Pollution permit trading

DEFINITION: Incentive-based strategy for pollution control in which government grants companies or other polluters the right to emit specified amounts of pollutants over specified time periods and to trade unused permits

Pollution permit holders may profitably reduce their emissions by selling unused permits to other polluters. Permit trading systems are generally viewed as a more efficient, less costly approach to pollution control than the command-and-control regulation traditionally used by government.

In a permit trading system (also known as a cap-and-trade system), a type of property right is created: the right to produce a certain amount of pollution. A regulatory agency or special commission decides on the number of permits to be issued based on the toxicity, longevity, and other characteristics of the pollutant. If, as is likely, the issuing agency wants to reduce the amount of pollution, the total number of permits circulated account for less than the existing pollution. Each permit gives the holder the right to emit one unit of pollution over a specified period of time, normally one year. The unit—tons, tonnes, pounds, cubic meters, or other measures—depends on the particular pollutant. Each company holds many permits. The firm can choose to emit all the pollution covered by its permits or reduce pollution and sell its unused rights to a different company. The right to pollute is transferable; thus, a market is created. Participation in the market is not limited to corporations. An environmental group or governmental unit may buy and hold permits, further reducing the amount of pollution actually created.

The cost of the permits is not set by government but rather by the forces of supply and demand within that particular market. Permit brokers and some form of trading exchange facilitate transactions. The demand in the market comes from new companies beginning operations, the expansion of existing companies, and those companies that face unusually steep pollution-abatement costs. The supply of permits comes from firms going out of business or, more important, from firms that have reduced emissions.

Optimal Pollution Levels

At first glance, granting ownership to a right to pollute seems harmful to society. It seems as if society would benefit more if pollution were to be completely eliminated rather than traded to someone else. However, one must consider that there are costs involved in reducing pollution. From an economic perspective, zero pollution is not the optimal level of pollution. Because resources are limited, both the cost—the cost of decreasing the pollution—and the monetary damage caused by the pollution must be considered. The optimal level occurs when the abatement cost and the damage cost are balanced. If the cost of reducing the pollution is greater than the damage created by the pollution, society is using too many resources to reduce that pollution. Environmentalists often object to this approach, arguing that not all environmental changes are quantifiable in dollars and that zero pollution is the optimal level of pollution.

Granting firms the ability to buy and sell pollution rights improves the overall efficiency of abatement. Each firm can decide whether it should reduce its pollution and sell more permits to others. Because firms do not use exactly the same materials and production processes, different firms have different abatement costs. Firms with abatement costs above the market price of the requisite number of permits benefit by buying permits rather than spending their resources on pollution control. Firms with abatement costs below the market price benefit by reducing their pollution even more and selling additional permits.

A simple example may help clarify this concept. Suppose XYZ company and ABC company are firms of similar sizes located near each another. Although they produce the same type of good, they use different production techniques. XYZ’s production costs increase by $1,000 each time it removes 1 ton of air pollution. ABC spends $200 to remove 1 ton of pollution. Suppose the permitting agency wants to eliminate 20 tons of pollution. If each company is required to reduce pollution by 10 tons, the total cost would be $12,000 (XYZ spends $10,000, and ABC spends $2,000). Using marketable permits, however, ABC could reduce pollution by 20 tons and sell ten permits to XYZ for $500 each. XYZ spends $5,000 on the permits, which is $5,000 less than it would have spent on abatement. ABC makes money: It spent $4,000 on abatement but made $5,000 selling the permits. Society still gets the benefit of a 20-ton reduction in air pollution. Marketable permits thus allow pollution reduction to occur in the most efficient, cost-minimizing way.

A permit trading system also has lower enforcement costs than traditional regulation. Regulation requires a permanent bureaucracy to gather and analyze information, monitor activity, and enforce compliance. Given the complexity accompanying these tasks, regulation often creates litigation. Permit trading relies on the market to achieve efficiency. Corporate decision makers do not have to wait for a government agency to tell them whether they are making proper decisions and do not have to go to court if they think the agency is wrong. The market will reward them for sound decisions and punish them for poor decisions. Permit trading encourages flexibility and rewards innovation by allowing corporations to decide the appropriate technology and techniques as long as the permitted pollution level is not exceeded.

Example: Trading of Permits

Responding to the criticisms economists and corporations aim at traditional command-and-control regulation, the US government began considering permit trading programs in the late 1970s. The Acid Rain Program (ARP) created under Title IV of the Clean Air Act (CAA) amendments of 1990 include the first statutorily mandated national market-based approach to pollution control. Sulfur dioxide (SO₂) emissions contribute to the acid rain problem in Canada and the northeastern section of the United States. The 1990 CAA amendments set a goal of permanently reducing total (human-caused) SO₂ emissions in the United States by 9.1 million tonnes (10 million tons) by the year 2010, down from the 23.5 million tonnes (25.9 million tons) emitted in 1980. Electric power generated by burning and other fossil fuels is responsible for about two-thirds of the nation’s anthropogenic SO₂ emissions. The ARP set a permanent cap on SO₂ emissions from electric generating units (EGUs) at 8.12 million tonnes (8.95 million tons) by 2010, a level roughly half that of 1980 emissions from the power sector.

During Phase I of the ARP (1995 to 1999), 263 of the nation’s largest, highest-emitting coal-fired EGUs participated, along with 135 to 182 additional units each year. The plants involved were major utilities in the East and Midwest. Each permit issued allowed the of 0.91 tonne (1 ton) of SO₂. By the time the program was implemented in 1995, pollution control measures had already reduced SO₂ emissions from Phase I sources to 4.8 million tonnes (5.3 million tons), which represented a decrease of 3.7 million tonnes (4.1 million tons) from 1980 levels and 3.1 million tonnes (3.4 million tons) from 1990 levels. When Phase I ended in 1999, emissions had dropped to 4.4 million tonnes (4.9 million tons). Annual emissions during Phase I were well below the caps set for each year, representing a total of 11.62 million allowances.

Phase II, which began in 2000, added the nation’s remaining coal-, oil-, and gas-fired EGUs with outputs greater than 25 megawatts. The Phase II cap began at 9.04 million tonnes (9.97 million tons) total for these 2,262 plants. Banked allowances from Phase I were used to offset emissions between 2000 and 2005, which exceeded annual caps. Yearly emissions began to fall in 2006, and by 2009 total annual emissions from the 3,572 EGUs subject to the allowance program were down to 5.2 million tonnes (5.7 million tons), substantially below the year’s cap of 8.6 million tonnes (9.5 million tons). The program entered 2010, the year the total number of annual allowances became fixed at 8.95 million, with 12.3 million unused allowances banked.

The ARP has generally been a successful program. By early 2010, participating EGUs had reduced their annual SO₂ emissions by 67 percent compared with 1980 levels and 64 percent compared with 1990 levels. Emission allowance costs were lower than initially projected, largely because of a reduction in compliance costs resulting from technological innovation and the availability of low-cost, low-sulfur coal. It was estimated that plants needing to buy emission permits would pay between $180 and $981 per ton. However, because so many plants successfully reduced emissions, the price of a permit during Phase I fell to less than $100 and generally traded around $125. During the first decade of the program, prices tended to remain under $200. The likelihood of additional emission reduction requirements under the proposed Clear Air Interstate Rule caused a rise in prices beginning in 2004, with a peak price around $1,550 in late 2005; however, as the market adjusted, prices fell sharply in 2006 and returned to pre-2004 levels by mid-2008.

To participate in the program, all firms are required to install and maintain continuous devices. Because the government does not have to perform the continuous inspections and litigation typical of traditional regulation, enforcement costs are quite modest. To ensure compliance, the program includes a fine of a few thousand dollars per ton for excess emissions, well above the price per ton determined in the market ($40 as of May, 2010). The fine is nondiscretionary, meaning that any violator must pay the entire fine and offset the violating emission in the following year. The US Environmental Protection Agency (EPA) maintains a central registry of allowances and transfers permits between accounts when a transaction is completed. In late 2001 the EPA introduced an online allowance transfer system, and by 2008 more than 99 percent of all private allowance transfers were conducted through this system.

Special Concerns

The success of permit trading is dependent on several factors. There must be a limited number of allowances in circulation. Existing polluters, understanding that permits will have value in the future, want as many as possible. Thus the first steps in the development of a trading program—deciding what formula to use to distribute permits and deciding whether to auction the permits or give them away—can stir great controversy. The eventual benefits of the tradable permit system are independent of the initial distribution. In other words, the eventual market price will not depend on whether the permits were initially sold or given away. The distribution process is political, not economic, in nature. This creates several problems. If permits are distributed based on current levels of pollution, companies that have already taken steps to reduce their emissions are penalized. If permits are distributed equally, very large and very small companies are affected differently. Some industries may have an easier time reducing pollution than others. Some local economies are completely dependent on single industries, while others are more diversified. What happens if the allocation of permits harms a plant that is the major employer in an economically distressed area? These concerns create considerable political difficulty in determining how to distribute permits.

The European Union (EU) launched the world’s largest trading system for carbon dioxide emissions in 2005. It covered more than 11,500 facilities such as ovens, coal plants, cement factories, and ironworks within the EU’s twenty-seven member nations. Prices were devalued shortly after trading began when it became evident that the EU had distributed too many emissions allowances, which left industries with little motivation to reduce emissions or purchase credits to meet targets. As a result, the period 2005-2006 saw a slight rise in carbon dioxide emissions from major polluters. While emissions trading was credited with the EU’s 3 percent decrease in carbon dioxide emissions in 2007-2008, critics maintained that the system created more economic benefit for major polluters than it did environmental benefit. To promote economic competitiveness, the EU continued to give away a substantial number of credits for free and had some success. Its capped emissions from stationary structures were 20 percent lower in 2018 than they were in 2005, when the program began.

In the mid-2020s, the major problem facing the development of marketable permits was that many potential pollution markets were hampered by thin markets with only a few buyers and sellers. Thin markets were troublesome because trades were so infrequent that the market price was not always immediately apparent. For example, if only ten cars were sold in Houston each year, would the eleventh buyer know the approximate cost of a car before stepping into the showroom? If a seller loses a potential buyer by setting the price too high, how long will it be before the next customer arrives? Under these circumstances, firmsd face considerable transaction costs as buyers and sellers independently tried to determine the appropriate price. The thin market problem proved an insurmountable obstacle in several early attempts to develop permit trading programs. The Emissions Trading Program initiated by the EPA and the Fox River, Wisconsin, water-pollution abatement program, for instance, experienced insufficient transactions to establish a market.

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