Surplus emission allowances as implicit side payments: could 'Hot Air' have saved the Kyoto Agreement?

The purpose of this article is to analyse whether the presence of surplus emission allowance trading jeopardizes the environmental target of an international environmental agreement. We argue that surplus emission allowance trading can be used as an implicit side-payment mechanism to actually bring about higher environmental protection compared with the situation without the trade option. We point to the existence of a fundamental trade-off between costs of compliance and the creation of dynamic incentives to develop cheaper reduction technologies. Implicit side payments, in terms of surplus emission allocations, may be needed in order to establish a compromise between these opposing demands. We identify the shortcomings and benefits of allowing fully flexible permit trading, including the allocation rule of grandfathering.