Tradable Pollution Permits as a Remedy for the
Negative Externality
By Eric
Dahlberg
Overview
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.
Bibliography
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. http://www.epa.gov
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:// wri.org/wri/wr-98-99/00
–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