Tradable Pollution Permits

Corrective Taxes and Tradable Pollution Permits

To understand corrective taxes and tradable pollution permits, it can be helpful to cover the nature of pollution and what can be done to solve it.

Corrective taxes and tradable pollution permits: The nature of pollution

The world we all find ourselves living in is massively interconnected. Each action of any human or even animal takes up space, uses energy, and leaves residue and waste.

When we breathe, we consume oxygen and exhale carbon dioxide; similar to when firms produce goods, they expend energy and resources and create waste and by-products. The problem with pollution is its effects are an externality as the full costs of its production aren't accounted for directly. The individuals that pay the price for pollution are those who aren't even involved in the market transaction that created it.

Producers don't derive joy from releasing pollution, and they know that others may get mad at them for doing so. Some producers may research the cost of containing or reducing their pollution; however, doing so would increase their prices and hurt their competitiveness.

Everything we do, in some way, creates pollution. What we must collectively solve is what pollution-creating actions are worth doing. Economists and environmentalists have set to work to measure the costs and damages created by the various products that sustain our lifestyles.

Corrective taxes and tradable pollution permits: What to do about pollution?

The science and math are in, we have ways of measuring the cost of many types of pollution. So how do we make it a reality?

The direct solution that has been imposed by many governments is to set a regulation that limits a particular type of pollution a producer can emit and impose a fine on them if they exceed the limit. The problem with the approach is that it doesn't provide incentives to reduce pollution below the limit. It also doesn't take into account the costs associated with preventing pollution.

Another method of addressing pollution is to tax producers on the cost of their pollution. If each unit of their production reduces air quality in a town resulting in $5 increased health expenses per every unit they produce. Then they would be taxed $5 per unit. Taxes are more socially efficient than regulation because regulation reduces production and raises prices, and creates deadweight loss. With taxes, the deadweight loss is the tax revenue that can be repurposed, even to pay for health expenses caused by the producer's pollution.

Similar to the tax is the tradable pollution permit method. It's similar in the sense that producers of pollution will have to pay to pollute. Tradable pollution permits are allowances given to similar industry members. These allowances give them the right to pollute up to the specified quantity. These permits and their attached allowances can be exchanged at a free-market-determined price to other members within the industry.

Tradable Pollution Permits Definition

A tradable pollution permit is a policy that uses the free market to efficiently regulate pollution; let's start with a definition.

A group of manufacturers within the same industry, such as natural gas power plants, would be selected. The total current pollution output is measured across the industry, at which point a reduced pollution output is set. Depending on the scenario, the manufacturers either buy or are given permits allowing them to expel pollutants up to the permitted level.

What makes these effective is the permits are then tradable on the open market between manufacturers in the industry. This creates a market where low-polluting firms are rewarded with the ability to sell their unused permits. Meanwhile, heavy polluting firms will be required to buy more permits and invest in ways to reduce their pollution output.

Tradable Pollution Permits Diagram

To clarify the effects on an industry, viewing a tradable pollution permit diagram will help. We will be able to analyze what the supply and demand for a tradable pollution permit market look like. This will also clarify the advantages of tradable pollution permits compared to using a corrective tax.

Corrective taxes seek to curb pollution by putting a price on each unit of pollution created. To achieve a reduction in pollution, the price must be greater than the profit gained by polluting over the socially optimal level. This policy is rigid and doesn't allow the market to reach a natural efficiency.

Tradable pollution permits seek to curb pollution by setting an industry limit and then allowing industry players to determine how much they are willing to pay to pollute. This policy gives flexibility to the industry to regulate its own pollution by making them compete for the right to pollute.

These two methods yield different results as they approach the market in drastically different formats.

The graph on the left side of Figure 1 is the supply and demand curve when a corrective tax is imposed. The tax is fixed at a singular price and doesn't change market conditions. Presently the quantity of pollution created is at Q, created by the intersection of the demand curve and the tax. However, consider what happens if demand were to increase. If producers were to experience increased profits, then they could afford to pollute more, raising the demand and shifting the curve to the right. When the demand curve shifts to the right, the quantity of pollution will increase. If pollution is able to increase, then the regulation fails to achieve its goal.

Fig. 1 - Corrective tax and pollution permits

The graph on the right side is the supply and demand curve for pollution permits. The pollution permits are tradable and will be highly desired by heavy polluting firms. The price will follow market demand because the pollution permits are set at a desired quantity of pollution. The quantity is immovable and, therefore, a vertical slope or otherwise known as perfectly inelastic supply.

When using a corrective tax, changes in demand increase the quantity of pollution. With the tradable pollution permits, however, we can recognize their key advantage. When demand changes, the quantity of pollution isn't flexible. Therefore the only thing that can change is the price. This is beneficial as the free market can dictate the efficient price, and the quantity of pollution won't exceed the maximum.

Tradable Pollution Permits Pros and Cons

What better way to understand a topic than to just list its pros and cons? Tradable pollution permits are by no means a perfect solution, not harmless, nor is it a "one size fits all." Every great theory has at least a few drawbacks; let's see how they compare with the benefits.

Tradable pollution permit benefits

Tradable pollution permits advantages include the following.

• It can be adjusted by lowering the number of permits in circulation. If it's too harsh for the industry, more can be issued.

• Permits have the potential to generate tax revenue or dividends for citizens.

• Realigns the profit motive to coincide with the cleanest production method.

• Cleaner firms are rewarded and receive extra income by selling permits.

• Changes in the market only affect the price and will not increase the quantity of pollution.

Tradable pollution permits problems

Unfortunately for climate progress, there are problems with tradable pollution permits. As always, though, we must consider whether the cost of the problems created by the solution is greater or less than the cost of the problems they address.

Tradable pollution permits disadvantages include the following.

• Setting an effective pollution limit can be challenging without destroying the industry.

• Firms under regulation may struggle to compete with international firms, which may lead them to offshore production in a cheaper location.

• Prices will increase for consumers, and any increase in costs of production will make its way into the final price.

• Industries with enough capital may be able to buy their way into not reducing pollution; however, it would generate tax revenue to be used elsewhere.

Tradable Pollution Permits Examples

Not every producer in an industry pollutes the same. Since they compete, they have variances in production practices. As a result, the quantity of pollution created will occur on a spectrum of the most polluting to least polluting.

Table 1 - Companies and their pollution output example

This example demonstrates how the market for pollution permits comes to exist. While some firms require more permits, others who don't can sell theirs. This does raise a question, though, how does this market determine how much the permits should cost?

Similar to how each firm produces different quantities of pollution, it is also true that their methods for reducing pollution may vary greatly.

Table 2 - Companies and their pollution reduction costs example

As the example above demonstrates, regulators do not need to solve problems in a way that addresses every detail. If a model is designed that gives free market players a flexible format, then an efficient outcome can be reached. The criticism of government regulation is the disruption of free market efficiency. By tailoring the policy to give free market control, governments can address market failures without causing markets to fail. It's possible that other regulations could be shaped in the same free market format. These could be used in different market sectors, such as pharmaceuticals, to align the free market with equitable social outcomes.