I heard that Pollution Emporium is having a sale. If you buy at least ten tons of carbon dioxide, you get ten more for free! Do you want me to buy you any? Have you not visited the pollution market? "Why would anyone willingly sell pollution, that's disgusting" is a reasonable response.
Nearly every action we take creates waste or pollution in some form. Economists determined the most effective way to handle pollution is to view it as a hypothetical market, to eventually become a real market. Meaning that the best way to manage pollution is to weigh the cost of its damage against the cost of preventing it. Read this explanation to learn more about pollution markets and tradable pollution permits!
Corrective Taxes and Tradable Pollution Permits
To understand corrective taxes and tradable pollution permits, it can be helpful to cover the nature of pollution and what can be done to solve it.
Corrective taxes and tradable pollution permits: The nature of pollution
The world we all find ourselves living in is massively interconnected. Each action of any human or even animal takes up space, uses energy, and leaves residue and waste.
When we breathe, we consume oxygen and exhale carbon dioxide; similar to when firms produce goods, they expend energy and resources and create waste and by-products. The problem with pollution is its effects are an externality as the full costs of its production aren't accounted for directly. The individuals that pay the price for pollution are those who aren't even involved in the market transaction that created it.
Producers don't derive joy from releasing pollution, and they know that others may get mad at them for doing so. Some producers may research the cost of containing or reducing their pollution; however, doing so would increase their prices and hurt their competitiveness.
An Externality is a cost or benefit created by the production of a good or service that affects someone not part of the market transaction.
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Everything we do, in some way, creates pollution. What we must collectively solve is what pollution-creating actions are worth doing. Economists and environmentalists have set to work to measure the costs and damages created by the various products that sustain our lifestyles.
Corrective taxes and tradable pollution permits: What to do about pollution?
The science and math are in, we have ways of measuring the cost of many types of pollution. So how do we make it a reality?
The direct solution that has been imposed by many governments is to set a regulation that limits a particular type of pollution a producer can emit and impose a fine on them if they exceed the limit. The problem with the approach is that it doesn't provide incentives to reduce pollution below the limit. It also doesn't take into account the costs associated with preventing pollution.
Another method of addressing pollution is to tax producers on the cost of their pollution. If each unit of their production reduces air quality in a town resulting in $5 increased health expenses per every unit they produce. Then they would be taxed $5 per unit. Taxes are more socially efficient than regulation because regulation reduces production and raises prices, and creates deadweight loss. With taxes, the deadweight loss is the tax revenue that can be repurposed, even to pay for health expenses caused by the producer's pollution.
Similar to the tax is the tradable pollution permit method. It's similar in the sense that producers of pollution will have to pay to pollute. Tradable pollution permits are allowances given to similar industry members. These allowances give them the right to pollute up to the specified quantity. These permits and their attached allowances can be exchanged at a free-market-determined price to other members within the industry.
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Tradable Pollution Permits Definition
A tradable pollution permit is a policy that uses the free market to efficiently regulate pollution; let's start with a definition.
A group of manufacturers within the same industry, such as natural gas power plants, would be selected. The total current pollution output is measured across the industry, at which point a reduced pollution output is set. Depending on the scenario, the manufacturers either buy or are given permits allowing them to expel pollutants up to the permitted level.
What makes these effective is the permits are then tradable on the open market between manufacturers in the industry. This creates a market where low-polluting firms are rewarded with the ability to sell their unused permits. Meanwhile, heavy polluting firms will be required to buy more permits and invest in ways to reduce their pollution output.
Tradable pollution permits are regulated allowances that allow producers to generate pollution. If pollution over the permitted allowance is created, a fine will occur. If firms find they produce less pollution than allotted, they can sell the excess permits to another firm for money.
Tradable Pollution Permits Diagram
To clarify the effects on an industry, viewing a tradable pollution permit diagram will help. We will be able to analyze what the supply and demand for a tradable pollution permit market look like. This will also clarify the advantages of tradable pollution permits compared to using a corrective tax.
Corrective taxes seek to curb pollution by putting a price on each unit of pollution created. To achieve a reduction in pollution, the price must be greater than the profit gained by polluting over the socially optimal level. This policy is rigid and doesn't allow the market to reach a natural efficiency.
Tradable pollution permits seek to curb pollution by setting an industry limit and then allowing industry players to determine how much they are willing to pay to pollute. This policy gives flexibility to the industry to regulate its own pollution by making them compete for the right to pollute.
These two methods yield different results as they approach the market in drastically different formats.
The graph on the left side of Figure 1 is the supply and demand curve when a corrective tax is imposed. The tax is fixed at a singular price and doesn't change market conditions. Presently the quantity of pollution created is at Q, created by the intersection of the demand curve and the tax. However, consider what happens if demand were to increase. If producers were to experience increased profits, then they could afford to pollute more, raising the demand and shifting the curve to the right. When the demand curve shifts to the right, the quantity of pollution will increase. If pollution is able to increase, then the regulation fails to achieve its goal.
Fig. 1 - Corrective tax and pollution permits
The graph on the right side is the supply and demand curve for pollution permits. The pollution permits are tradable and will be highly desired by heavy polluting firms. The price will follow market demand because the pollution permits are set at a desired quantity of pollution. The quantity is immovable and, therefore, a vertical slope or otherwise known as perfectly inelastic supply.
When using a corrective tax, changes in demand increase the quantity of pollution. With the tradable pollution permits, however, we can recognize their key advantage. When demand changes, the quantity of pollution isn't flexible. Therefore the only thing that can change is the price. This is beneficial as the free market can dictate the efficient price, and the quantity of pollution won't exceed the maximum.
Tradable Pollution Permits Pros and Cons
What better way to understand a topic than to just list its pros and cons? Tradable pollution permits are by no means a perfect solution, not harmless, nor is it a "one size fits all." Every great theory has at least a few drawbacks; let's see how they compare with the benefits.
Tradable pollution permit benefits
Tradable pollution permits advantages include the following.
It can be adjusted by lowering the number of permits in circulation. If it's too harsh for the industry, more can be issued.
Permits have the potential to generate tax revenue or dividends for citizens.
Realigns the profit motive to coincide with the cleanest production method.
Cleaner firms are rewarded and receive extra income by selling permits.
Changes in the market only affect the price and will not increase the quantity of pollution.
Tradable pollution permits problems
Unfortunately for climate progress, there are problems with tradable pollution permits. As always, though, we must consider whether the cost of the problems created by the solution is greater or less than the cost of the problems they address.
Tradable pollution permits disadvantages include the following.
Setting an effective pollution limit can be challenging without destroying the industry.
Firms under regulation may struggle to compete with international firms, which may lead them to offshore production in a cheaper location.
Prices will increase for consumers, and any increase in costs of production will make its way into the final price.
Industries with enough capital may be able to buy their way into not reducing pollution; however, it would generate tax revenue to be used elsewhere.
Want to learn more about how regulations like this affect the market?
Check out this explanation!
- Effect of Taxation on Equilibrium
Tradable Pollution Permits Examples
Not every producer in an industry pollutes the same. Since they compete, they have variances in production practices. As a result, the quantity of pollution created will occur on a spectrum of the most polluting to least polluting.
Company | A | B | C | D |
Quantity of Pollution | 20,000 | 35,000 | 45,000 | 65,000 |
Table 1 - Companies and their pollution output example
Using the data from Table 1 above.
Suppose the community determines that no industry should pollute more than 35,000, so they issue every firm 7 permits for 5,000 pollution units each.
Firms A and B require no change to meet the regulation; firms C and D, however, do.
Firm A has permits they do not need and can therefore sell them to firms C and D.
As a result, firm A is rewarded for producing less pollution. Firms C and D have to pay more as a result of creating more pollution.
This example demonstrates how the market for pollution permits comes to exist. While some firms require more permits, others who don't can sell theirs. This does raise a question, though, how does this market determine how much the permits should cost?
Similar to how each firm produces different quantities of pollution, it is also true that their methods for reducing pollution may vary greatly.
Company | A | B | C | D |
Quantity of Pollution | 20,000 | 35,000 | 45,000 | 65,000 |
Cost of reducing pollution by 5,000 units | $1500 | $1500 | $500 | $2000 |
Table 2 - Companies and their pollution reduction costs example
Using the data from Table 2 above.
Suppose the community determines that no industry should pollute more than 35,000, so they issue every firm 7 permits for 5,000 pollution units each.
Firm A has 15,000 units of pollution to 'spare,' therefore can sell 3 permits.Firm B is using all their permits.
Firm C is over their permitted allowance and must buy 2 permits or reduce pollution by 10,000.
Firm D is over its permitted allowance and must buy 6 permits or reduce pollution by 30,000.
Firms that are over their permitted allowance must decide whether to pay to reduce pollution or buy more permits.
Firm C won't spend more than $500 on a permit, as they could reduce pollution for the same cost and not need the permit.
Firm D is willing to buy permits for anything less than $2000 for the same reasons.
Firm A offers its 3 available permits on the market, and firm D quickly outbids firm C.
Firm D buys 3 permits for $1500 from firm A.
Firm D must still acquire 3 permits or reduce pollution.
Firm C realizes that firm D is willing to pay $1,500 for a permit. Firm C can decide to reduce their pollution not by 10,000 units but by 25,000 units. This will cost them $2,500. Firm C now pollutes 20,000 units and has 3 permits available for sale. Firm C sells these 3 permits to firm D for $1,500 each for a total of $4,500. Firm C makes $2,000 in profit because they refined their products to be more environmentally friendly.
Conclusion:
Firm A started with low pollution levels and was rewarded with $4,500 by selling unused permits.Firm C was over their pollution allowance but could cheaply reduce their pollution. They reduced their pollution below the permitted allowance, to then sell unused permits to firm D for $2,000 of profit. Without the tradable pollution permits, firm C would not have had this incentive to reduce its pollution.
Firm D, who is a heavy polluter, was forced to buy 6 permits for a total of $9,000.
As the example above demonstrates, regulators do not need to solve problems in a way that addresses every detail. If a model is designed that gives free market players a flexible format, then an efficient outcome can be reached. The criticism of government regulation is the disruption of free market efficiency. By tailoring the policy to give free market control, governments can address market failures without causing markets to fail. It's possible that other regulations could be shaped in the same free market format. These could be used in different market sectors, such as pharmaceuticals, to align the free market with equitable social outcomes.
Tradable Pollution Permits - Key takeaways
- Tradable pollution permits address climate regulation while letting the free market have some control over how it is executed.
- Tradable pollution permits work by allotting a maximum amount of pollution for an entire industry, then dividing the permits among the industry members. The industry can trade permits among themselves at a market-determined rate.
- Industries that are already environmentally friendly will see an increase in their income by selling their unneeded permits.
- Tradable pollution permits appear bad for industry because they hold it accountable for the cost of the externalities their production creates.
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