Jan 11 2008
Reducing negative externalities - the European market for carbon emissions
Published by Jason Welker at 1:44 pm under
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WikipediaTighter European limits set to push up price of carbon emissions - Times Online
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 shift their supply curves leftward, decreasing 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 externalities, involving the creation of a whole new market: one where 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 pollution-control agency decides the acceptable amount of pollution in a particular region and creates rights that firms can purchase to allow them to pollute. Each right will allow a certain amount of pollution. The total supply of rights is perfectly inelastic
- The demand for pollution rights should be 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.
- With the given supply of rights, and a demand for rights, an equilibrium price will be established for each right to pollute.
There are several advantages to this system:
- 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.
- Conservation groups as well as producers can buy rights. If conservation groups are unhappy with the existing amount of pollution, they can acquire pollution rights 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.
- 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 reduction 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.
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About the author: Jason Welker is a teacher at Zurich International School in Switzerland, where he teaches Advanced Placement and International Baccalaureate Economics. Jason was an international school student in Malaysia before studying economics at Seattle University then earning his Masters in Education. He calls Seattle and Northern Idaho home. In addition to maintaining an economics wiki and this blog for economics student and educators, Jason also gives presentations on using Web 2.0 tools in education at workshops and conferences around the world. His economics wiki won the 2007 "Best Educational Wiki" award from the "EduBlog Awards". 
Before reading this blog post, I found an article for homework about the aviation industry in the EU. Here is the website: http://www.sciencedaily.com/. It is kind of creepy how right after I print out the article, I read this blog post. The two seem to be perfectly connected, as the article I found, titled “Climate Pollution From Aviation Increasing”, talks about the carbon emission from EU’s aviation industry, and their suggested solution is, you guessed it, pollution permits.
Is it simply a coincidence, or are pollution permits extremely popular in Europe?
Pollution permits are extremely popular in Europe… good work Helen!
It’s very interesting how this whole marketing pollution rights works. In this way the “commons” in the tragedy of the commons becomes privatized, and companies are forced to take responsibility for their pollution which is being dumped into the atmosphere.
I do have one question, though, and that is how does one regulate the amount of pollution a factory dispenses into the air? How can the government be sure that a firm is not violating the law by dumping more than its licensed amount?
Kevin,
Great question. I don’t know the whole answer, so I have forwarded your question to the environmental Econ professors Tim Haab and John Whitehead who write the blog http://www.env-econ.net/
I will post their reply hear once I get it!
-Mr. W
It sounds like a localized version of the Kyoto Protocol, which makes me a bit nervous because the Kyoto protocol didn’t really work. But some environmentalists are saying the optimal amount of pollution is only economically speaking, environmentally speaking, it’s still to high. So, whilst this may be great economically and environmentally, what happens when one day the optimal amount of pollution is reached and the planet is still building up pollution because pollution levels are still to high for the Earth to recover?
When I first read about the buying and selling of rights to pollute in the textbook, I found the idea pretty weird. However, now that I know the benefits the society obtains from this system, it makes a lot of sense. All in all, I think this will help improve the environment as it discourages polluters to pollute, and money from the buying and selling of these rights can be used to further improve the environment.
As a member of Roots and Shoots, I feel like i need to say pollution is BADDDDD. However, I have to admit that these “rights to pollute” are a pretty good idea in our fast paced, technological world. If we can’t get people to stop polluting, then we might as well charge them for polluting. This way, at least SOME people will stop or produce less. Also, it gives them further incentive to stop polluting if everyone is competing to see who would have the least costs. I really hope these rights to pollute become more popular and effective, not just in Europe, but everywhere.
Doesn’t the UN already set quotas on the carbon emission rates for all of the Kyoto Protocol signatories? This would work really well with the rates being sold to private sectors, because the nation must determine the rates that the government will consume in order to benefit the people, while the remainder can be bought by businesses or organizations. This way, the supply of the right to pollute the air will be severely reduced, driving up the price of the rights, and hence decreasing the demand.
Yeah the right to pollute sounds a bit contradictory to me. It makes sense the way they have it so that these “rights” can be sold from one to another based on how well you take care of your environment and it certainly has potential. The only thing needed to be worried about is honesty and corruption. Companies might just pay off people or mess with measurements.
The market for pollution rights is parallel to the market for products that impose negative externalities on society, such as cigarettes. Completely banning either would not owrk (black markets would emerge) so governments might as well try to benefit as much as possible through taxes from the production of pollution and cigarettes.
This idea of buying and selling pollution rights is a good start to actually tackling the issue of climate change and the problems it pose to the environment. It seems like the part of the world that seems to be doing something good for the world is Europe. After seeing the success that Europe has had with this program and how carbon emissions have been cut, the US should follow suit (if it hasn’t already, and I doubt there is such a thing there).
I think the rising prices per ton of pollution show a good sign towards environmental awareness. I can see this as pressure from the government for companies to spend the money in researching new technologies to cut down their carbon emissions. Do you guys think such a plan would work in China?
I have heard about this idea of the “right to pollute” and it can help in many ways. If a firm feels like they are going to be producing a lot of pollution, they can buy more rights to pollute. In some cases, they can also buy some rights to pollute from other firms who do not pollute as much. By making a whole new market and using economic methods for this problem, it seems like it is going to work very well.
The “right to pollute” is even being adopted in the states as methods to control pollution. For instance, large chicken farms in the US are now required to pay annual permits to raise their poultry because the bird waste pollutes the surroundings with excess nitrogen and phosphorus. Similar to the EU’s view, US senators see buying the rights to pollute as a method of regulating companies which are producing goods at the expense of the environment.
This concept of the “right to pollute” appears to be a viable solution towards restricting companies from emitting CO2 and other GHGs; however I have a few questions towards the “right to pollute” in individual nations. As mentioned before, one nation’s pollution not only affects the nation producing it, but those it around it as well. Thus, my question is how can one nation, that adopts the pollution permit idea, fairly determine the amount of pollution it is allowed to produce, when neighboring nations do not adopt the “pollution permit” concept? For example, some nations in Europe have adopted the market for carbon emissions, but its pollution will still affect other nations and add to the total pollution produced. So if other nations, that do not adopt the concept, and continue increasing to produce, will it affect the supply of the nations that have the carbon emission market?
The notion of buying the right to pollute seems like it would work extremely well, but I would like to propose a scenario (though it may be rather extreme) that I’m not too sure how firms would economically respond to:
In this blog, the ability of environmental awareness groups to purchase these rights to pollute and hold them to lower the amount of pollution is an interesting idea. But what if all the environmental awareness groups somehow form an alliance and essentially buy all the permits to pollute and hold them off? What will happen to the economy?
‘Course, the best response for the world is that because the firms that need to buy these permits can’t since the environmentalist groups aren’t even selling (consider the price of one permit to be infinite, if you may), and thus all the firms will commit to researching for methods to abate the amount of pollution emitted by their factories.
However, is that likely? Research for this sort of technology is extremely expensive, and many firms will likely have to shut down due to their inability to achieve any success with this sort of research.
Another possible outcome to me is that the firms simply secretly pollute. Many people question in earlier comments of how a government will be able to monitor the pollution of every plant, and because the government likely won’t be able to the monitor every single plant, the plants will just secretly pollute.
Finally, the scariest potential outcome of the 3 in my opinion… Will the government, for the sake of keeping its economy up and running, begin to sell more permits to pollute exclusively to the firms?
I think the pollution permits are a great idea and should be able to control the amount of pollution released into the air. Also how they can make money by selling the permits when they don’t need it anymore. The countries that need this method of pollution control are the developing countries since they pollute the most. If China had pollution permits and there was a fixed amount of permits, the air here would be much cleaner.
I too have the same questions as some of people that commented. How can you be 100% sure that the amount of pollution released into the air is the amount they say it is? isn’t there like a way where they can alter the numbers? Also if the country is really desperate and they can not find another way to keep the economy up, would they resort to selling more pollution permits?
I tip my hat to the European environmentalist economists who came up with this plan. The US should definetly adopt this solution for market control. I love this idea, although there are some things I’m not sure about. Like someone mentioned above, what if a company is unable to purchase pollution permits because all the environmentalist groups have bought them all and the company would have to close down. This would cost many people their jobs. Is it morally right to put hundreds, or maybe even thousands of employees out of their jobs and potentially ruining their lives?
This is obviously on the major steps towards slowing down the issue of global warming and pollution in general. By making a market out of something that normally would be free, the EU has successfully (and will gradually) fix the problem of pollution. Now if only nations like China would adopt this sort of methods.. We wouldn’t be drowning in an atmosphere of 170 API…
One of the largest problems corrupting the modern world is the pollution problem. As we know, the pollution problem is causing the global warming and sudden deaths of many living organisms. However, as some people have already said, this new policy will obviously be a major step toward the slowing down of the global warming. Even though the price of carbon would rise, this policy will eventually protect the enviroment. Moreover, I agree with the idea that if China would adopt this policy like the EU, the global warming and other pollution problem will slow down dramatically.
This solution is simply brilliant! Just think. You have an incentive to be a non-polluter. But if for instance one year you screw up, you have to pay. Big time. The prices will probably be more than what the government will charge you, but at least you get to keep your business’s nose clean. So next year you decide to clean up your act. In the long run it will allow for more people to get clean, and not put so much bad stuff into the world around them.
It is a little bit scary that firms are willing to pay $100 billion dollars just for the right to pollute the air that everyone breathes. But putting a price tag on pollution makes it somewhat fair. Now instead of polluting the environment endlessly, factories have to think about the costs placed on them from purchasing the pollution rights. Further causing less pollution would be the fact that all the money they are paying will be used to help lessen pollution. I also understand that if an environmental group did not like the pollution they themselves could purchase the pollution rights. However, the problem with this is that they will have to raise the money, whereas businesses are constantly making money from their products. Therefore, although this seems like a fair compromise polluting businesses can still have their way as long as they are making good profits. I mean how can an environmental agency genuinely compete with a multi-million dollar company? But then again pollution is still lessened through pollution rights, so overall they are a good idea.
This isn’t the first time i heard about this, last year in environmental science we talked about the selling and buying the right to pollute, when I first heard about this last year, i was like wow people actually pay for it to pollute. Setting a price for the right to pollute is a great idea, this would cause
firms to reduce the amount of pollutants they release to the airs. These years global warming has become one of the biggest problems we are facing; I hope the selling and buying the right to pollute will slow down the speed of global warming. =)
i think that the system of pollution permits are helpful to reduce pollution and at the same time also somewhat push the economy. Environmentalist groups who buy these permits and kept them for the goods of the people are largely appreciated and more firms should start to support these groups as the issue of global warming continues to increase. I believe that if all other countries start to adopt this policy global warming rates could slow down by a lot and also help the economy.
[...] Towards the end of our last Micro unit, which was on Market Failure, SAS AP Econ student asked a good question in a comment on my blog post “Reducing negative externalitites - the European market for carbon emissions” [...]