1 Topic 3.c: Transferable emission permits We will start analyzing the last policy we will look at...

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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.

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• 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.

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• 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.

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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.

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• Denote the price of permits as Pp. Then the firm will

– Sell permits and abate if Pp > MAC; and

– Buy permits and pollute if Pp < 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.

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• 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?

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100 80E1E2

60

40

MAC1

MAC2

• firm 1 would have to abate 60 units MAC1 = 60.

• firm 2 would have to abate 40 units MAC2 = 40.

A1 = 60 A2 = 40

So at the initial permit allocation, MAC1 > MAC2.

Tell us that there exists some Pp such that

MAC1 > Pp > MAC2.

Which means there exits some Pp such that firm 1 will want to buy permits and firm 2 will want to sell permits.

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Topic 3.c: Transferable emission permitsThe initial allocation is 40 permits to each firm.

At that allocation: 100

80

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100 80E1E2

60

40 39

41

MAC1

MAC2

TAC1 > TAC2 reallocation represents efficiency improvement.

But does it make the firms better off?

Firm 1: Benefit = TAC1= $59.50

Cost = Pp = $45

The trade makes each firm better off.

59

41

40

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Topic 3.c: Transferable emission permitsExample: suppose firm 1 offered to buy 1 permit from firm 2 for $45.

Firm 1 can emit 1 more unit, TAC1 = $59.50

Firm 2 can emit 1 less unit, TAC2 = $40.50

Firm 2: Benefit = Pp = $45

Cost = TAC2 = $40.50

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100 80E1E2

60

40

MAC1

MAC2

So trade will continue until MAC1 = MAC2 at emissions levels such that E1 + E2 = 80 = number of pollution permits:

MAC1 = MAC2 100 - E1 = 80 - E2

E1 + E2 = 80 100 - E1 = 80 - (80 - E1) 100 - E1 = E1

100 = 2E1

E1 = 50 & E2 = 30.& MAC1 = MAC2 =

50

40

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Topic 3.c: Transferable emission permitsGain from trade possible because MAC1 MAC2 at initial allocation

Tells us firms will want to trade as long as MAC1 MAC2

100

50

80

50 30

10

100 80E1E2

60

40

MAC1

MAC2

Firm 2 sells 10 permits, meaning E2 by 10.

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40


Key point: Only if Pp = $50 per permit will firm 1’s demand for permits = firm 2’s supply of permits.

For instance, if Pp > $50:

firm 1 will demand < 10 permits firm 2 will supply > 10 permits

Similarly, if Pp < $50, excess demand.

100

50

80

50 30

buy sell

Firm 1 buys 10 permits, allowing E1 by 10 (relative to initial allocation).

Excess supply Pp must to clear market

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100 80E1E2

60

40

MAC1

MAC2

40

40


Firm 1:

With no trade, compliance costs = TAC1 (E of 40) = $1,800

With trade, compliance costs = TAC1 (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

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100 80E1E2

60

40

MAC1

MAC2

40

40


Firm 2:

With no trade, compliance costs = TAC1 (E of 40) = $800

With trade, comp. costs = TAC1 (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

Gain from trade

Note: Gains from trade for each firm are only the same here as slopes of MACs are the same.

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100 80E1E2

60

40

MAC1

MAC2

40

40


We know that E = 40 for each firm is inefficient (MAC1 > MAC2), while E1 = 50 & E2 = 30 is efficient (MAC1 = MAC2)

With no trade TAC1 + TAC2 = $2,600

With trade TAC1 + TAC2 = $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)?

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• 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 (MAC1 = MAC2 after trade).

• Important to understand: this can be achieved with no knowledge of either firm’s MAC curve.

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• 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.

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• Another important point:

– Equilibrium in the permit market is where MAC1 = MAC2 such that E1 + E2 = 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.

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• Exercise: Work through this example again, only now, at the outset, give all the permits to firm 2.

• You should find that:

– E1 = 50 and E2 = 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…..

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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 CO2 in the atmosphere, and it doesn’t matter whether the stock grows because of CO2 emissions in China, Canada, or Antarctica.

• But for a pollutant like SO2, it matters. A ton of SO2 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.

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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 SO2 emissions that all the high MAC firms are coal-fired power plants located in Ohio River Valley, where SO2 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).

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• 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.

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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.

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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.

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Topic 3.c: Transferable emission permits2. 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).

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Topic 3.c: Transferable emission permits3. 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.

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