Saturday, 20 April 2013

Marketable Permits

Another market based instrument the government can use to try and internalise the externalities caused by the use of environmental goods and services is marketable permits. The authorities choose the amount of pollution they feel is acceptable for a particular pollutant. Then, they issue permits to firms, each one allowing the firm to emit one unit of pollution. The amount of permits they give out will be equal to the pollution limit they have set. A market has then been created - firms can buy or sell these permits when they need to, the price of the permits will depend on the demand and supply. These marketable permits leave the decision to the firm as to how many permits to buy and how much pollution to abate.

The firms marginal abatement cost and the cost of permits will influence the firms decision to cut their pollution. If the marginal abatement cost is greater than the permit price then the firm will keep its pollution as it is and buy permits to cover it. If the permit price is greater than the firms marginal abatement cost then the firm will cut its pollution because it will be cheaper than buying the permits to cover it all.

Marketable permits are a lower cost way of reducing pollution than command and control. Imagine we have two firms: Firm 1 and Firm 2. Firm 1's MAC is £100 and it is polluting 50 tonnes. Firm 2's MAC is £150 and it is also polluting 50 tonnes. Total emissions is 100 tonnes. If we wanted to cut pollution down to 80 tonnes using command and control methods we'd get each firm to cut pollution by 10 tonnes. This would have a cost of £1,000 to Firm 1 and £1,500 to Firm 2, a total cost of £2500 to cut the pollution.

Now, If the permit price was £130 and we were trying to get to 80 tonnes under marketable permits the cost would be different. 80 permits would be issued to firms, so Firm 1 and Firm 2 would both get 40. Firm 1 could cut pollution by 20 tonnes to reach a total of 30 tonnes emitted at a cost of £2000. They could then sell 10 spare permits netting them £1300, meaning the net cost was £700. Firm 2 could buy up 10 additional permits and keep its pollution at 50 tonnes - this would cost them £1300. So, pollution has now fallen to 80 tonnes (30 from Firm A and 50 from Firm B) but it has only cost a total of £2000 (£700 for Firm A and £1300 for Firm B). Therefore marketable permits is a more cost effective way of reducing pollution than command and control.

Marketable permits also have a benefit over the pollution tax system. Permits allow authorities to set the amount of pollution and then let the market choose the price. With taxes, the authorities choose the price and let the market choose the pollution level.

There are many technicalities to the system that I'll talk through now. The first of these is 'bubbles'. This is essentially a 'bubble' over a whole firms pollution - the aim is to make the aggregate level of pollution in the bubble stay the same. So, they can increase pollution from one of their outlets as long as they reduce pollution elsewhere in their firm by an equal amount. 'Banking' is an extension to this. It allows a firm to bank credits for later use if they reduce below the aggregate amount - it allows them to temporarily pollute more in the future by using these credits. 'Netting' is another concept. This allows firms to create a new source of emissions only if they generate equal reductions elsewhere in their firm - they cannot buy new permits from the outside to cover the new emissions they must internally trade the permits they already have.

In reality, marketable permits are a difficult concept to get going. An example of this is the EU CO2 Emissions Trading Scheme of 2005. It ultimately failed because too many permits were given out at the start and therefore nothing was achieved, but a lot of money was wasted. There are many other problems with the system. Firstly, the politics behind it make it difficult to impose and coupled with this the unethical-ness of actually permitting firms to pollute generates a lot of opposition. The system comes with massive administration costs that only get higher with more firms being included in the operation. The main problem is how to actually allocate the permits in the first place? One method used already is 'grandfathering'. Firms are given permits based on historical emissions data, the more the firm polluted in the past the more permits they get. This is, in essence, rewarding dirty firms. It also incentivises firms to increase production and therefore pollution when talk of a permit scheme being introduced starts so that the firm can gain more permits. 

In theory marketable permits are a great idea, currently in reality they don't work too well and there are many obstacles that need to be overcome. Maybe in the near future we will see these sort of schemes becoming more common and helping the pollution problem. What is your opinion? Cheers for reading.

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