Jan 11 2008

Reducing negative externalities – the European market for carbon emissions

Tighter European limits set to push up price of carbon emissions – Times Online

Market for pollution permits

When it comes to correcting the market failure of negative externalities, governments have several options. The most interventionist approaches may involve placing strict limits on the amount of a pollutant firms are allowed to emit and fining them for exceeding this limit, taxing firms that pollute in order to increase their costs and decrease market supply, reducing output and increasing price closer to a socially optimal level, or simply banning the production and consumption of goods whose existence places excessive spillover costs on society.

Such interventionist approaches to externality reduction tend to require a complex bureaucracy to administer, monitor, execute and enforce. The government may not be able to determine the appropriate level of a tax on a polluter if it can’t determine the exact level of the externalized costs placed on society; the government cannot always check up on every producer in the economy to determine just exactly how much pollution each factory’s producing, and then levying a fine on excessive polluters again raises the question of how high should a penalty be?

Because of the complexities involved in the interventionist approaches above, economists have recently promoted and the worlds’ governments have begun adopting a market-based approach to reducing negative externalities, involving the creation of a whole new market: one in which the right to pollute is bought and sold by firms. This may sound crazy at first, but here’s a basic summary of how these markets work:

  • A government or international agency decides on the acceptable amount of pollution in a particular region and issues permits that firms can purchase giving them the right to pollute. Each permit will allow a certain amount of pollution. The total supply of permits is perfectly inelastic since it is decided by the government agency.
  • The demand for pollution permits is downward sloping. At high prices, firms will either stop polluting or pollute less by acquiring pollution-abatement equipment, which is more attractive when the rights are more expensive. If the “cost of pollution” is cheap, then firms will chose to buy permits rather than acquiring expensive abatement equipment or upgrading to “greener” technology.
  • In the market for pollution permits, the “price to pollute” will be determined by the downward sloping demand among firms for pollution permits and the perfectly inelastic supply of permits determined by the number issued by the government. If the price of permits is too low to make firms bear the full environmental and social costs of their production, the government can reduce the supply thus increase the price and decrease the quantity of pollution permits demanded, reducing the negative externalities of pollution as firms will shift to greener production techniques.

There are several advantages to this system over direct government controls:

  • It reduces society’s costs because pollution rights can be bought and sold. Some firms will find it cheaper to buy the rights than to acquire abatement equipment; other firms can sell their rights because they may be able to reduce pollution at a lower cost. The incentive for all firms is to reduce their own pollution and sell the permits they no longer need, adding to the profits of “green firms”.
  • Conservation groups and  individuals can buy permits as  well as producers. If conservation or individuals wish to make it more expensive for firms to pollute, they can buy permits and hold them. This drives up the price of remaining rights, further encouraging polluters to reduce emissions.
  • The revenue from the sale of pollution rights could be used to improve the environment or subsidies more environmentally friendly methods of production.
  • The rising cost of pollution rights should lead to improved pollution-control techniques.

In the article above, we see how the creation of a market for carbon pollution permits in Europe evolved from a fledgling, ineffective experiment in market-based externality reduction a few years ago to a major market where billions of dollars worth of carbon permits are exchanged each day between firms, all of which have incentives to continually reduce their level of carbon emissions so as to minimize their costs and perhaps even earn revenue through the sale of unneeded permits.

The first phase (of the carbon permit market) was launched in 2005 but was widely dismissed as a failure, primarily because too many permits were granted by member states to individual polluters, leading to a collapse in market prices to as little as €1 (74p) per tonne. The slide undermined the principle of the scheme – to make carbon emissions a meaningful cost for big polluters, thereby encouraging reductions.

The key difference in the second phase is a reduction of between 5 per cent and 10 per cent in the emissions permits granted. Mr Marcu said that he expected the tougher regime to “start delivering some substantive reductions” in carbon emissions.

City analysts believe that it will lead to a big increase in the market price of carbon. Deutsche Bank expects forward prices to rise from the present level of about €23 a tonne to €35. UBS has predicted a rise to €30 a tonne.

35 euros per ton of carbon may not sound like a lot, until you consider how many millions of tons of carbon are emitted by the big factories of Europe each year. In fact, when we realize the size of this market at $100 billion, we then begin to grasp just how significant such a market can be in reducing greenhouse gas emissions. That means that firms are spending $100 billion for the right to pollute!

Just imagine, if you were a manager of a firm that was polluting heavily, the more expensive these permits get, the higher your average costs of production get, the less competitive you become with firms who have taken steps to clean up their production. Not only do you not have to buy as many permits once you start cleaning up, but you actually start earning revenue by selling the permits you no longer need!

A market for externality permits minimizes the role the government must play in managing the production and emission practices of the economies big polluters. Furthermore, if the permits are auctioned off from the beginning, billions can earned in revenue for the government, which in theory could be used to subsidize the research and development of pollution abatement technologies and “green energies” like wind and solar power.

While it still may seem weird that governments are giving firms the right to pollute, the logic of such a plan makes sense once the picture is clear. Markets work, even when they’re being used to correct a market failure.

Discussion questions:

  1. What are some ways a government could invest the revenue earned from the sale of pollution permits to firms?
  2. Why is a market for pollution permits easier to implement than strict government control of the pollution of individual firms?
  3. What is the importance of incentives in achieving reduction of negative externalities? Does a market for pollution permits create more or less of an incentive to reduce emissions than direct government controls?

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

167 responses so far

167 Responses to “Reducing negative externalities – the European market for carbon emissions”

  1. Dogan_Can_Ozcanon 23 Feb 2011 at 8:45 am

    @Juan_Manuel_Arguedas_Rodriguez

    I liked your opinions for the questions. Especially for the 3rd question. Your explanation helped me to understand the question.

  2. Muhammet_Murat_Sekbaon 23 Feb 2011 at 9:00 am

    1. What are some ways a government could invest the revenue earned from the sale of pollution permits to firms?

    One of the alternative is; the government could invest the money, that they make for improving Technologies. E.g. to make new machines which pollutes environment less than current ones.

    2.Why is a market for pollution permits easier to implement than strict government control of the pollution of individual firms?

    It is easier to implement pollution permits, as it uses the concept of a market. It would be very difficult to control if the companies stick to the regulation. Moreover, there should be more people to check .

    3.What is the importance of incentives in achieving reduction of negative externalities? Does a market for pollution permits create more or less of an incentive to reduce emissions than direct government controls?

    When people health is getting less damaged( e.g. pollution) , there will be social benefits of reducing negative externalities. It is better for the government to make a market pollution permits than putting strict controls , because the government can make profit from that.

  3. Muhammet_Murat_Sekbaon 23 Feb 2011 at 9:05 am

    @ Daniella

    I agree with you .As you said the government could invest money on finding ways for the firms to pollute less.

  4. Asucan_Odcikinon 25 Feb 2011 at 9:16 am

    1) Government can use this revenue for the sake of environment. For example, government can create new environmentally friendly ways of producing for companies. Also they can use this money to clean up the damage that’s already done by the companies and they can spend this money on technology for reducing environmental damage. Moreover, they can spend more money on alternative energy types like wind tribunes or solar energy. In short saying they should use this money on environmental aspects in order to turn negative externalities into positive ones.

    2) The market for pollution permits is easier to implement than strict government control of the pollution of individual firms because government always want companies to do their job. If they use strict government control then they need to spend more time on it, also they should use more money to inspect them which is not economically profitable. But when they permit they also earn loads of money which they can use to fix environmental damage.

    3) Incentives are very significant for firms and companies as they only think about economical benefit. Because the aim of a company is to earn as much as they can instead of spending loads of money on environmental ways of producing that decrease their profit. So incentives play big role to motivate companies about environmental aspects. Strict government controls do not motivate companies, they usually make companies disobedient. But when there are permits companies can turn them into profits which make these permits into incentives.

  5. Asucan_Odcikinon 25 Feb 2011 at 9:20 am

    @Daniella Majluf

    I agree with your answers. I think you made a very good explanation for the second question. Government cannot inspect a company every single day in order to be strict ruler. So this lead companies to pollute environment more.

  6. Matt Burnhamon 25 Feb 2011 at 10:37 am

    1. What are some ways a government could invest the revenue earned from the sale of pollution permits to firms?

    They could use the extra revenue to pay for wind farms or other green energy sources that don't pollute as much. It would also mean that governments could pay for environmental damage that has already been done. For example planting trees or investing money into promoting recycling centers so that they might become more abundant.

    2. Why is a market for pollution permits easier to implement than strict government control of the pollution of individual firms?

    No matter how strict the control is on firms, chances are they will find a way to bypass the control or find loopholes in which they can pollute just as much without any dire consequences. There isn't any way of bypassing taxes because it's directly against the law.

    3. What is the importance of incentives in achieving reduction of negative externalities? Does a market for pollution permits create more or less of an incentive to reduce emissions than direct government controls?

    Every firm wants to maximize profits, so by reducing CO2 emissions by buying lots of permits, the permits that the company realized it might not need, it can sell them off for pure profit. This is the incentive to buy the permits and reduce their pollution.

  7. Bryan_DiLauraon 25 Feb 2011 at 11:07 pm

    1. What are some ways a government could invest the revenue earned from the sale of pollution permits to firms?

    The government could invest the revenue in many things. If they wanted to keep with the environmental idea, they could invest in clean energy research such as wind, solar, or fusion power. They could also invest to reduce other negative externalities such as smoking. Really they could use the money for anything they would want.

    2. Why is a market for pollution permits easier to implement than strict government control of the pollution of individual firms?

    The pollution permits idea is much easier to implement because there is a return from it. Strict government control would be extremely hard to enforce (as we saw with the whole BP incident in the Gulf of Mexico region) and there needs to be money spent on the enforcement. On the other hand a pollution permits idea that involves a tax is much harder for a firm to avoid, and the government doesn't have to do much to enforce it. They also gain large amounts of revenue from this plan. This makes the pollution permits idea a much more attractive plan to the government.

    3. What is the importance of incentives in achieving reduction of negative externalities? Does a market for pollution permits create more or less of an incentive to reduce emissions than direct government controls?

    Incentives are very important in reducing negative externalites. This is because it allows there to be a greater incentive for firms to want to start the program in the first place, and for the ones that are suffering from the program, it gives them a reason to change. If a firm is an extremely efficient firm (in regards to pollution and environmental friendliness) they would want a program like this as they would most likely be benefiting from it. Firms that aren't as good may have a consequence from being inefficient, but they would have a reason to change. The idea of earning money is much more attractive than paying less money.

  8. Bryan_DiLauraon 25 Feb 2011 at 11:10 pm

    @Juan_Manuel_Arguedas_Rodriguez

    I really liked the way how you answered the third question. I think that the idea of incentives is extremely important when talking about something such as environmental responsibility (which no one wants to take the blame for). You have to give people a reason to care and incentives, such as money, is a great way to do that.

  9. Dilan_Guneson 28 Feb 2011 at 12:44 pm

    1. What are some ways a government could invest the revenue earned from the sale of pollution permits to firms?

    A government could invest the revenue earned from the sale of production permits to firm by environmentally friendly ways of producing which may lead the environment pollute less. “. Furthermore, if the permits are auctioned off from the beginning, billions can earned in revenue for the government, which in theory could be used to subsidize the research and development of pollution abatement technologies and “green energies” like wind and solar power.” (from the article) Government could invest money or subsidize.

    2. Why is a market for pollution permits easier to implement than strict government control of the pollution of individual firms?

    “It reduces society’s costs because pollution rights can be bought and sold. Some firms will find it cheaper to buy the rights than to acquire abatement equipment; other firms can sell their rights because they may be able to reduce pollution at a lower cost. The incentive for all firms is to reduce their own pollution and sell the permits they no longer need, adding to the profits of “green firms”.”( from the article) And also individual firms can buy permits to make more expensive for firms to pollute.

    3. What is the importance of incentives in achieving reduction of negative externalities? Does a market for pollution permits create more or less of an incentive to reduce emissions than direct government controls?

    Incentives are very important in achieving reduction of negative externalities. “If conservation or individuals wish to make it more expensive for firms to pollute, they can buy permits and hold them. This drives up the price of remaining rights, further encouraging polluters to reduce emissions.”( from the article) As I have mentioned in the second question by individual firms the incetive emissions can be reduced.

  10. Dilan_Guneson 28 Feb 2011 at 12:50 pm

    To Karen:

    It was a nice idea to mention about the article called " The Commons of Tragedy" but it would be better if you mentioned this article in the same answer too…

  11. Muhammet_Emin_Uylason 05 Mar 2011 at 10:53 pm

    1.What are some ways a government could invest the revenue earned from the sale of pollution permits to firms?

    Government can use that money for building public goods or money can be used for finding solutions for overcome the pollution problem by create new methods to decrease pollution in production process.

    2.Why is a market for pollution permits easier to implement than strict government control of the pollution of individual firms?

    As in article mentioned, control of pollution is very hard thing for government. They do not use taxation or another things because it is hard to decide how much will it be and how can they control the pollution by taxation so selling permits for pollution is a good way for controlling that and by doing that individuals can also get this permits so price of permits will become much and it will force firms to find more environmentally friendly methods for production.

    3.What is the importance of incentives in achieving reduction of negative externalities? Does a market for pollution permits create more or less of an incentive to reduce emissions than direct government controls?

    When government controls it by taxes, firms are reducing their supply and increase prices so by doing that they can control their profit easily and consumers are being damaged by that so governments use permits to overcome that problem.

  12. Muhammet_Emin_Uylason 05 Mar 2011 at 10:55 pm

    @Asucan Odcikin

    I agree with your idea which is using revenue for the sake of environment.

  13. SuyeonSoon 09 Mar 2011 at 5:27 am

    1. To take further steps that they can reduce the pollution, the government could use that money to investigate about the way to reduce the emission of CO2 gases or any other pollutes in to national level, such as planting trees. Though this looks like really small thing, if it is conducted into the national level and done regularly, the efficiency of it would increase tremendously, which would contribute to solve the global warming problems and any other environmental problems. Also, government’s investigation would help companies that cannot make investigate themselves due to financial reasons.

    2. I don’t get the second question that much, but I think this is easier to implement than having really strict government, because this lets corporations to work individually. When there is one strict government, the government has to intervene all the details to control the pollution problem, and this would cost a lot to actually supervise them and there would be so many wastes in the administration process, too.

    3. By putting pollute permits in economic meaning, the market theory would work to reduce the negative externalities. As it is mentioned in the article, if the corporation does not reduce the money spend on to buy permits, their costs of production would be higher, and this would make them lose competition in the meaning of price in the market. Therefore, this regulation would encourage reducing emissions of CO2 gases by giving them reason to try to reduce CO2 gases.

  14. SuyeonSoon 09 Mar 2011 at 5:29 am

    @Muhammet Emin Uylas

    I think your explanation about question 2 and 3 is really good. I was kind of lost when i first read the question, but now i was able to get what's going in in this article 🙂

  15. Gökçe G&on 18 Mar 2011 at 8:29 am

    I think that the best way is that all of this money should be put into one pool in which funds solemnly the progress of alternative energies and funding initiatives which are making changes to the amounts of pollution released (in all forms: cars, factories, etc.). The amount of revenue that can be generated from these permits is immense and I genuinely think that the right way to allocate this money is to help improve the progression of the world in terms of keeping the planet green and clean.

    2. The market for pollution permits is easier to implement than strict government control because there is less regulation needed with the permits, it is basically left up to the individual businesses to handle their permits and sell them off to each other. With strict government control there is a lot of government attention needed to assure the proper follow through of the regulations and thus it might not be carried out as effectively since it is harder for the government to properly evaluate which businesses are producing too much waste or are not following the rules, etc.

    3. When government controls it by taxes, firms are reducing their supply and increase prices so by doing that they can control their profit easily and consumers are being damaged by that so governments use permits to overcome that problem.

  16. Nesibe Zirzak?ranon 18 Mar 2011 at 9:36 am

    Goverment could do that by tending towards to the use of reneweable engergy such as hydroelectric and wave and wind. Also government may take initiatives to decrease pollution and emission of CO2 gases. Also enviromentally friendly products and users of those products can be appreciarted by government and taxes can be imposed to the ones who do not use.

    Government control is not economically profitable issue. It also causes loss of time and there will be money spent on inspectors to check it.

    A market for pollution permits leads consumer to be more incentive to decrease emissions because it increases the production cost for the polluting firms which would decline revenue. To firms to minimize the damage inflicted upon their profits, they have to improve more environment-friendly ways of producing services, goods.

  17. Kansu Aydoganon 18 Mar 2011 at 8:01 pm

    1. What are some ways a government could invest the revenue earned from the sale of pollution permits to firms?

    Government can invest this money in building some renewable energy sources like wind, solar etc. They can also use the money to provide required equipment to people or firms responsible of pollution, also called polluter.

    2.Why is a market for pollution permits easier to implement than strict government control of the pollution of individual firms?

    It is easier to implement because there is less regulation needed with the permits. In strict government control of the pollution, there is going to be a wast of many resources to regulate.

    3.What is the importance of incentives in achieving reduction of negative externalities? Does a market for pollution permits create more or less of an incentive to reduce emissions than direct government controls?

    I think that incentives will have an important impact on reducing negative externatilies. Because for example sometimes, a force for you to do all your HW is needed (in this case you is the firms and the force is government).