts on their aviation industries (Malina et al, 2012).It is widely believed by those in the third group that European Union (EU) charges for "carbon fee" unilaterally are a violation of the "Chicago Convention" and the "Kyoto Protocol".Some even declair that such a policy will not only violate other countries' airspace sovereignty thereby against international law, but also increase the cost of the international aviation unnecessarily.China Air Transport Association (CATA) has insisted its attitude of opposition since EU announced the implementation of this policy.The CATA united more than 20 foreign airline carriers to co-publish the "Beijing Joint Statement".In this statement, the CATA officially expressed its strong opposition to the policy, and called upon other countries to oppose the policy.This statement also manifests that the policy forces the developing and developed countries bear the same responsibility for emissions reductions, which violate the the prevailing principle of "common but differentiated responsibility".

Literature Review
This controversy also draws many attentions from Economics and policy research communities.Qin and Chen (2011) roughly describe the operational mechanism of EU ETS and the policy that including the aviation industry into the EU ETS in details.Guo (2010) briefly introduces the existing controversy, and qualitatively discusses the potential impacts after the implementation of this policy.Until now, the existing literatures largely focus on introducing the policy and related controversies, and their endeavors to provide some policy suggestions on dealing with the climate change, energy consumption, emissions reduction, or better policy design of a "fair" emissions trading scheme (Gao, 2007;Gong, 2010;Li, 2010;Zheng & Song, 2010;Li, 2010).
However, there are many other studies, which try to quantify the policy's impacts on macroeconomic and industries.Vespermann and Wald (2010) employ a simulation model to quantify both economical and ecological impacts from the inclusion of aviation industry to the EU ETS system, and find that the ecologic effect is based on the design of the system and the emission reduction is comparably low.Anger (2010) applies a dynamic model called Energy-Environment-Economy Model, and find that adding air transport to the EU ETS has no impact on economic growth in the EU, but by contrast can decrease the CO2 emissions by 7.4%.Andrew and Zhang (2011) investigate the effects of unilateral measures, such as the EU-ETS system, on airline competition and global emissions with a cost-benefit method, and conclude that the unilateral regulation will actually increase the amount of global greenhouse gas emissions in the long term.Taking the Lufthansa and Continental Airlines as examples, Scheelhaase et al. (2010) indicate the effects on competition between European and non-European aircraft operators, and believe that the policy is good for the non-EU airlines in terms of the competitiveness.Albers et al. (2009) analyze the impact of the policy on the cost of different routes and people's needs, and then give the result that the policy will cause a small increase in the cost, but it is not enough to affect the structure of the aviation industry.Using a tourism arrivals model, Pentelow and Scott (2011) examine the implications of the proposed climate policies for the world's most tourism dependent region-the Caribbean, and find that there will be no meaningful impact on arrival numbers to the Caribbean under the current policy, but will have a great decrease if the policy become more stringent.
In summary, few existing qualitative studies can quantify the impacts of this policy to China, although some try to quantify the influences of the policy on European countries rather than China.In fact, the quantification of the impacts is crucially important for understanding China's further policy-making.Therefore, we aim to investigate the impacts of the policy on China's macro economy, the aviation industry (and of course other industries), and the CO2 emissions reduction.

Method
In a Computable General Equilibrium (CGE) model, sets of equations are used to describe supply, demand and market relations in an economy under a series of constraints.The CGE model, originating from Walrasian general equilibrium theory, is commonly used nowadays.To assess the impacts of the policy including China's aviation industry into the EU ETS system, we employ a simple static multi-region CGE model, including producers, consumers, government and abroad sectors.

Production and Trade Module
The model assumes that there are only two production factors: labor and capital.The factors can mobile within each region; product and factor markets are full competition structures so that their returns to scale are constant.The Leontief input-output matrix is applied to describe intermediate demands; the Cobb-Douglas (CD) function is used to define the production.
where X i denotes the output in sector i; A i stands for efficiency parameters; al i represents the elasticity of substitution between the labor and the capital in sector i; INT ij means the intermediate input of commodity j in sector i; ij a indicates input-output coefficient; X j means the output in sector j.
As for the import, the Armington assumption is adopted in the paper, i.e., we assume that there exists imperfect substitutability between imports and domestic products sold domestically, and that consumers choose commodities between domestic and foreign products in order to maximize their utility.As for export, this model uses a constant elasticity transformation (CET) function to allocate total domestic products between exports and domestic sales to maximize the producers' interests.

Price Module
We define the international market prices of the imported and the exported goods as exogenous variables in the CGE model.The price functions are as follows: Eq.( 3) indicates that the price of imported goods, where PM i is determined by the international price of imported goods PWM i , market rate of exchange ER and import tariff rates tmi.Eq.( 4) indicates that the price of exported goods PE i is determined by the international price of the exported goods PWE i , market rate of exchange ER, export rebate rate te i and ad valorem rate for carbon tar.

Income Module
where YG represents government revenue; YTM i denotes the import tariff revenue; YTX i is the indirect tax revenue; YTD means the corporate income tax; YTH stands for personal income tax; FTR is transfer payment from the foreign to our government; YH means households income; YHL represents households income from labor; asch stands for ratio of the capital returns for residents to the total capital returns; YK respresents total capital gains); EHT denotes transfer payment from enterprises to residents; GHT means transfer payment from government to residents; NFN stands for foreign transfer payment to residents.

Demand Module
Resident consumption is described by the Extended Linear Expenditure System (ELES) function, which derives from the Stone-Geary utility function based on the maximization of consumer utility.
where CH i denotes household demand for commodity i; YH stands for households income; bn j means the family's basic demand for commodity i; mch i is the family's marginal consumption of commodity i.

Macro Closure Module
According to Yan and Fan (2009), the Keynesian economic theory can explain and best fit the reality of China's current macroeconomy with excess labor supply.Therefore, this model chooses the Keynesian closure rule, and assumes that there exists unemployment, and that the labor demands for the various sectors are endogenous.
Eq.( 8) shows the clearing of capital market, where K i stands for capital requirements of sector i, TK for the total supply of capital, which is set exogenously.Eq.( 9) shows the invest-saving balance, where TI stands for the total investment, SH for household savings, SE for corporate savings, SG for government savings, NSAV for foreign savings, which is exogenous.Eq.( 10) shows the clearing of products market, where INT i stands for the intermediate input of sector i; CG i for government consumption; II i for investment demand; ST i for inventory needs of sector i.

Scenarios
According to the policy, all CO2 emissions from flights departing from or flying into any EU airport have to be offset; thereby emissions from aviation activities are limited.For the first trading period in 2012, the quantity of allowances to be allocated among airlines will be equivalent to 97% of the mean average of the historic annual emissions from air transportation in the years 2004-2006.85% percent of these allowances are granted for free, the remaining 15% of allowances are to be auctioned.From 2013 on, the total quantity of allowances will be reduced to 95% of historic aviation emissions and the free quota be reduced to 82%.And by 2020, the all allowances will be auctioned.An airline carrier could sell its surplus carbon allowances if its emissions are below the free quota, and has to buy appropriate amount to offset some of the excess emissions if its emissions are higher than the free quota but less than the total quota.If one's emissions exceed the total quota, the airline carrier is required to purchase the excess from carbon market before 30 April of next year; otherwise, it will be imposed a fine of 100 Euros per ton for CO2 emissions, and offsets the excess by the following year's quota.
In this paper, we assume that all of China's international flights are limited in carbon emission in accordance with the rules of EU ETS, and that the allocation of the allowances is based on the data in 2007.Considering the policy in EU and its trends, we set up three purchasing ratios, that is, 15%, 50%, and 100%, as three scenarios.
According to Zhu and Wang (2010), the purchase proportion of the quota to the ad valorem tax rate is defined where tar stands for the ad valorem tax rate;  for the purchase proportion of the quota; EC for the CO2 emissions from the International routes of aviation; X for the total production value of International routes of the aviation industry; tar c for the price per tons of the carbon dioxide emissions.By Eq.( 11), we can get that tar are 0.1664%, 0.5547%, and 1.1094%, respectively, corresponding to the three scenarios that  =15%, 50%, and 100%, respectively.

Data Sources
The Social Accounting Matrix (SAM) provides a detailed description of the economy in a region in a given period and a consistent source of data for the model.We suppose that a department produces only one product, and the prices of products are 1 in the base period.Then we calculate the China micro-SAM2007 and balance the micro-SAM2007 using the RAS method.The data involved in the aviation sector are taken partly from the Civil Aviation Statistics 2008, partly from the macro SAM table.The values of exogenous parameters including miscellaneous substitute elasticities and carbon emission factors are from the related literatures (Wang et al., 2010;Zhao & Wang, 2008;Liu & Fu, 2011).The values of endogenous parameters are estimated with the method of calibration in GEMPACK based on the equations and the data in the SAM.

Macroeconomic Impacts
We select the nominal gross domestic product (nominal GDP), real gross domestic product (real GDP), government revenue and household income as representative indicators of China's macro-economic.
As one might see in Table 1, the policy has negative impact on China's nominal GDP: when the ratio is 15%, the nominal GDP will decrease 840 million RMB; when the ratio increase to 50% or 100%, the nominal GDP will decrease 2790 or 5530 million RMB.The real GDP, on the contrary, increases slightly, simply because the increase of production in aviation industry (5% per year) is greater than the loss this policy induces.The household income and government revenue decrease under all three scenarios (see Table 2): at the purchasing ratio 15%, government revenue and household income decrease by 130 million RMB and 210 million RMB; at 100%, the losses of government revenue and household income are 880 and 1400 million RMB respectively.Therefore, the implementation of this policy has negative impact on Chinese residents' welfare.

Impact on Foreign Trade
The results also show that the purchasing of carbon allowances for the international airline increase the operating costs and diminish the profits of the aviation industry.The decline in profits is also reflected in export prices (see Table 3), that is, the greater reduction in export prices indicates the greater loss in the industry.The international airline industry suffers a great decline in its export price, which decreases by 1.13% at the purchasing ratio 100%.The declines in the export prices decrease the export profits; then decreased profits reduce quantity of exports.The combination of decline in price and decrease in quantity reduce the value of exports.From the results, on can estimate that the value of exports decrease by 1220 million RMB at the purchasing ratio 100%.

Impact on Industries
One can find that the implementation of policy will incur the reduction of sectoral outputs in all the thirteen sectors.The sectoral output loss of International Airline, Domestic Airline and Manufacture of Transportation Equipment are 0.156%, 0.0793%, and 0.0232% respectively (see Figure 1).
www.ccsen  t and giable e EU have significant negative impacts on China's aviation industry, reduce China's nominal GDP and the residents' welfare, influence China's total exports and the export price, and definitely hold back the growth of China's economic production.Interestingly, although the original purpose of this unilateral and coercive policy is to reduce aviation's CO2 emissions, the results show that the emission reduction is dispointedly trivial.
Based on the input-output table in 2007 and data from the China Financial Yearbook 2008, China Tax Yearbook 2008, China Statistical Yearbook 2008, the China SAM2007 is obtained.The SAM is balanced by means of the RAS method.We split with the 142 departments in the 2007 input-output table and categorize them into 13 sectors.

Table 1 .
Changes in GDP under different purchasing ratio

Table 2 .
Changes in income under different purchasing ratios

Table 3 .
Changes in export price under different purchasing ratios