Nov 01 2012

“Cap & Trade” – An introduction market-based approaches to pollution reduction

Inside Obama’s Green Budget – Forbes.com

Some say that Global Warming may be the greatest market failure of all. This podcast was originally broadcast in January of 2007 while George Bush was still in office. The commentator claims that global warming is “nothing but one giant market failure”, arguing that the United States therefore must get serious about tackling the problem.

The allocation of resources towards carbon emitting industries has almost undoubtedly contributed to the warming of the planet over the last half century. Only recently have governments begun taking active measures to reduce the impact of industry on the environment through greater regulation of polluting industries, employing corrective taxes in some instances and market-based approaches to pollution reduction in others.

US President Barack Obama, unlike his predecessor, appears to be serious about correcting the “market failure” represented by global warming:

Obama’s budget, announced Thursday, looks to fund a host of new energy programs, from carbon sequestration to electric transmission upgrades. It would also provide the EPA with a $10.5 billion budget for 2010, a 34% increase over the likely 2009 budget. Nineteen million dollars of that would be used to upgrade greenhouse gas reporting measures.

The Interior Department would get $12 billion for 2010. The agency would use part of the money to asses the availability of alternative energy resources throughout the country.

Funding comes from elaborate carbon “cap and trade” program, which puts a price on emitting pollution and is the core of Obama’s plans. Starting in 2012, the government would sell permits giving businesses the right to emit pollution, generating $646 billion in revenue through 2019.

During those years, the number of available permits would gradually decline, forcing businesses to buy the increasingly scarce, and costly, rights to pollute on an open market. Obama hopes that the rising cost of permits will encourage businesses to invest in clean technologies as a cheaper alternative to meeting pollution mandates, helping to cut greenhouse gas production to 14% below 2005 levels by 2020.

Below is a diagram that illustrates precisely how the Obama cap and trade plan is meant to work. Notice that between 2012 and 2020 the cost to firms of emitting pollution will increase dramatically, while at the same time the total amount of carbon emissions in the US economy will fall due to regular reductions in the number of permits issued to industry.

market-for-pollution-rights_1

The Obama cap and trade scheme is not the first experiment with such a market based approach to externality reduction:

Europe established such a market in 2005. But some E.U. governments allocated too many credits at the outset, causing the value of some permits to fall by half and making it relatively easy for large polluters to simply buy credits rather than cut emissions. Overall emissions grew in 2005 and 2006. In 2008, E.U. emissions dropped 3%; 40% of that drop was attributed to the carbon trading scheme.

Europe’s cap and trade program took a few years before it began having any noticeable impact on the emission of carbon by European industry. While unpopular among the firms who are forced to pay to pollute, the fall in emissions in Europe shows that a market for carbon may be effective in forcing firms “internalize” the costs of carbon emissions, which until now have been born by society and the environment in the form of the negative effects of global warming.

Discussion Questions:

  1. Why do you think tradeable pollution permits are more politically viable than a direct tax on firms’ carbon emissions?
  2. Why did Europe’s carbon emission permit market fail to reduce emissions over its first couple of years of implementation?
  3. Is making firms pay to pollute a good idea in the middle of a recession? Do you think that we should even be worrying about the environment when millions of people are losing their jobs and entire industries are struggling to survive?

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

60 responses so far

60 Responses to ““Cap & Trade” – An introduction market-based approaches to pollution reduction”

  1. Marcelo.echl.f09on 12 Feb 2010 at 7:03 am

    Armando,

    You make a very good point when saying that eventually, the recession will be over, but the environment will not be cured. Of course, someday, the economy will re-establish itself in its approapriate position; but if this involved destroying our natural surroundings, then what's the point? Even if the economic crisis might appear as terrible, the destruction of our planet is much more serious and much worse.

  2. Anuon 23 Jan 2011 at 2:32 pm

    1. Why do you think tradeable pollution permits are more politically viable than a direct tax on firms’ carbon emissions?

    Tradeable pollution permits are more politically viable than a direct tax on firms' carbon emissions because they do not represent stringent government measures. Firms still have the option of continuing production at high levels of pollution if they are willing and able to buy permits. This is a market solution to a negative externality,and is therefore better welcomed by the voting public, as taxes on firms also reduce consumer surplus.

    2. Why did Europe’s carbon emission permit market fail to reduce emissions over its first couple of years of implementation?

    Europe's carbon emission permit market failed to reduce emissions over its first couple of years of implementation because the supply of permits wasn't limited enough. With greater number of permits in the market, the economic value of each remained relatively low and enabled firms to continue producing at high levels of pollution with minimal additional cost.

    3. Is making firms pay to pollute a good idea in the middle of a recession? Do you think that we should even be worrying about the environment when millions of people are losing their jobs and entire industries are struggling to survive?

    I don't think that making firms pay to pollute is a good idea in the middle of a recession. Additional costs may force firms to lay off workers in the short run, increasing unemployment and thus negatively affecting national and international economies. Perhaps,if bail-out packages had conditions that firms must use some of the money to buy carbon permits, than perhaps carbon permits could still be a feasible solution to decreasing pollution levels.

  3. Simon B.on 23 Jan 2011 at 5:05 pm

    Why did Europe’s carbon emission permit market fail to reduce emissions over its first couple of years of implementation?

    Europe's carbon emission permits were sold too cheaply for companies to be affected by them. This meant that they were so abundant that the price of each unit dropped to a level where companies did not feel the need to lower their CO2 output to avoid buying the permit. The result for the first couple of years was that European emissions kept on rising, until, since these permits are sold in a free market concept, the abundance slowly dried out. When this happened, the price of each permit increased, which made it more expensive for companies to pollute. The incentive then, was for new companies entering the "polluting" market to start up with clean energy and for the older ones to renovate their factories. This way they could all avoid the expensive permit. The result of this was a 4% drop in CO2 in Europe.

  4. Graham N.on 23 Jan 2011 at 5:27 pm

    1. I think that tradable pollution permits are more politically viable than a direct tax because the market determines the price of the permits. Even with an initial overabundance of permits, the decrease over time naturally corrects this and creates strong incentives to reduce carbon output.

    2. Europe's carbon emission permit market failed to reduce emissions over its first couple of years because the permits were not scarce enough to warrant reductions of carbon emissions of firms.

    3. Making firms pay to pollute is a reasonable idea in the middle of a recession because the pollution will have long term spillover costs which must be addressed as soon as possible. Current hardships pale in comparison to some of the hardships that continued pollution and inaction could have on the environment.

  5. Alain Meyeron 23 Jan 2011 at 9:07 pm

    1. Tradeable pollution permits are more politically viable than a direct tax because if they're tradeable that means that depending on the supply of permits and the demand for permits, the market will reach some form of equilibrium. Though this is less efficient than merely allowing "unlimited" carbon output, this is the next best alternative. A direct tax is purely speculative, whereas the price of permits is based on empirical evidence.

    2. It failed to reduce carbon emissions over the first couple of years due to the overabundance of permits supplied by the government. There was demand for them, but the scarcity aspect of the price was not in play yet. It took a few years for the number of free permits to reduce in the market.

    3. We should certainly worry about it during this time. There would never be a good time to begin taxing polluters. If we were in the middle of a golden age, people would complain that the government are going to end it prematurely, and if we were at a time further down the recovery road, people would complain that this will throw us back into a recession. In addition, without the environment, we don't have business. We kind of need to be alive in order for firms and their products to be at all useful to us. Also, it's a good idea to simply "kick people while they're down", because that way as firms attempt to recover, this is just another bump in the recovery road, so it has less psychological significance compared to if it were a new tax without any other problems going on.

  6. Uday Srinivasanon 23 Jan 2011 at 10:34 pm

    1. Why do you think tradeable pollution permits are more politically viable than a direct tax on firms’ carbon emissions?

    A "free market" of permits created through this government intervention will reach a stable equilibrium where everybody is doing they best they can. Efficiency will be forced because firms are directly spending money to gain the rights to pollute – they're going to pollute as efficiently as possible to make use of that money spent. This incentive to be efficient will drive progress and development of new technology that reduces pollution.

    2.

    There were so many permits in the permit market that it was inexpensive to buy more permits and pollute. Later, after the supply died down, permits became scarcer and more expensive and therefore actually had an influence.

    3.

    Yes, because it will allow only the best of the firms that are able to overcome this tax during a recession to prosper. It creates a survival of the fittest scenario that improves the industry.

  7. Jad Z.on 25 Jan 2011 at 3:42 pm

    1. Tradeable permits are more politically viable because this puts the firm in a negative light rather than the government; taxes are viewed by people as a government scam to earn money, therefore putting it in a negative connotation. This tradable permit is "tax in disguise" where it give the government more control and flexibility when it comes to firms polluting.

    2. It failed in the first couple of years because the governments were handing out permits to firms too freely without restricting the supply, which defeated the purpose of the permit. There was a great demand for the permits but there was a great supply too, for they were not limited yet like intended in order to create a scarce supply.

    3. I believe in finding a balance between charging firms to pollute during a recession, but I don't believe the whole permit should be eradication; it would be best if the permits were still in place but not at a large price that could further contribute to the loss of jobs. There should be different priced permits for different sized firms so small firms don't find them self in a position to drastically let go employees or shut down, because the obvious choice for the firm would be to fire people. When the recession is over the price of the permits can gradually increase.

  8. Alisha and Pennyon 25 Feb 2011 at 10:24 am

    Discussion Questions:

    1.Why do you think tradeable pollution permits are more politically viable than a direct tax on firms’ carbon emissions?

    Tradable pollution permits are more politically viable than a tax because even if large producers of pollution are taxed, the prices will increase but they are still able to pollute, whereas if permits are used the supply can be altered which ultimately reduces the amount of pollution produced by firms. Taxes are also recieved negatively and it is hard to establish prices whereas prices for permits are set by the market.

    2.Why did Europe’s carbon emission permit market fail to reduce emissions over its first couple of years of implementation?

    Europe's carbon emission permit market failed because the supply of permits was too high and the prices were too low in order to decrease demand and force people to produce less pollution.

    3.Is making firms pay to pollute a good idea in the middle of a recession? Do you think that we should even be worrying about the environment when millions of people are losing their jobs and entire industries are struggling to survive?

    There is never a good time start making people pay to pollute and although the recession may not be a perfect time to move this forward, the enivronment is a constant problem that won't go away based on our financial problems, and it's our responsibility to do something to fix it. We can't ignore certain issues because we are faced with other problems such as a recession, governments just need to find a way to introduce this in a way that won't further hurt the economy.

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