Steve Bain

Tradable Pollution Permits Explained

Tradable pollution permits are created by governments as a means of tackling this 'negative externality' that arises from industrial production. They have gained a lot of interest in recent years due to concerns over global warming and the influence of carbon emissions in speeding up that process.

Now, in this article, I won't be getting into the whole political debate over whether or not the carbon emissions that result from our current industrial production practices are causing any significant extra warming effects on the global climate.

Nor will I discuss the likelihood of getting any firm global commitment to reduce emissions given that the biggest polluter, China, is intending to construct hundreds more coal-fueled power stations in the coming years. Further questions arise as to whether India is likely to produce more emissions as it too develops, or the rest of the world's poor countries too.

Raising basic standards of living is understandably the first, second, and third priority for the people in these countries.

Given that, for the world's poor, reducing their carbon footprint effectively means that they and their children will need to go cold and hungry at night, they might struggle to see the fairness of doing that solely on the basis that people in the rich countries have made sacrifices and set an example for them, e.g. by switching to hybrid 4x4's instead of the old gas guzzlers!

The politics embroiled in all of this is understandably complex, and likely to be extremely combative before any workable solutions or compromises are agreed - much less followed up and enforced. You may confidence in the Paris Accord, I have none at all!

Thankfully for me, this is an economics focused website and not a politics website, so I will stick with an explanation of tradable pollution permits and how they work.

Allocation of Permits

The first problem with deciding which firms should receive the tradable pollution permits, and which should not, starts with identifying what the total amount of current emissions is, and what society desires it to be.

Once this is established we need to know which particular industries are creating unacceptable amounts of carbon emissions and then pass regulations requiring the firms within those industries to possess permits for the pollution that they create.

These permits may be allocated for free in proportion to the level of output that each firm produces, or they could be sold for a fee. The point is that the government would need to set an overall industry pollution level that is lower than the existing level.

Regardless of how the permits are allocated, they are tradable, meaning that those firms which value permits the highest can purchase them from the firms that value them relatively less.

There are many reasons why an individual firm within an industry would have a different valuation for a pollution permit. Some firms are more profitable, and therefore have more to lose if their production levels are constrained. Some firms have more fuel-efficient technology, and can produce all the output that they want whilst still operating within their permit levels, meaning that they can sell their spare capacity for a profit to another firm that needs a bigger permit.

Over a period of time, the cost of obtaining tradable pollution permits will encourage the whole industry to move towards a more carbon emission friendly technology. The speed at which this happens will depend on the cost of 'pollution abatement' i.e. the cost of reducing emissions.

Pros and Cons of Tradable Pollution Permits

Pros

  • Efficiency gains from self-selection - since some firms will be better able to adjust their technology than others, the firms that face the highest costs of reducing their emissions will be the ones that purchase extra permits. This has the effect of reducing emissions to the specified level with the least overall cost to businesses.
  • Directly controls overall pollution levels - alternatives to tradable pollution permits such as taxes on emissions or 'emissions standards' imposed upon all firms equally, do not determine what level of overall pollution will result, and therefore cannot guarantee an optimal response.

Cons

  • Inaccurate estimates of desired emissions and costs - correctly calculating the precise amount of pollution that is optimal for society is near impossible. It is also impossible to reliably estimate the cost of reducing emissions to that desired level, meaning that some industries might be pushed into insolvency by over-zealous environmentalist policies.
  • Tracking and enforcing compliance - this will be more of a problem in countries that, whilst agreeing to global accords on reducing carbon emissions, actually have other conflicting priorities that dominate their goals. The developing world, for example, is much more likely to pursue economic growth over any sort of policy that would restrict that growth.

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