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Tradeable Pollution Permits

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Published in: Economics
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How are pollution permits used as a policy to regulate pollution? What are the advantages and disadvantages of pollution permits?

Parul G / Delhi

8 years of teaching experience

Qualification: M.A (Johns Hopkins University (USA) - 2015), B.A (Lady Shri Ram College for Women (LSR), Delhi - 2009)

Teaches: BA Tuition, Economics, Mathematics, Statistics

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  1. Tradeable Pollution Permits/Cap-and-trade system Short description: A permit is a right to pollute. A tradeable/marketable permit can be sold to other firms at a mutually agreed upon price. Typically, the lower cost firm will consider it profitable to sell the permit and incur abatement costs, while the higher cost firm would be interested in buying a permit and saving on abatement costs. Assuming flexible prices and costless negotiation, the equilibrium price of permits will be equal to the marginal cost of abatement of all firms involved in the trading. The cap-and-trade policy thus satisfies the equimarginal principle and hence achieves the required abatement at the least cost. Detailed description: This system provides polluters with incentives to reduce pollution. In this system, the regulator sets a "cap"/limit on the total number of emissions that can be allowed in the society, and issues permits equal to the cap. Permits are typically certificates bestowing the right to pollute to whoever holds the permits. The permits are allotted to firms by lottery or through auctions, and the firms are free to trade the rights/permits among each other. This system achieves abatement at the lowest cost, by following the equi-marginal principle. The lowest abatement cost firms will be willing to sell the permits to earn revenue and abate (at a low cost) while firms with higher abatement costs will buy permits and save on abatement costs. Trading will continue until the marginal abatement costs (MAC) are equalized and no more gains from trade are possible. The equilibrium permit price is equal to marginal abatement costs of the last unit for each firm price). This method has been used by Europe to regulate carbon dioxide emissions in 2005. Example Units abated by each firm 1 2 3 4 5 6 7 MAC for firm 5 10 15 20 25 30 35 MAC for firm 10 20 30 40 50 60 70 Let's say total desired abatement is 6 units (desired emissions-8 units). Thus total permits allotted will be 14-6=8 units. Say 6 permits are allotted to firm 1 and 2 permits are allotted to firm 2. Then MACI=5 and MAC2=50. Firm 2 will offer a price between 10 and 50 to buy one permit from firm 1. For the next permit, firm 2 will offer a price between 15 and 40 and so on. Firm 2 will buy permits until MACs are equalized across firms. In equilibrium, firm 1 will abate 4 units (emit 3) and firm 2 will abate 2 units (emit 5). Thus, we get 6 units of abatement (8 emissions) and the marginal cost of both firms is same (=20). The equilibrium permit price will be $20. We see that the low cost firm abates more in equilibrium, even though it was given more permits to begin with. The low cost firm acts in its self-interest and gives up permits and chooses to abate instead, since selling the permit brings in revenue. Through the reallocation/trading of permits, least cost abatement is achieved.

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