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Cap and Trade Polution Permits |
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Clever Markets
Some new uses of markets deserve special attention because they are very useful for social policy, but often misunderstood, particularly by the left. One example is market for pollution, which is often incorrectly seen as granting rights to pollute.
Flat limits
Suppose coal plants are all the same size and there are 100 of them which collectively emit 200 tons of some specific pollution per year. Suppose we decide that is too much and we wish to limit them to 100 tons per year. We could require each plant to emit only 1 ton per year, and fine them enough if they don’t to make it worth there while to comply.
A Cap with Tradable Permits
Another approach is to given them all 2000 permits to emit 1 pound per year and let them buy and sell these permits, with a similar fine if they emit more than they have permits for. Some view these permits as a “right to pollute,” and so immoral. But notice that in the beginning all coal plants had the right to pollute as much as they want, and in the flat-limit system all coal plants are given the right to permit up to 1 ton for free. In market based “cap and trade” system all plants are given that same right for free. The only difference is that to plants can cooperate as follows. One says I will reduce my pollution by X pounds if you pay me enough and the I will give you X permits so you can emit X pounds more than one ton. This makes the bad plant pay more and the rewards the good plant. Total pollution is unaffected, to why should society care?
Why is this better?
But then why should it care at all? What’s better about cap and trade? Say one plant can reduce its pollution for a cost of $100 per pound and the other can do it for only $50 per pound. The $50 plant will offer to sell permits to the expensive plant for $75, and the expensive plant will buy them because it save $100 for every pound by which it does not need to reduce it’s pollution and the permit costs only $75. The net result is that the cheap plant still emits its full 2 tons per year, while the cheap one cleans up completely and emits none. The average is 1 ton, and the total cost of clean up is 2 tons (4000 pounds) times $50 per pound. That’s $200,000.
Under a flat limit the expensive plant must spend 2000 pounds times $100, while the cheap one spends only 2000 pounds times $50. That’s $300,000. So the same amount of pollution reduction costs 50% more with the flat limit than with the cap and trade system. Why should we care? Those costs inevitably get passed on to consumers.
If you want to reduce pollution by X and you can do it for $200,000 or for $300,000, why would anyone pick $300,000?
Selling the permits instead of giving them away
Another way to attain this same savings is to have the government issue the 100 tons of permits, but instead of giving them away, they can sell them. This way the government collects a lot of money in return for the right to pollute. But the difference is not as great as it looks. This will impose more cost on coal plant, and they will pass that cost on to consumers—trust me on this one.
The risk of Cap and Trade.
There is one problem with cap and trade. The government might make a mistake. It might find out that the cost of pushing pollution down to 1 ton is so expensive that the price of coal-fired electricity goes through the roof. It really doesn’t know what it will cost until it tries it out. This is the same as with the flat limit, the only difference being that with cap and trade we can see the price of permits and we learn something about the actual cost of pollution abatement.
A Supply Curve for Tradable Permits
What if we don’t want to take the risk of an unknown cost? Easy. Say we want to cap pollution at 1 ton per plant, but not if it cost anyone more than $200 per pound to reduce their pollution. Since costs are passed on to consumers, at a high enough level, society would definitely rather pay the cost than clean up the pollution. In this case we issue 1 ton of permits to each plant, and then make more available at a cost of $200 per pound. If there is any way to reduce the average level of pollution to 1 ton per plant for less than $200 per pound, the market in permits will find it and we will meet our goal. But if this is impossible, some plants will buy permits for $200 per pound, but no one would spend more than that to reduce pollution when they can just buy a permit instead.
The above example is a supply curve for permits, and many other useful designs can be arrived at by drawing different shaped supply curves. But because of coal plants can trade permits, all will achieve their pollution reduction at the lowest possible total cost.
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http://zfacts.com/p/387.html | 01/18/12 07:23 GMT
Modified: Thu, 01 Jun 2006 04:40:19 GMT
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