- Pollution permits involve giving firms a legal right to pollute a certain amount e.g. 100 units of Carbon Dioxide per year.
- If the firm produces less pollution it can sell its pollution permits to other firms.
- However, if it produces more pollution it has to buy permits from other firms or the government.
- This crease a market for pollution permits with the price set by demand and supply.
- The aim of pollution permits is to provide market incentives for firms to reduce pollution and reduce the external costs associated with it. For example, it is argued carbon dioxide emissions contribute towards global warming.
- Pollution permits can also be a way for the government to raise revenue, by selling firms these permits to allow pollution.
Diagram for pollution permits
A very simple diagram showing the fixed supply of pollution permits. If demand for pollution increases, the cost of tradeable permits rises from P1 to P2.
Pollution permit scheme
In this case, the government reduces the number of permits over time. This means the price will steadily increase and create a growing incentive to reduce pollution over time. The idea is that it gives firms time to try and invest in different technology which creates less pollution.
Pollution permits and social efficiency
If firms produce carbon as a side-effect of production, it is classed as a negative externality. In this case, the social marginal cost of the polluting industry is greater than private marginal cost. In a free market, we get over-production of pollution and social inefficiency. (see: negative externality)
Pollution permits are a method to try and reduce output to a more socially efficient level. The aim is to make the price of pollution permits as close as possible to the social marginal cost
Pollution permits vs carbon tax
- Pollution permits have a similar goal to carbon tax. They both aim to increase the cost of producing pollution and create an incentive to reduce the quantity of pollution.
- The diagram on left shows how a tax can shift supply to the left and make firms pay the full social marginal cost of pollution. It raises the market price to P2.
- The diagram on the right shows how pollution permits have a similar effect. If the quantity of permits is set to Q2, the market price rises to P2
Problems of Pollution Permits
- It is difficult to know how many permits to give out. The government may be too generous or too tight.
- It can be difficult to measure pollution levels. There is potential for hiding pollution levels or shifting production to other countries, with looser environmental standards. In a globalised world, multinationals increasingly shift production around.
- There are administration costs of implementing the scheme and measuring pollution levels.
- For global pollution permits, countries who pollute more than their quotas can simply buy permits from other countries. Therefore rich developed countries can simply buy permits from less developed countries. This does not significantly reduce pollution but shifts it from the richer countries to poorer countries.
- The biggest carbon trading scheme is the EU Emissions Trading Scheme (ETS), however political interference has created a glut of permits and it has done little to reduce carbon dioxide and reverse global warming.
- Environmentalists have argued a higher price of carbon is insufficient to reduce carbon dioxide to levels necessary to stop global warming. Demand for carbon permits is often price inelastic and too slow to act.
- Some carbon trading schemes have a component called ‘carbon offsetting. This means if pay to plant trees, this can count against carbon emissions. However, critics argue carbon offsetting effectively enables firms to keep polluting with no guarantee planting trees will on their own solve the pollution problem.
Examples – Sulphur Trading scheme
In 1990, the US pursued a form of sulphur trading scheme which gradually reduced the number of permits to pollute sulphur. (a cause of acid rain).
- It was relatively straight-forward as sulphur emissions came predominantly from coal-burning power stations. This made it easy to monitor
- There was no scope for ‘sulphur offsetting’
- The scheme was successful in reducing sulphur dioxide by 40%.
- Though critics note sulphur dioxide also fell in other countries who pursued more standard regulatory legislation to limit the amount of pollution – rather than carbon trading.
China’s national cap-and-trade program
- The biggest carbon trading scheme will be in China, who have sought to learn from the EU’s experience with ERS
- The scheme will give a cap to polluters – this is the amount of pollution that can be created without cost. If polluters go above this ‘free’ cap, they have to buy allowances on the market for permits.
- The scheme set the initial carbon allowances to 3 -5 billion tones per year
ACUS provides marketable permit recommendations to harness efficiency and maintain policy objectives.
Although cap-and-trade programs for government permits to emit carbon dioxide occasionally makeheadlinenews, the average American may not realize that billions of dollars’ worth of government permits are auctioned or traded in a wide variety of industries, from broadcasting to construction to fishing.
Those industries all rely on “marketable permits”: government licenses issued for various activities that regulated parties can purchase from the government or buy from and sell to other private parties. The intended goals of making regulatory permits marketable include harnessing the efficiency of the market to lower compliance costs, encourage innovation, and ease administrative burdens, all—in theory—without compromising the policy objectives of the regulation.
The alienability of marketable permits makes it important for regulatory agencies to clearly define the privileges and requirements of ownership. Regulatory agencies must also oversee permit markets to ensure the permitting program achieves its regulatory objectives efficiently and without market manipulation.
Last December, the Administrative Conference of the United States (ACUS) adopted recommendations to provide guidance on such issues to federal agencies, articulating the best practices to follow in designing and overseeing marketable permit programs.
Marketable permits have a long history of bipartisan support in a variety of contexts, starting with air pollution markets in the 1970s and 1980s and exemplified by the 1990 Clean Air Act’s creation of the acid rain market. Since then, marketable permits have spread to other environmental and natural resource regulations, including water quality trading, tradable fish catch shares, and offset credits that land developers can purchase from third parties to mitigate their development projects’ impacts on endangered species or wetlands.
These programs are quite popular with regulated entities. For example, there are 1,500 wetland mitigation banks, and over 50 percent of development projects purchase credits from those banks for their required wetland mitigation. Some 15,000 hectares are traded annually, with cumulative transactions worth over $3 billion.
Marketable permits are not limited to the environmental context. A presidential Executive Order instructs agencies broadly to consider the possible advantages of regulating through marketable permits across all policy contexts. There are marketable permit programs for motor vehicle efficiency standards, renewable energy credits, auctions for electromagnetic spectrum licenses, and secondary trading of airport landing slots. And that is just at the federal level; at the state and local level, marketable permit programs thrive for transferrable property development rights, liquor licenses, and taxi medallions. Possible future applications, discussed by agencies and academics, include helping to manage satellite congestion or even to curtail the over-prescription of antibiotics.
Active interest in marketable permits remains strong among federal agencies. Most recently, at the end of November 2017, the U.S. Department of Energypublished a request for information on a proposed rule to consider allowing credit trading for its appliance and equipment efficiency standards. At the same time as this ongoing interest in applying marketable permits in new regulatory areas, there continue to be open questions and inconsistent practices on how best to manage existing permit markets. For example, in recent years, there have been accusations and congressional calls for investigations into possible fraud and extreme price volatility in the renewable fuels credit market.
Similarly, the Inspector General of the National Oceanic and Atmospheric Administration has found that information collected by the agency on fish catch share ownership and transaction prices was especially spotty in some regional catch share programs, preventing interested parties from making informed, efficient decisions in the market. There are even questions about the legal status of some programs. Some participants at a recent interagency workshop on water quality markets expressed concern that the lack of codified regulations establishing the water quality trading program may create uncertainty about the longevity and privileges of permits.
On such management issues, as well as in creating future marketable permit programs, the recommendations from ACUS can help guide agencies on how to use marketable permits to harness the efficient decision-making powers of the market without undermining policy goals.
ACUS recommends that agencies consider which type of permit trading system—if any—will best promote the prescribed policy objectives. Agencies are encouraged to issue clear guidelines to clarify issues like permit longevity; ideally, agencies should do so through notice-and-comment rulemaking to ensure public input and transparency. Agencies are also advised to promote market liquidity, but simultaneously are cautioned that some market design choices could increase opportunities for manipulation. ACUS calls on agencies to work together to share expertise and responsibility for preventing manipulation and enforcing compliance in permit markets.
On overseeing marketable permit programs in general, ACUS reminds agencies that compliance is key, and noncompliant parties should develop plans to come into compliance. Agencies must carefully track permit ownership, transactions, and the regulated activity levels. Offset credits must be “real,” and credit verification procedures should have standards, like preventing conflicts of interest in third-party credit verifiers. Extreme price volatility should be addressed through appropriate tools, such as price ceilings and floors. A reserve pool of credits can help facilitate new entrants into the market.
Finally, the careful management of information is key to running an efficient permit market and keeping market actors on a level playing field. Agencies should collect data to assess the market’s efficiency and its effectiveness at achieving the intended policy objectives. Mindful of confidentiality issues and other legal limitations, agencies should release data needed for the public and market participants to monitor permit transactions and prices. When it comes to the agency releasing its own information about potential policy changes or enforcement actions that could influence the market, clear communication policies, such as pre-scheduling announcements, can help minimize information asymmetries among market actors.
By following ACUS’s recommendations, agencies will be able to use the efficiency of the market to lessen compliance costs, encourage innovation, and ease administrative burdens, all without sacrificing policy objectives.
This essay is part of a five-part series, entitled Five Recommendations for Improving Administrative Government.
Tagged: ACUS, Guidance, Marketable Permits
Jason A. Schwartz is an adjunct professor at New York University School of Law and was the consultant to ACUS on the marketable permit project.
H. Russell Frisby, Jr. is a partner at Stinson Leonard Street LLP and chaired the ACUS Committee on Regulation meetings on the project.
E. Donald Elliott is senior of counsel at Covington & Burling LLP and chaired the ACUS Committee of the Whole meetings on the project.