Topic 3.c: Transferable emission permits
•
We will start analyzing the last policy we will look at for
pollution control.
–
–
Tradable/transferable emission permits (TEPs)
Also referred to as transferable discharge permits
•
Like emissions charges, tradable pollution permits offer an
“incentive-based” policy for pollution control.
•
Contrast to emission standards.
•
More decentralized policy than emissions charges.
1
Topic 3.c: Transferable emission permits
•
How the policy works:
–
Government sets a cap on aggregate emissions, and
prints permits equal in number to target aggregate
emissions.
– Permits are distributed to firms
• Auction or grandfathered
– Every time the firm emits a unit of pollution, it must
have a permit to cover that unit.
– Permits can be traded among firms.
2
Topic 3.c: Transferable emission permits
•
The chosen method of initial allocation reflects an implicit
assignment of property rights:
–
grandfathering assigns property rights to the waste to
incumbent polluters
–
auctioning assigns property rights to the state, and
reflects the same “polluter pays principle” embodied in
emission charges.
3
Topic 3.c: Transferable emission permits
•
•
Choice faced by firms as to what to do with the permits the
government gives it.
Does it
– Use the permit to pollute; or
– Sell the permit to another firm?
•
If it uses the permit to pollute, it gives up the opportunity to
sell the permit to another firm (opportunity cost), but saves
the cost of abatement.
•
If it sells the permits, it must abate the unit of pollution and
incur abatement costs, but gains the revenue from permit
sales.
4
Topic 3.c: Transferable emission permits
•
Denote the price of permits as Pp. Then the firm will
–
–
•
Sell permits and abate if Pp > MAC; and
Buy permits and pollute if Pp < MAC.
Example:
–
Suppose MAC1 = 100 - E1; MAC2 = 80 - E2; and the
government has capped emissions at 80 units in total.
–
80 pollution permits are issued, assume half (40) are
allocated to each firm.
5
Topic 3.c: Transferable emission permits
•
Questions:
–
Can trade in permits make both firms better off?
• Better off, relative to each firm using all its
permits to emit (analogous to an emission
standard of 40 units for each firm).
–
If so, who will buy permits and who will sell?
–
What price do we expect to prevail in the market
for permits?
6
Topic 3.c: Transferable emission permits
The initial allocation is 40 permits to each firm.
100
At that allocation:
MAC1
80
60
• firm 2 would have
to abate 40 units 
MAC2 = 40.
40
MAC2
40
100
E1
A1 = 60
40
80
• firm 1 would have
to abate 60 units 
MAC1 = 60.
E2
A2 = 40
So at the initial permit allocation, MAC1 > MAC2.
Tell us that there exists some Pp such that
MAC1 > Pp > MAC2.
Which means there exits some Pp such that firm 1 will want to buy
permits and firm 2 will want to sell permits.
7
Topic 3.c: Transferable emission permits
60
59
Example: suppose firm 1 offered to buy 1 permit from firm 2 for
$45.
Firm 1 can emit 1 more unit,
MAC1
TAC1 = $59.50
MAC2
41
40
40 41
100
E1
Firm 2 can emit 1 less
unit, TAC2 = $40.50
39 40
80
E2
TAC1 > TAC2  reallocation represents efficiency improvement.
But does it make the firms better off?
Firm 1: Benefit = TAC1= $59.50
Firm 2: Benefit = Pp = $45
Cost = Pp = $45
Cost = TAC2 = $40.50
The trade makes each firm better off.
8
Topic 3.c: Transferable emission permits
Gain from trade possible because MAC1  MAC2 at initial allocation
100
MAC1
80
60
50
MAC2
40
40 50
100
E1
30 40
Tells us firms will want
to trade as long as
MAC1  MAC2
80 E2
So trade will continue until MAC1 = MAC2 at emissions levels such
that E1 + E2 = 80 = number of pollution permits:
MAC1 = MAC2  100 - E1 = 80 - E2
E1 + E2 = 80
 100 - E1 = 80 - (80 - E1)
 100 - E1 = E1

100 = 2E1

E1 = 50 & E2 = 30.
& MAC1 = MAC2 = 50
9
Topic 3.c: Transferable emission permits
100
MAC1
80
60
50
MAC2
Firm 1 buys 10 permits,
allowing E1 by 10 (relative to
initial allocation).
40
sell
buy
40 50
100
E1
30 40
Firm 2 sells 10 permits,
meaning E2 by 10.
80 E2
Key point: Only if Pp = $50 per permit will firm 1’s demand for
permits = firm 2’s supply of permits.
For instance, if Pp > $50:
firm 1 will demand < 10 permits
firm 2 will supply > 10 permits
Excess supply  Pp
must  to clear market
Similarly, if Pp < $50, excess demand.
10
Topic 3.c: Transferable emission permits
100
MAC1
One question of interest:
Gain from
trade
80
60
50
MAC2
40
40 50
100
E1
30 40
What are the gains from
trade for each firm (relative
to the case where each
has E = 40)?
80 E2
Firm 1:
With no trade, compliance costs = TAC1 (E of 40) = $1,800
With trade, compliance costs = TAC1 (E of 50) + cost of 10 permits
= $1,250 + $500
= $1,750
 Gain of $50 (relative to the case of no trade)
11
Topic 3.c: Transferable emission permits
100
MAC1
Gain from
trade
Gain from
trade
80
60
50
Note: Gains from
trade for each firm
are only the same
here as slopes of
MACs are the same.
MAC2
40
40 50
100
E1
30 40
80 E2
Firm 2:
With no trade, compliance costs = TAC1 (E of 40) = $800
With trade, comp. costs = TAC1 (E of 30) - rev. from 10 permits sold
= $1,250 - $500
= $750
 Gain of $50 (relative to the case of no trade)
12
Topic 3.c: Transferable emission permits
Second question of interest:
100
MAC1
80
60
50
MAC2
40
40 50
100
E1
30 40
What are the efficiency
gains from trade (relative to
the case where each has E
= 40)?
80 E2
We know that E = 40 for each firm is inefficient (MAC1 > MAC2),
while E1 = 50 & E2 = 30 is efficient (MAC1 = MAC2)
With no trade TAC1 + TAC2 = $2,600
With trade TAC1 + TAC2 = $2,500
 Aggregate TAC is $100 lower (relative to the case where
E = 40 for each firm).
Note: agg. TAC with no trade = agg. TAC with uniform E
standards.
13
Topic 3.c: Transferable emission permits
•
•
Note that the pollution permit trading policy allows us to:
–
Choose
a
target
emissions/abatement; and
–
Ensure that this target is met in the least cost way (MAC1
= MAC2 after trade).
level
of
aggregate
Important to understand: this can be achieved with no
knowledge of either firm’s MAC curve.
14
Topic 3.c: Transferable emission permits
•
Not true in the case of E standards or E charges.
•
With E standards, if we have no knowledge of MACs we
can choose the level of aggregate abatement, but generally
we cannot achieve this abatement in the least cost way.
•
With E charges, if we have no knowledge of MACs we are
unable to choose the level of aggregate abatement, but
whatever level of abatement we get, it is achieved in the
least cost way.
15
Topic 3.c: Transferable emission permits
•
Another important point:
–
Equilibrium in the permit market is where MAC1 = MAC2
such that E1 + E2 = total number of permits.
•
This will be true irrespective of the initial distribution of
permits (unless firms acquire market power due to the
distribution of permits, that is, the permit market must be
competitive)
•
In this example, we gave half the permits to each firm.
16
Topic 3.c: Transferable emission permits
•
Exercise: Work through this example again, only now, at
the outset, give all the permits to firm 2.
•
You should find that:
–
E1 = 50 and E2 = 30 after trade;
–
Permits sell for $50 each.
•
What will be different are the compliance costs and the
gains from trade.
–
In fact, in this case, firm 2 has negative compliance costs
after trade…..
17
Topic 3.c: Transferable emission permits
•
•
•
•
•
•
One last point to make about pollution permits trading
schemes.
So far, we have been ignoring the spatial aspects of the
problem of regulating pollution.
– This is OK, if the only thing that matters is the total
amount of pollution, not its distribution.
True for some pollutants, not for others.
For instance, for climate change, all that matters is the
stock of CO2 in the atmosphere, and it doesn’t matter
whether the stock grows because of CO2 emissions in
China, Canada, or Antarctica.
But for a pollutant like SO2, it matters. A ton of SO2 emitted
in (say) Ohio results in damage to Quebec, Vermont, etc. A
ton emitted in Arizona, impacts a different geographical
region.
Same as saying that the MD of emissions in OH  MD of
18
emissions in AZ.
Topic 3.c: Transferable emission permits
•
With tradable pollution permits, if we don’t have info on
MACs, we don’t know who will buy and sell permits.
– All we know is that high MAC firms will buy permits and
hence abate less.
•
Suppose in the case of SO2 emissions that all the high
MAC firms are coal-fired power plants located in Ohio River
Valley, where SO2 emissions damage forest in New
England and Quebec.
•
Historically, these have been the firms we wanted much
lower emissions from, as they are the firms that caused
major acid rain problem (i.e. they had the highest MD from
their emissions).
19
Topic 3.c: Transferable emission permits
•
If they are high MAC firms as well as being high MD firms,
though, they will actually abate relatively little, as they are
better off buying permits and continuing to emit.
•
So we might end up with a lot (or all) of our emissions
concentrated in one region, so even though total emissions
are lower than with no regulation, they could affect some
regions disproportionately.
•
Often referred to as the “hot-spot” problem.
20
Topic 3.c: Transferable emission permits
•
How to solve the problem?
•
Ends up being quite complex, as a unit of emissions needs
to be treated differently, depending on where it takes place.
•
One of the desirable things about permit schemes is their
simplicity in administering, so once we add layers of
complexity, it looks like a less desirable policy alternative.
21
Topic 3.c: Transferable emission permits
•
If it has so desirable features why don’t we see TEPs as
the main environmental policy?
•
1.
2.
3.
In practice there can be several problems:
complexity and regulatory restrictions
market thinness
sovereign risk
1. Complexity and regulatory restrictions
•
Complexity and excessive regulation within the market for
permits can lead to high transaction costs, which can in
turn undermine the functioning of the market.
22
Topic 3.c: Transferable emission permits
2. Market thinness
•
A thin market (as opposed to a deep market) is one in
which there are relatively few traders.
•
Market thinness can cause high transactions costs and
non-price-taking behaviour.
•
That is, for the permit market to work properly we need a
large number of buyers and sellers.
•
That is why this scheme is the preferred approach to green
house gas regulation (many, many firms will be regulated
under climate change policy).
23
Topic 3.c: Transferable emission permits
3. Sovereign risk
•
Sovereign risk relates to the potential for the regulator to
confiscate permits in response to new information about
the damaging effect of the regulated pollutant.
•
That is, the property rights over the permits may not be
secure.
•
This will undermine permit trading since sources will be
reluctant to pay for a permit that may be confiscated in the
future.
24