Tradable Pollution Permits

Tradable Pollution Permits

More Realistic Interventions to Solve Externality Problem Efficient Tax requires a lot of knowledge that government needs to have. Assigning property rights is not enough when many agents are involved and transaction costs are high What else can the government do? Set emission standards Pollution charges Create market for the externality through marketable pollution permits Slide 2

Standards and Charges We are now deviating from the assumption that the government knows the socially optimal level of waste and instead we assume that it tries to decrease pollution to a level that it deems acceptable. Standards: The government tells each firm by how much to cut pollution. Charges: The government announces that firms have to pay an environmental fee a charge for each unit of pollution. By making polluting more costly the governments hopes to decrease pollution to the acceptable level. Slide 3

Two or More Firms and Standards Suppose the government can monitor pollution of each firm and requires each firm to cut pollution by half, to bring down pollution to the acceptable level. Suppose firm A loses $10 in profit if it cuts pollution by one more unit than required by the government, while firm B loses $12 in profit if it reduces pollution by one more unit. This also means that firm B would gain $12 in profit if it increases pollution by one more unit. Slide 4

Setting Standards is not efficient Both firms would then be better off if firm A cuts pollution by one more unit than required and firm B increases pollution by one more unit. Society gains $12 and loses $10 without changing the total level of pollution. We have therefore a Pareto-improvement and conclude that across-the-board cuts are not efficient. Slide 5

Two or More Firms and Charges In order to bring down pollution to the acceptable level in a more efficient way, the government can levy charges on the amount of pollution caused by each firm. For example, the government announces that it will charge $10 on every unit of waste dumped into the water. Then each firm will produce and pollute until the marginal benefit (the marginal profit without the charge) is equal to the charge. At the equilibrium, the marginal costs of abatement for both firms will be the same. Slide 6

Example To abate means to cut pollution! Abatement Firm A s MC 1 3 2 2 6 4 3 10 6 4 15 8 5 21 10 6 28 12 Firm B s MC Slide 7

Example Cont d If the charge is $10, that means firms need to pay $10 dollars for each unit of pollution they produce, then firm A will abate 3 units and firm B will abate 5 units. With standard for each firm needing to cut back 4 units, the same level of pollution is achieved at a higher cost. Slide 8

Weaknesses of Standards and Charges Again, the government needs to know quite a lot. It must somehow determine what the acceptable level of pollution is and, in the case of charges, it must have a good idea by how much pollution will decrease once the charges are in place. If it estimates the costs of abatement incorrectly, firms may decrease pollution by not enough or by too much. On the other hand using charges rather than across-the-board cuts will enhance cost efficiency. Slide 9

Marketable Permits Marketable permits combine the advantages of standards and charges: The government issues permits in the amount it will tolerate pollution and hence removes all the uncertainty about whether or not the target level of pollution is reached. This is the advantage over charges. Can collect revenue, while bringing about cost efficient pollution reduction. By having firms bid for permits, the firms will set a price of the permit equal to the marginal benefit of polluting one more unit. Therefore the inefficiency caused by standards does not apply to marketable permits. Slide 10

Trading Carbon http://www.cbc.ca/news/background/ kyoto/carbon-trading.html Kyoto protocol and Canada: timeline http://www.cbc.ca/news/background/ kyoto/timeline.html Slide 11

Pollution Permits Note that initial distribution of permits (property rights) doesn t effect efficiency result Could sell permits to firms Could give permits to firms Could distribute equally across firms Could give all to one firm As long as a market for the permits exists, firms will buy the permits so long as the price of the permit is less than their marginal abatement cost Buy permits until P=MAC (marginal abatement cost) Slide 12

Govt auction of pollution permits There are three firms in a community that pollute the environment. Each of them are polluting the environment by releasing 7 units of pollution. The government has decided that 12 units of pollution must be abated. The marginal cost of pollution abatement for each firm is given in the table below. Slide 13

Unit abated Firm A Firm B Firm C 1 6 3 9 2 8 5 12 3 10 7 15 4 12 10 18 5 14 11 21 6 16 12 24 7 18 16 27 Slide 14

Govt auction of pollution permits Suppose the government auctions pollution permits using a second price auction. (That is, the highest bidder receives the permit at a price equal to the second highest bid). Without any pollution permits, each firm must abate all of its pollution, that is 7 units. It is a well-established economic result, that in second price auctions, people are best off if they bid equal to their true willingness to pay. Slide 15

Govt auction of pollution permits That is, if for example firm A must abate 7 units but now has an option to get a pollution permit, this permit is worth $18 to firm A, because this is exactly how much firm A would save by having to abate one unit less. Sometimes two firms may be the highest bidders. In this case only one firm can receive the permit. To break the tie, give the permit to the firm whose name appears first in the alphabet. Slide 16

Permit Firm A s bid Firm B s bid Firm C s bid Winner Price paid 1 st 18 16 27 Firm C 18 2 nd 18 16 24 Firm C 18 3 rd 18 16 21 Firm C 18 4 th 18 16 18 Firm A 16 5 th 16 16 18 Firm C 16 6 th 16 16 15 Firm A 15 7 th 14 16 15 Firm B 15 8 th 14 12 15 Firm C 14 9 th 14 12 12 Firm A 12 Slide 17

Explanation of table entries: Without a permit, a firm needs to abate 7 units of pollution. So how much is it worth to the firm to receive one permit? It s equal to cost savings of not having to abate the 7 th unit of pollution. Thus when the government auctions off the first permit, firms bids equal their MC of abating the 7 th unit of pollution. Once firm has purchased one permit, it values another permit equal to the cost savings of not having to abate the 6 th unit of pollution, and so on and so forth. Slide 18

Auctioning permits is cost efficient Notice that the last permit is bought at a price of 12. Every firm abates pollution until its MC of abating is equal to 12. Buy permits until P=MAC (marginal abatement cost) Slide 19

Conclusion This is what cap and trade is all about Likely to be key component of world efforts to reduce carbon emissions Cost saving makes it social-welfare improving over standards Increases chance of getting business on board with emissions reductions (lessens hardship on them per unit of abatement) Has Sierra Club support Obama s energy plan (currently in Congress) has cap and trade component Slide 20