Taxes, Standards and Tradable Permits

• Standards
– Permissible level of emissions for each factory in an industry (each industry gets same target), or
– Targets how much emissions must be reduced by each factory (again, same target for all)
Taxes
– Direct tax on emissions
• Indirect on input/output if there is a direct correlation between input/output and pollution
– E.g., tax on gasoline, coal based on sulfur content
• Tradable permits
– Gives each firm the “right” to pollute to a certain level
– Firms are allowed to trade/sell permits

1. What is the optimal level of pollution?
2. How should it be allocated among its sources (firms)?

Equate MC of damage
To MC of abatement

• Essentially all 3 approaches can theoretically be set to achieve an optimal standard
– MC[damages] = MC[abatement]
• In practice
– Hard to obtain accurate data on damages
– Standards have been set arbitrarily in all 3 cases

• Economic Efficiency
– Does the policy result in meeting the standard in a least-cost manner?
• Administrative Cost Efficiency
– What are the monitoring, enforcement and other administrative costs?
• Flexibility: responding to changes in market dynamics, e.g., inflation, changes in demand?
– Self-adjusting or not?

• Standards
– Can produce optimal level of pollution
• But setting same standard for all firms (and are not productively efficient, e.g. min cost)
• To set individual quotas: requires knowledge of each firm’s costs
• Provide no incentive for firms to reduce pollution below current
“authorized” levels
– Have higher administrative costs
• Not only have to monitor emissions
• Enforcement costs: legal proceedings (time delays and expense)
• Not very flexible: regulatory process for changing standards
– Can not respond easily to changes in market conditions
• Require rewriting legislation, establishing new standards

• Standards
– Are most useful when:
• Problem is short-lived (“burn” bans for high pollution days)
• Optimal level is zero

• Taxes
– Can produce “optimal” amount of pollution at minimum costs and lower administrative costs
• Kneese (1977): comparing taxes versus standards found that desired quality costs half as much using taxes
– Automatically allocates pollution levels among firms based on their costs
• Provides incentive for firms to reduce pollution levels through technological innovation
– Easy to adjust/”tune” to “right” level
• But does not respond without change to tax rate
– Tax revenues can be used finance admin costs

• Tradable Permits
– Cost efficient
• Firms will purchase permits from more efficient firms if permit cost < abatement (technology) costs
– Technological incentive to reduce pollution
• Marginal cost of abatement = permit cost
– Similar to taxes
– Administratively simpler
• Require less information about the firms’ cost
• Better able to handle “spatial” variation in pollution
– Fewer permits auctioned in bad areas
• Adjust “automatically” for changes in inflation and growth
– E.g., Ca RECLAIM experience
– If auctioned -> revenues for admin costs

• http://www.sightline.org/research/energy/re s_pubs/cap-in-trade-2009-sightlinewebinar