Tradable Pollution Permits as a Remedy for the Negative Externality

By Eric Dahlberg




Beyond environmental problems associated with poverty are those that can arise from economic growth itself As countries become more industrialized, augment their agricultural production, and expend greater amounts of fossil fuels, the environment often suffers.  The challenge facing policymakers worldwide is to manage economic growth in a way that maximizes its benefits and reduces its costs, in terms of damage to both the environment and to the free market system.

Since the Industrial Revolution, economic growth has required the burning of coal and oil as fuel for production in the economy.  Burning coal contributes to the greenhouse effect, which it is hypothesized will raise the temperature of the earth, causing severe global climate problems, The degradation of the atmosphere is, to a certain extent, an unavoidable consequence of economic growth.  However, if this growth is not carefully monitored, environmental problems will be incurred.  Denying firms incentives to control or reduce the amount they pollute, the environment will surely suffer.  Given that the environment - in this case, the atmosphere - is a public good, there exist no incentives for firms to reduce their emissions at the margin.  This situation can be likened to a rancher grazing his herd on a public pasture.  The rancher no incentive to graze the fewer head of cattle that is socially optimal.  Thus, some incentive must be built into this public good so that there will be consequences for excessive degradation (1).

Policymakers have a much wider variety of tools at their disposal then they did 20 years ago, many of which could improve environmental protection at a relatively low cost.  In the past, the typical approach was to regulate behavior, often through what are

known as command-and-control approaches.  Although these approaches are important, they can also be costly and difficult to enforce.  More recently, policymakers have been using market-based incentives as a way to achieve environmental health goals.  These incentives can take the form of subsidy reforms, taxes to increase prices to reflect social costs, or the establishment of new markets in which pollution permits can be traded.

These increasingly popular market-based pollution permits aim to limit pollution at an optimal cost to industry.  By deciding on the proper level of atmospheric pollution desired, we create a market mechanism so that the "invisible hand" efficiently allocates the right to pollute among firms.  This mechanism allows for firms to trade the right to pollute through emissions trading, Firms can reduce emissions by relying on renewable energy, reducing usage, employing new technologies, or developing other strategies.  Firms that reduce their emissions below the number of permits they hold may trade or sell them to other firms, or save them to cover emissions in the future.  Allowance trading provides incentives for energy conservation and technology innovation that can both lower the cost of compliance and yield pollution prevention benefits.  The market-based allowance trading system capitalizes on the power of the marketplace to reduce pollution cost-effectively and uses economic incentives to promote conservation and the development of innovative technology (3).


Economic Theory


It has been asserted that tradable pollution permits achieve a desired level of pollution control at an optimal cost to society.  But what basis do we have for these assertions?  While these claims may seem intuitively true, they are also firmly grounded in economic theory.

When the costs of producing a good or the benefits from consuming a good spill over to people whom are not involved in the consuming or producing of the good, an externality occurs.  The production of goods that cause pollution is a classic example of a negative externality.  Externalities that have a negative effect - a cost - on society are known as negative externalities.  In the case of these negative externalities, the competitive market does not generate the socially optimal, or efficient, amount of the good.  Producers do not take into account the external costs when calculating their costs of production.  Therefore, the quantity produced is greater than the efficient quantity.  If the external costs were taken into account, the producers would produce less (2).

In a tax-based policy, a tax is set (usually in the form of a fine) for pollution beyond a certain level.  When the marginal benefits and marginal costs of pollution control are known with certainty, the amount of the tax can be set to the efficient marginal cost of pollution and firms will choose to clean up an amount of pollution that is exactly efficient.  In this situation, either an emissions tax or a tradable permit policy can achieve the same efficient level of pollution abatement.  In terms of efficiency alone, the two policies are equivalent (4).

In practice, policymakers rarely know the marginal cost of pollution control before policy is formulated.  In this case, a tax-based system makes it necessary to formulate policy based on an estimate of marginal pollution control costs.  If the estimate is not an accurate one, the desired level of pollution control is not achieved.  Determining the appropriate amount of the tax can be a very difficult undertaking.  By simply setting acceptable levels of emissions among polluters, we fail to recognize that costs differ among factories.  For one factory, it may be very inexpensive to reduce pollution emissions at the margin but for the other it may be much more expensive (3).  Secondly, the cost of regulating emissions from polluters is very high with command and control methods.  In order to set some sort of socially optimal level, information must be obtained about the true cost of emitting.  Obtaining information can be done in two ways.  First it can be obtained from the companies in the industry, which have a vested interest in overstating their reduction cost.  Another way of obtaining information about emissions is to obtain it independent of the company, which can be very cost prohibitive.

Because of these problems, pollution permits are often an attractive alternative to taxes.  Marketable pollution permits get around these problems by perfectly reflecting the

firms' willingness to pay and marginal pollution control costs.  In fact, after the EPA started the permit auctions, they found that the true costs of abatement were much lower than they initially believed.  Under a permit policy, one must first choose the desired level of abatement and create an according number of permits.  Firms are then allowed to trade permits in a profit-maximizing manner, thus finding the minimal cost of pollution control.  Pollution permits also give firms an incentive to develop new technologies aimed at inexpensively reducing pollution.  These permits allow policymakers the ability to rest assured that whatever level of pollution control they choose, the "invisible hand" of the market will let firms to comply at a cost most advantageous to the firms and to society itself.


Method of Allocation


The system of tradable pollution permits is a remarkably simple way to regulate pollution at a cost that is optimal to society.  Perhaps the most difficult aspect of implementing a policy of tradable pollution permits lies in the initial allocation of the permits.

The most accepted method of allocating permits currently used by the EPA is the sealed bid auction.  Under this method, buyers of permits must send their bids in a sealed envelope to the agency conducting the auction.  The permits are sold to the highest bidders until there are no more bidders or the permits run out.  There are two main features of sealed bid auctions that make them different from other methods.  For one, they can be organized to prevent firms that control a large fraction of the permits from exhibiting monopoly power.  And secondly, they enhance price stability, which adds rational planning of pollution control by the polluters.  Silent auctions are most efficient when permits can be traded freely at any time.  With free trade, the permits become an asset- firms who pollute too much can buy additional permits to cover their emissions at a price that reflects the marginal social cost of the pollution.  One problem with this mechanism is that it is not popular from a political perspective.  Firms which have freely polluted in the past will not be happy when this right is taken away.  Another method is to award permits to firms based on the amount of pollution they have historically emitted.  This method, however, seems to reward those firms that have polluted excessively in the past.  In determining who should get pollution permits when they are initially allocated, it is necessary to contemplate the question of who owns the property rights to clean air.  If it is determined that industry holds the right to pollute, permits must be allocated based on past pollution.  If it is determined that no one has the right to pollute without compensating society for the cost of the pollution, then we may award the right to pollute to the highest bidder (1).

One final policy note must be mentioned regarding who is able to purchase the permits once they have been initially allocated.  It is important that nongovernmental organizations be allowed to participate in the free trade and auction process.  These organizations play an important role in determining the socially optimal level of pollution.  If individuals or organizations feel strongly enough, they must be allowed to purchase permits, thereby reducing the allowable level of pollution.  This feature insures that the socially efficient outcome is attained regardless of the initial allocation of permits.


Case Study in the United States


Permit trading is the centerpiece of EPA's Acid Rain Program, and permits are the currency with which S02 emissions requirements are achieved.  Through the market-based permit trading system, utilities regulated under the program, rather than a governing agency, decide the most cost-effective way to use available resources to comply with the acid rain requirements of the Clean Air Act.  Utilities can reduce emissions by employing energy conservation measures, increasing reliance on renewable energy, reducing usage, employing pollution control technologies, switching to lower sulfur fuel, or developing alternative strategies.  Units that reduce their emissions below the number of allowances they hold may trade allowances with other units in their system, sell them to other utilities on the open market or through EPA auctions, or bank them to cover emissions in future years (3).

The market-based allowance trading system capitalizes on the power of the marketplace to reduce S02 emissions cost-effectively and uses economic incentives to promote conservation and the development of innovative technology.  The Acid Rain Program may establish a precedent for solving other environmental problems in a way that minimizes the costs to society and promotes new technologies.


The Future of Tradable Pollution Permits


A summit was held in Kyoto, Japan in December of 1997 to discuss global warming and how the world should deal with the problems it presented.  As a result of the conference, the United States agreed to reduce emissions equivalent to 7 percent of 1990 levels, by 2012.  Similar commitments to reduce emissions were made by other industrialized countries.  Pollution permits that would turn carbon emissions into a commodity on a global scale were discussed as a way to achieve the objectives agreed on at the conference.  In addition, rewards for exceeding these goals were also discussed.

Expanding emission trading to a global scale would serve as one way of dealing with the global pollution problem, since few countries face any restrictions on pollution emissions.  International emissions trading is currently being proposed by some as an answer to the problem of global warming.  Given that global warming is a global problem, and pollution travels freely without respect to political boundaries, it seems that global pollution permits would be an excellent solution.  In a statement endorsed by over 2500 economist, including 8 Nobel laureates, the problem of global climate change was addressed by stating:

The most efficient approach to slowing climate change is through marketbased policies.  In order for the world to achieve its climatic objectives at minimum cost, a cooperative approach among nations is required- such as an international emission trading agreement.  The United States and other nations can most efficiently implement their climate policies through market mechanisms, such as carbon taxes or

the auction of emissions permits.  The revenues generated from such policies can effectively be used to reduce the deficit or to lower existing taxes. (1)

One of the ideas that has been proposed would give each country a certain amount of permits, which could then be distributed to domestic companies.  These permits could then be traded on a global scale.  One of the most immediate problems facing the internationally tradable permit movement is one of logistics.  It is difficult to find any sort of common ground on which countries should reduce their emissions and how much they should be required to reduce.  Inevitably, the more developed countries feel that their industries are far too mature to drastically change methods of production in order to reduce pollution.  The industrialized countries feel that it would be much easier for the underdeveloped countries to do things right from the beginning than it would be for them to fundamentally change after a century of industrialization.  The underdeveloped countries feel that the industrialized nations have created the problem, therefore, it should be their responsibility to correct it.

Not unlike emissions trading at the local level, the initial allocation of globally traded permits can have a huge effect on the economies of all countries involved.  Huge wealth transfers are possible if a less developed country sells many of its permits to an expanding economy.  An example of this can be seen with the current Russian situation.  With the collapse of Russian industry, emission goals for the year 2012 set by the Kyoto summit have easily been met, several years early.  If a global permit system were in place, Russia would be able to sell permits for pollution that its depressed industry will not be emitting.  Critics, such as Louise Comeau of the Sierra Club, point out that Americans will unfairly be able to buy their way out of lifestyle changes, using Russian depression to fuel their Cadillacs.  However, this problem does not seem insurmountable if emissions permits are reissued every year.  Any temporary inequities in allocation could be remedied the next year. (1).

Thus, there are many obstacles to a global system of tradable pollution permits.  However, given the economic advantages and incentives to industry, and the fact that a single government would be unable to enforce taxes on a global scale, pollution permits seem a worthwhile possibility in the face of a global environmental crisis.





1   Lynn Haney.  "Marketable Pollution Permits".  May, 1998.  University of Colorado at Boulder


2.     John B, Taylor.  Economics, second edition.  Houghton Mifflin Company. Boston. (DI998


3.   The United States Environmental Protection Agency.


4.     Peter J. Wilcoxen.  "Taxes vs.  Permits under Uncertainty".  The Department of Economics, The University of Texas at Austin


5.     "Impending Doom".  The Economist, March 6-12, 1999


6.     "Improving Health Through Environmental Action: Addressing the Unintended Consequences of Development".  World Research Institute. http:// –devl.htm


7.     Dr. David Harrison, Jr. "Considerations in Designing and Implementing an Effective International Greenhouse Gas Trading Program", Prepared for Global Climate Coalition, October 1997.  National Economic Research Associates