1. 1 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.

2. 2 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.

3. 3 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.

4. 4 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.

5. 5 Topic 3.c: Transferable emission permits Denote the price of permits as P p. Then the firm will –Sell permits and abate if P p > MAC; and –Buy permits and pollute if P p < 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.

6. 6 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?

7. 7 100 80 E1E1 E2E2 60 40 MAC 1 MAC 2 firm 1 would have to abate 60 units  MAC 1 = 60. firm 2 would have to abate 40 units  MAC 2 = 40. A 1 = 60 A 2 = 40 So at the initial permit allocation, MAC 1 > MAC 2. Tell us that there exists some P p such that MAC 1 > P p > MAC 2. Which means there exits some P p such that firm 1 will want to buy permits and firm 2 will want to sell permits. 40 Topic 3.c: Transferable emission permits The initial allocation is 40 permits to each firm. At that allocation: 100 80

8. 8 100 80 E1E1 E2E2 60 4039 41 MAC 1 MAC 2 TAC 1  > TAC 2   reallocation represents efficiency improvement. But does it make the firms better off? Firm 1: Benefit = TAC 1  = $59.50 Cost = P p = $45 The trade makes each firm better off. 59 41 40 Topic 3.c: Transferable emission permits Example: suppose firm 1 offered to buy 1 permit from firm 2 for $45. Firm 1 can emit 1 more unit, TAC 1  = $59.50 Firm 2 can emit 1 less unit, TAC 2  = $40.50 Firm 2: Benefit = P p = $45 Cost = TAC 2  = $40.50

9. 9 100 80 E1E1 E2E2 60 40 MAC 1 MAC 2 So trade will continue until MAC 1 = MAC 2 at emissions levels such that E 1 + E 2 = 80 = number of pollution permits: MAC 1 = MAC 2  100 - E 1 = 80 - E 2 E 1 + E 2 = 80  100 - E 1 = 80 - (80 - E 1 )  100 - E 1 = E 1  100 = 2E 1  E 1 = 50 & E 2 = 30. & MAC 1 = MAC 2 = 50 40 Topic 3.c: Transferable emission permits Gain from trade possible because MAC 1  MAC 2 at initial allocation Tells us firms will want to trade as long as MAC 1  MAC 2 100 50 80 5030

10. 10 100 80 E1E1 E2E2 60 40 MAC 1 MAC 2 Firm 2 sells 10 permits, meaning  E 2 by 10. 40 Topic 3.c: Transferable emission permits Key point: Only if P p = $50 per permit will firm 1’s demand for permits = firm 2’s supply of permits. For instance, if P p > $50: firm 1 will demand < 10 permits firm 2 will supply > 10 permits Similarly, if P p < $50, excess demand. 100 50 80 50 30 buy sell Firm 1 buys 10 permits, allowing E 1  by 10 (relative to initial allocation). Excess supply  Pp must  to clear market

11. 11 100 80 E1E1 E2E2 60 40 MAC 1 MAC 2 40 Topic 3.c: Transferable emission permits Firm 1: With no trade, compliance costs = TAC 1 (E of 40) = $1,800 With trade, compliance costs = TAC 1 (E of 50) + cost of 10 permits = $1,250 + $500 = $1,750  Gain of $50 (relative to the case of no trade) 100 50 80 50 30 One question of interest: What are the gains from trade for each firm (relative to the case where each has E = 40)? Gain from trade

12. 12 100 80 E1E1 E2E2 60 40 MAC 1 MAC 2 40 Topic 3.c: Transferable emission permits Firm 2: With no trade, compliance costs = TAC 1 (E of 40) = $800 With trade, comp. costs = TAC 1 (E of 30) - rev. from 10 permits sold = $1,250 - $500 = $750  Gain of $50 (relative to the case of no trade) 100 50 80 50 30 Gain from trade Note: Gains from trade for each firm are only the same here as slopes of MACs are the same.

13. 13 100 80 E1E1 E2E2 60 40 MAC 1 MAC 2 40 Topic 3.c: Transferable emission permits We know that E = 40 for each firm is inefficient (MAC 1 > MAC 2 ), while E 1 = 50 & E 2 = 30 is efficient (MAC 1 = MAC 2 ) With no trade TAC 1 + TAC 2 = $2,600 With trade TAC 1 + TAC 2 = $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. 100 50 80 50 30 Second question of interest: What are the efficiency gains from trade (relative to the case where each has E = 40)?

14. 14 Topic 3.c: Transferable emission permits Note that the pollution permit trading policy allows us to: –Choose a target level of aggregate emissions/abatement; and –Ensure that this target is met in the least cost way (MAC 1 = MAC 2 after trade). Important to understand: this can be achieved with no knowledge of either firm’s MAC curve.

15. 15 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.

16. 16 Topic 3.c: Transferable emission permits Another important point: –Equilibrium in the permit market is where MAC 1 = MAC 2 such that E 1 + E 2 = 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.

17. 17 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: –E 1 = 50 and E 2 = 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…..

18. 18 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 CO 2 in the atmosphere, and it doesn’t matter whether the stock grows because of CO 2 emissions in China, Canada, or Antarctica. But for a pollutant like SO 2, it matters. A ton of SO 2 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 emissions in AZ.

19. 19 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 SO 2 emissions that all the high MAC firms are coal-fired power plants located in Ohio River Valley, where SO 2 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).

20. 20 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.

21. 21 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.

22. 22 Topic 3.c: Transferable emission permits If it has so desirable features why don’t we see TEPs as the main environmental policy? In practice there can be several problems: 1.complexity and regulatory restrictions 2.market thinness 3.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.

23. 23 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).

24. 24 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.