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Carbon dioxide (CO2) emissions are a global concern; impacts on the climate do not depend on where the CO2 is emitted. To meet this concern, a worldwide program for cutting greenhouse gases was formed in Kyoto, Japan in December 1997. The Kyoto protocol formulates the general principles for a worldwide treaty on cutting greenhouse emissions and specifies reductions for the industrialised world. The European Union has introduced an EU wide emission trading system (EUETS) that became operational in 2005 as an instrument for EU member states to meet their Kyoto obligations. Transports are not included, but may become a part of the EU-ETS in future revisions. Instead emissions from transports are regulated by other means, including fuel taxes. To further reduce CO2 emissions from passenger cars and to improve fuel efficiency, the European Community has adopted a separate strategy. An important element of this strategy are the Commitments of the European, Japanese and Korean Automobile Manufacturers Associations to achieve total new passenger car fleet average CO2 emissions of 140 g CO2/km by 2008/2009. In this paper we assess the option of introducing an EU wide certificate/emission permit trading system for new passenger cars as an alternative to the commitments made by the European Automobile Manufacturers Associations. An overview of alternative trading systems is presented, possible objectives and evaluation criteria are discussed, arguments for introducing separate systems for new passenger cars are discussed, the potential for emission reduction through technological advances and changed consumer behaviour is analysed and a possible design of a system of tradable permits for new passenger cars is presented. CAP-AND TRADE OR BASELINE-CREDIT? In a cap-and-trade system a total limit (a cap) on emissions is defined. Emission permits that sum up to the limit or cap are then allocated among the agents generating the emissions. Having allocated the permits, trade is introduced. If certain conditions are achieved, trade will continue to the point where marginal abatement costs are the same across sectors and nations. Cost-effectiveness is then achieved. The EU-ETS is an example of a cap-and-trade system. A baseline-credit system is an alternative. In such a system certificates or credits are based on the achievement of improvements in relation to a baseline. Agents with emissions lower than the predefined baseline receive credits and those exceeding the baseline will have to buy credits. The baseline is typically defined in relation to a rate-based value such as CO2-emissions per kilometre or emissions per unit of output. A relative baseline system of this kind is thereby designed to control average emissions, e.g. per car and kilometre, rather than total emissions. The cap-and-trade system has the advantage by allowing a larger variety of choices for adjusting emissions. Taking road transports as an example, total emissions can be reduced not only by reducing average emissions per car and kilometre but also by reducing total car fleet mileage e.g. by giving incentives to travellers to drive less, drive shorter distances or shifting to alternative modes of transport. If the overall objective is to reduce emissions in a cost-effective manner across sectors and nations, including the transport sector in current EU-ETS would be an option to consider. The advantage of such a system is that it has the potential of providing incentives to agents to act in a way that will equalise marginal abatement costs across sectors (assuming also that current CO2-based fuel taxes/other taxes linked to CO2 emissions are adjusted accordingly), thus leading to cost-effective abatement. The baseline-credit system, on the other hand, would concentrate on reducing average emissions and consequently target the behavioural changes necessary to reduce average emissions. If, for example, the objective is to increase energy efficiency through technological improvements, a baseline-credit system may therefore be the optimal choice. Moreover, myopic behaviour in the market for new passenger cars may lead to a situation where consumers' preferences and willingness to pay for CO2-reducing technology is insufficient to cover the costs of developing the technology and put it to the market even if car manufacturers were to trade in EU-ETS and thereby receive monetary gains by developing technology that reduces fuel consumption and CO2 emissions. A system such as the baselinecredit system may therefore be necessary in order to provide sufficient incentives to manufacturers to work towards increased energy efficiency in new cars through technological improvements. The average CO2 emissions from new cars sold in the market can be reduced in two ways; either by increasing the energy efficiency in each type of car put to the market (i.e. improved technology) or by providing incentives to consumers to choose the most energy-efficient cars already in the market. Achieving objectives such as 120 g CO2/km for new car fleet most likely requires both of these. Also, in order to influence consumer behaviour it is important to make technology available to consumers at low cost. Consumers choose to pay for new technology only if the benefits of improved gas-mileage exceed the costs of higher car prices. TECHNOLOGICAL IMPROVEMENT OR CHANGED CONSUMER BEHAVIOUR? Considering technological improvements there are two ways in which to reduce specific CO2 emissions: By reducing fuel consumption in vehicles with conventional combustion engines (petrol and diesel), or by using renewable, low-CO2fuels (partly) in conjunction with new engine technologies. Fuel consumption in vehicles with conventional combustion engines can in turn be reduced in a number of ways. Technological measures can be roughly divided into four categories: Improved engine technology, downsizing and enhanced transmission technology, energy management and hybridisation, and vehicle design. The literature shows that conventional combustion engines have considerable potential for fuel-saving. In the case of petrol engines, it is thought that measures involving the drive train in a middle-size vehicle could achieve fuel savings of around 38 per cent. Further measures such as weight reduction, reduced rolling and air resistance, and promotion of fuel-efficient driving habits can result in 40 per cent or greater decrease in overall consumption. Diesel engines have lower savings potential than petrol engines because diesel engines are less wasteful than petrol engines when run at partial throttle, and significant increases in diesel motor efficiency have already been achieved. Nevertheless, hybridisation and improved transmission could result in savings of around 32 per cent. Additional savings could also be achieved with a reduction in vehicle weight, reduced rolling and air resistance, and by promoting fuel-efficient driving habits. Turning then to consumer behaviour, it is important to recognise that consumers consider a large variety of characteristics before finally choosing the car that best fits their needs and their personal preferences. From a CO2 point of view consumers should ideally be concerned about fuel efficiency more than any other characteristics. This, however, is not the case. Studies have shown that factors such as safety, prestige and powerful engines influence consumer behaviour more than does fuel efficiency, especially in times when disposable incomes increase. However, in spite of recent trends there seems to be a potential to provide incentives to consumers to shift to low-emitting cars without any large sacrifices being involved. Consider, for instance, Volvo V70, which was the most popular new car model in Sweden in 2005. The emissions from the different petrol versions range between 214 and 266 g CO2/km, whereas diesels are available with emissions ranging from 171 to 223 g CO2/km. A movement form the highest CO2/km per kilometre value to the lowest would thus imply savings of 95 grams per kilometre. To achieve these savings a consumer who currently prefers the highest emitting car has to change fuel, automatic transmission and engine power. However, brand, model or car size would not need to change. For most consumers the "adjustment cost" would thus be relatively low. The above is an extreme case scenario involving only one car model. Considering instead the whole fleet of new passenger cars, our calculations show that there is a general potential to reduce CO2 emissions from new cars by 13-30 g CO2/km within the same car model (or approximately 8-15 per cent). THE COST OF INCREASED ENERGY EFFICIENCY The main purpose of a baseline-credit system for new passenger cars would be to provide incentives for car manufacturers to develop and introduce the technology in new cars required to reach the specified CO2-objectives. However, this also means that consumers must find it worthwhile to buy a low-emitting car, i.e. the benefits of the improved technology, not the least in terms of increased gas mileage, must exceed the increase in sales price. The technological potential is large, but the benefits for consumers could be questioned since car buyers apparently do not judge energy efficiency as an important characteristic. Assuming unchanged market shares for petrol and diesel cars as well as small, medium and large sized cars, our calculations show that a reduction of the average emissions to 120 g CO2per car and kilometre in the EU would imply an increase in retail prices by 2 000 euro. There is technological potential to further reduce emissions to an average of 100 g CO2 per kilometre. However, the cost increase for this additional reduction is about 6 000 euro. THE DESIGN OF A SYSTEM FOR NEW PASSENGER CARS It is our conclusion that an emission trading system for new cars should be separated from the EU-ETS and designed as a baseline and credit system, based on emission intensity. Setting up a separate emission trading system for new cars as a baseline and credit system involves defining a baseline. It is natural to tie the baseline to the goals that are under discussion in the European Union i.e. 140 and 120 g CO2/km. Different time frames have been discussed. One possibility is to reach 140 CO2/km by 2008/2009 and 120 g CO2/km by 2012. Earlier discussions about technological development show that this time frame is feasible. Before trade can take place, demand and supply of credits need to be created. In a cap-and-trade system initial allocation of permits is a very important issue. In the baseline and credit system the allocation of credits is automatic: cars below baseline receive credits and cars above baseline need to purchase credits. In principle, this implies that no cost is imposed on the baseline car. High-emitting cars will become more expensive and low-emitting cars less expensive. The credits will work in a way similar to a system of subsidies for cars emitting below the baseline and taxes for those above. Trade with credits need to perform in a way that supports attainment of the baseline. A possible solution is that credits are traded in a market that is similar to a stock exchange. The offers of sellers and the bids of buyers will meet in a market that ideally clears each trading day. As long as markets clear, there is attainment of the baseline. To overcome imbalances, an accommodating system that handles short time excess credits or shortages will need to be worked out. There is also a need for an enforcement and compliance mechanism. Another issue to deal with is that there may be different incentives for buyers and sellers. Buyers will generally be obliged to buy credits. Sellers, on the other hand, may want to capitalise their credits later, or to bank them for coming periods. The differences in incentives can lead to shortages and an upward pressure on prices and fluctuating prices. The issue whether trade of credits should take place downstream or upstream includes several options in the production-consumption chain. The recommendation is that the retailers should be the trading entity. We also suggest gradual reductions in baseline. However, the details of a system of baseline and credits will need further analysis. Important issues in a future analysis will be designing mechanisms for compliance, monitoring and penalising. Incentive problems need also to be dealt with.