Pollution permits

There are several policies that can be adopted specifically to deal with pollution and the degradation of the environment, including tradable permits to pollute, pollution taxes, the extension of property rights, and various forms of carbon offsetting.

Tradable Pollution Permits

Tradable permits are a ‘market based’ solution to emission control and reduction. The carbon permits market works on a ‘cap and trade’ principle, where the government or its appointed agencies set targets for allowable pollution within an industry, and then issue permits to individual firms.

If producers pollute within the agreed allowance (the cap) then they will not require further permits. However, should they pollute more than allowable, they must either reduce their pollution levels, or purchase additional permits. The most polluting firms will enter the emissions trading market as buyers, and those firms that pollute below their allowed level can sell their surplus permits. When a permit is purchased it adds to the firms costs, just like any other production cost.

This, then, forces the polluter to ‘internalise’ the externality. Hence, the effect of higher pollution levels is to increase costs, which can be shown with a standard cost and revenue diagram. The effect of the carbon permit is to increase variable costs. [i]

The effect of carbon permits - costs are increased, pushing up prices and reducing the firm’s competitiveness

In order to maximise profits [where MC = MR] the polluting firms must cut back on production, and increase price. Over time this firm become less competitive, with the non-polluter becoming more competitive. This process continues, so that the industry slowly moves from a polluting industry to a greener one.

The European Emissions Trading system (ETS)

The European ETS [EU-ETS] started in 2005 as a direct response to the Kyoto Protocol, signed in 2003.

The EU-ETS is the largest example of emissions trading, and involves around 12,000 plants, across 30 countries and covers some 40% of EU emissions from 4 main sectors: electricity generation, Iron and steel, mineral processing, such as cement manufacture, and pulp and paper processing. [1]

Typically, of the annual emission allowances issued, the largest portion are provided freely, with around 15 to 20% of the allowance sold off at auction. The quantity of free allowances decreases each year to provide an incentive to firms to cut their emissions. [2]

In essence, the system of carbon permits puts a price on carbon emissions for those firms that are regulated. The pioneering work of the ETS led the way for other countries to introduce their own systems, including Canada, Japan, New Zealand, South Korea, Switzerland and the United States.  After 4 years of preparation, following its pledge at the Paris Agreement in 2015, China launched its own carbon trading programme in 2021. [3]


Reduced emissions

Although estimates vary regarding the success of the system, research suggests that the gradual reduction in the number of allowances has led to a 20% reduction in emissions since the system started. This [provides a significant advantage over carbon taxes which do not cap carbon emissions. [4]


Pricing can be too low

Critics have argued that the prices of carbon permits if often too low, generally as a result of their over-supply by governments wishing to ease the burden on the regulated industries.

It is estimated that the price is frequently much lower than the social cost of the emissions. [5]

In an attempt to reduce the surplus the EU introduced the Market Stability Reserve in 2019. This reform reduces the total number of allowances in circulation by soaking up surpluses to create stability and help increase the long term price of carbon permits. [6]

Carbon leakage

It has also been noted that, as a result of the cap-and-trade system, firms have relocated part of their production to unregulated parts of the world. For example, regulated firms can outsource some of the carbon-intensive parts of their production in an attempt to remain competitive. [7] Perhaps the best solution to carbon leakage is to have a legally binding international climate agreement which prevents carbon leakage. [8]

These issues, and others, are likely to be discussed at the COP26 summit in Glasgow, Scotland, in November 2021.

Sources and endnotes

[i] Green, R. (2008). Carbon Tax or Carbon Permits: The Impact on Generators' Risks. The Energy Journal, 29(3), 67-89. Retrieved May 8, 2021, from http://www.jstor.org/stable/41323170

[1] https://ec.europa.eu/clima/policies/ets/cap_en

[2] https://ec.europa.eu/clima/policies/ets/allowances_en

[3] https://www.international-climate-initiative.com/en/news/article/china_starts_national_emissions_trading

[4] PBL Netherlands Environmental Assessment Agency; https://www.pbl.nl/en

[5] The European Union Emissions Trading System reduced CO2 emissions despite low prices; Patrick Bayer, Michaël Aklin

[6] https://www.pnas.org/content/117/16/8804

[7] MUÛLS, M et al; 2016, Evaluating the EU Emissions Trading System: Take it or leave it? An assessment of the data after ten years, viewed May 8th 2021, https://www.imperial.ac.uk/media/imperial-college/grantham-institute/public/publications/briefing-papers/Evaluating-the-EU-emissions-trading-system_Grantham-BP-21_web.pdf

[8] https://www.gov.uk/guidance/participating-in-the-eu-ets

[9] https://www.imperial.ac.uk/media/imperial-college/grantham-institute/public/publications/briefing-papers/Evaluating-the-EU-emissions-trading-system_Grantham-BP-21_web.pdf

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