Essay！！

Transferable Emission Permits

Richard Martin

University of Victoria

March 25, 2019

Richard Martin (University of Victoria) Chapter 13 March 25, 2019 1 / 17

Synopsis:

Transferable Emission Permits (TEP) (aka Cap and Trade):

are just like a performance standard, with one key difference: transferability. recall that with a performance standard firms are allowed to emit a certain amount of pollution (their allowance), but then face fines, jail time, etc. if they exceed their allowance. the only difference with TEP is that the allowance is broken into units (kg, tons, litres) which the sources of the pollutant can trade.

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Location on the policy spectrum.

Transferable Emission Permits (aka Cap and Trade) are in the middle of the policy spectrum.

1 Decentralized: property rights plus either liability or negotiation. 2 Middle ground: Transferable Emission Permits and Taxes/Subsidies. 3 Centralized: standards, in particular technological standards.

The main take away is that the waste disposal services of the environment is a valuable input for production: firms should face either an out of pocket or opportunity cost to use this service.

When an input has a positive out of pocket or opportunity cost firms will use the input sparingly.

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Location on the policy spectrum.

Transferable Emission Permits:

Require the monitoring of emissions by the government, so they require more government involvement than decentralized solutions. Furthermore the government needs to determine the initial allocation of permits and keep track of who has the permits: the government needs to be quite involved in the market for permits. Firms are free to choose what ever level of emissions they wish: there is more freedom for firms to choose than under either performance or technological standards.

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A firm’s response to TEP

Transferable Emission Permits:

The firm’s MAC curve tells us how expensive it is for a firm to reduce its emissions marginally. If the firm can buy or sell pollution permits at a price pp it will continue to reduce its emissions until MAC = pp Permits should flow from firms with low marginal abatement costs (they will choose to abate instead of use the permit) to firms with high marginal abatement costs (they will purchase permits rather than incur their high marginal abatement cost.) Trade should continue until marginal abatement costs are equalized across all sources. In terms of static analysis (choosing emissions at a point in time) if the permit price is the same as either a tax or a subsidy we should observe the same abatement behaviour.

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A firm’s response to TEP

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emissions

Figure 1: profit maximizing response to a permit price of pp.

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The socially optimal number of permits.

Suppose there are two sources of emissions, and the government knows both the marginal abatement costs and the marginal damages.

MAC1 = 200 − 10e1 MAC2 = 150 − 5e2 MD = 5(e1 + e2) e?? = Optimal number of permits is e??.

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The socially optimal number of permits.

Sources will trade permits whenever their MAC’s are different.

To demonstrate the equilibrium in the permit market we plot the MAC curves in permit space (# of permits on x-axis).

A permit is worth more to the firm that has the higher MAC: demand for permits is V shaped, the supply for permits is A shaped.

Equilibrium in the permit market occurs where the demand for permits equals the supply of permits.

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The socially optimal number of permits.

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The socially optimal number of permits.

This animation of the permit market reminds me of one of my childhood fave movie scenes:

https://www.youtube.com/watch?v=6u3QInIMVME

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The socially optimal number of permits.

Properties of TEP:

Assuming we have compliance TEP ensure that there is a limit on the pollutant (like a performance standard, unlike a tax) Cost effective: when all sources can buy or sell permits at the same price then marginal abatement costs are equalized across sources. (unlike a performance standard, like a tax)

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The socially optimal number of permits.

Properties of TEP:

If a firm needs to buy an additional permit the permit price is the explicit cost associated with one more unit of emissions. If the firm already has the permit the permit price is the opportunity cost of using the permit to emit one more unit of pollution: if the firm reduced emissions by one unit it could sell the permit instead. Obviously we lose cost effectiveness when different jurisdictions have different permit markets. Less political push-back than emission taxes: Firms prefer gifts from the government when compared to new taxes.

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The socially optimal number of permits.

Complications:

initial allocation of permits. who can participate in the market? non-uniformly mixed pollutants: ambient based TEP... not really practical. tension between economic reasons for broad market vs. ecological reasons for limited scope (e.g. urban smog) enforcement: government needs to keep track of how many permits each source has (on top of the monitoring of emissions, which must be done for all policies.)

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The incentive to innovate.

The incentive to innovate (small firm)

The incentive to innovate depends on whether the firm expects the number of permits they are allocated will change post innovation. Depends on what proportion of total emissions the source is emitting. A small source would be able to innovate and reduce its MAC without response from the government. In this case TEP innovation incentives are identical to a non-responsive tax.

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The incentive to innovate.

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emissions

Figure 2: Incentive to innovate with unresponsive allocation of permits (small firm).

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The incentive to innovate.

The incentive to innovate (big firm)

At the other extreme, if there is only two sources the innovation would likely trigger a response from the government: a reduction in the number of permits gifted to the firm. This reduction in gift size diminishes the incentive to innovate: This is easiest to see in the special case where firms are gifted permits exactly equal to their socially optimal emissions, both prior and post innovation. In this case TEP innovation incentives are identical to a responsive standard.

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The incentive to innovate.

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emissions

Figure 3: Incentive to innovate with responsive allocation of permits (big firm)

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