Pollution Permit

A pollution permit is a right, granted by an authority, to emit a specified quantity of a pollutant. Pollution permits are the basis of cap-and-trade systems, in which the total quantity of emissions is limited and the permits are traded among the emitters.

Design

A cap-and-trade system sets a cap on the total quantity of emissions that may be released. The authority issues permits that correspond to the cap, and the permits are allocated to the emitters, either through a free allocation or through an auction.

The emitters must surrender permits that cover their emissions, and they may trade permits with one another. The trade allows the emitters with low abatement costs to reduce their emissions and sell their surplus permits, while the emitters with high abatement costs buy permits and continue to emit.

The cap ensures that the total quantity of emissions does not exceed the limit, while the trade ensures that the reductions are achieved at the lowest cost. The system is therefore efficient, in the sense that it achieves the environmental objective at the least cost.

Comparison with Taxes

A pollution tax sets a price on emissions, and the emitters decide how much to emit given the price. A cap-and-trade system sets the quantity of emissions, and the market determines the price.

The two instruments differ in the certainty that they provide. A tax provides certainty about the price, while a cap-and-trade system provides certainty about the quantity. The choice between them depends on which form of certainty is more important.

The two instruments also differ in their distributional effects and in their revenue. A tax generates revenue for the government, while a cap-and-trade system generates revenue only if the permits are auctioned. The design of the allocation affects the distribution of the costs.

Implementation

The implementation of a cap-and-trade system involves several decisions, including the coverage of the system, the level of the cap, and the method of allocation. The design of these elements affects the effectiveness and the cost of the system.

The coverage determines the sources that are subject to the cap. A broader coverage increases the opportunities for low-cost abatement and reduces the cost of meeting the cap. A narrower coverage may leave some sources unregulated and may create distortions.

The level of the cap determines the environmental objective. The cap must be set at a level that achieves the objective without imposing excessive costs. The cap can be tightened over time to achieve the long-term objective.

Experience

Cap-and-trade systems have been implemented for several pollutants, including sulphur dioxide, which causes acid rain, and carbon dioxide, which causes climate change. The systems have achieved reductions in emissions, and the experience has informed the design of future systems.

The experience has also highlighted challenges, including the volatility of permit prices and the risk of leakage, in which emissions are shifted to jurisdictions without a cap. The design of the systems must address these challenges.

The European Emissions Trading System

The European Union emissions trading system is the largest cap-and-trade system in the world, covering the emissions of carbon dioxide and of other greenhouse gases from a range of sectors. The system was launched in 2005, and it has been revised several times.

The system sets a cap on the total emissions and allocates permits to the covered installations. The permits are traded, and the price of the permits reflects the cost of the emissions and the balance between the supply and the demand.

The experience of the system has been mixed. The price of the permits has been volatile, and it fell sharply during the financial crisis, when the demand for the permits declined. The reforms have addressed the volatility and have tightened the cap.

The Social Cost of Carbon

The social cost of carbon is the estimate of the economic damage caused by the emission of an additional tonne of carbon dioxide. The estimate is used in the design of the policy and in the assessment of the benefits of the abatement.

The estimation of the social cost requires the integration of the effects of the emissions over time, including the effects on the climate, on the economy, and on the welfare of the population. The estimates are subject to substantial uncertainty and depend on the assumptions about the discount rate and about the damages.

The social cost provides a benchmark for the price of the permits and for the level of a carbon tax. The choice of the discount rate has a large effect on the estimate, and the debate about the rate is central to the analysis of the climate policy.

The Design of the Permit System

The design of the permit system involves decisions about the coverage, the cap, and the allocation. The coverage determines the sources that are subject to the cap, and the cap determines the environmental objective.

The allocation determines the distribution of the costs. A free allocation to the emitters provides a windfall to the incumbent firms, while an auction captures the revenue for the government. The choice of the allocation affects the political acceptability of the system.

The design must also address the risk of leakage, in which the emissions are shifted to jurisdictions without a cap. The measures to address the leakage include the border adjustments and the free allocation to the sectors that are exposed to trade.

Summary

Pollution permits are the basis of cap-and-trade systems, which achieve the environmental objective at the lowest cost. The design of the systems, the estimate of the social cost of carbon, and the responses to the risk of leakage are central to the analysis of the climate policy.

See also

• Environmental Economics
• Sustainability
• Public Economics