Tradeable Pollution Permits

The latest release of our principles of economics class covers Externalities, Costs and Profit Maximization, Competition and the Invisible Hand, and Monopoly.

I am especially fond of our video, Trading Pollution, which explains the economics of tradeable pollution permits. Tyler and I worked with the incredibly talented team at Tilapia Film for a long time on a montage involving jigsaw puzzle pieces that’s near the middle of the video. The montage is only a few seconds long but I think it’s a beautiful way of illustrating how the price system draws upon information that is dispersed across many minds. There is a lot of deep economics behind the visual metaphors.

Addendum: For those of you using our textbook, this video and others are available directly from the textbook (using QR codes) and also available with assessment in our course management system, Launchpad.


Tradeable permits was the rage a decade ago, and before that "cap and trade" but I think the pendulum is swinging back to the dreaded 'ceiling on pollution' with heavy fines for any firm that exceeds the ceiling. This last sort of regulation guarantees that China gets the lion's share of polluting manufacturers, and I don't think agnostic multinational corporations care much about this issue anymore (since they can relocate anywhere, depending on which state gives them the best tax breaks and incentives).

Wouldn't "heavy fines for any firm that exceeds the ceiling" just lead to reduced firm size? Just as I suspect a quota for female workers would simply lead to investment banks merging with primary schools.

Not sure what you mean, Ray. Can you give an example of a recent regulation that puts a "ceiling on pollution"?

@libert - not recent, but from the 1970s, that's what was done back in those days. See AlexT's video.

Clean Air Act of 1970 as amended in 1990.

When Clinton tried to implement tradeable permits, the polluters sued, taking it all the way to SCOTUS, and SCOTUS agreed with the polluters that the law requires caps while Bush was president. The Bush administration did nothing, so the States sued on behalf of We the People and SCOTUS agreed with the States that the law requires caps, directing the executive to implement caps.

The Obama administration has proposed alternatives to caps, but Republicans oppose all the alternatives, fighting them totally in 2010 and since.

The EPA has just issued the final regulations imposing caps, after responding to one million comments on draft rules implementing the bipartisan law requiring caps on all dangerous emissions.

If caps were not the preferred solution, surely Congress would have replaced them with pollution taxes, or cap and trade.

Other than the real die hard free lunchers who argue that denying reality makes all the harms go away, cutting taxes makes everyone rich, taking away health insurance cures all diseases, etc., caps on pollution are the solution We the People agree on.

Why are making this crap up? Cap and trade, aka tradeable permits, have been used in several pollution markets since the 1980s. With respect to carbon, Mitt Romney sued the Bush EPA to force it to regulate carbon, and won. Thus, Obama is simply implementing regs that the SCOTUS has ordered the EPA to implement. Under the Clean Power Plan, states must meet rate (not mass) targets, but have many options to do so, including cap and trade if they want.

@mulp, seems you are correct, and Bartman is not complete in his answer. For example, in mercury and power plants there's a cap rather than cap-and-trade, see below, ripped from today's headlines.

The U.S. Supreme Court appeared deeply divided after hearing oral arguments today on whether the EPA should have considered the costs to coal- and oil-fired power plants before deciding whether to subject them to regulation. Chief Justice Roberts questioned Obama administration estimates that the actual benefits of the regulations would be at least $37B, which would easily exceed the anticipated $9.6B in costs.

Tradeable permits are the preferred solution, unfortunately the GOP scuttled the idea as a possible bipartisan area where the two parties could meet (Republicans "it's market based", Democrats "it's less pollution"). On the left carbon offsets have been tried (essentially trying to do the tradeable permit idea without government's help so polluters are essentially selling a reduction in what they would have polluted to the market) but their effectiveness is limited.

Carbon isn't a pollutant, hence no agreement.

Risk is a cost, if there is even a 1% chance that global warming is real and caused by carbon then it is a pollutant in the sense that releasing carbon imposes a cost on everyone. That would be no different than if you owned an empty lot and your buddy started parking his construction equipment on it. Chances are nothing bad would happen but if someone got hurt, you could get sued as the owner of the property. So he is imposing a cost on you and you demand that he pays you something to offset that...even if it is just a small amount to cover the additional insurance premium you are charged.

So unless you have achieve absolute, metaphysical proof that carbon does not cause any problems for humanity....proof beyond simple wishful thinking on your part, then your assertion fails.

Your method would be correct, but what do you do for the next 2* that are supposed to have positive effects? Subsidize CO2?
To do your analysis you need to be able to calculate the dangers, which would be difficult. A 1% chance of anything truly bad is an overstatement.
I'd start with a reasonable tax on carbon that offset some other tax. At least we know there is value in eliminating particulates from the atmosphere.

Actually yes, you would subsidize CO2 if it had net positive effects. That would essentially be putting a 'negative tax' on CO2 (which is a little bit like what we do for charitable deductions).

Let's suppose you could identify a group that would benefit, say corn farmers would see their income double with global warming. If corn farmers taxed themselves 99% they could create 'negative permits'. In essence they could take that 99% of income and have others compete for that pot of money by 'bidding' on increasing CO2. For example, one company may pledge to replace all their squiggly light bulbs with the old fashioned type. Another may pledge to burn piles of coal every day in their front yard. If that induced enough warming to double the farmer's income while paying off those who change their behavior to increase warming then famers increase their income by net 1% and so does everyone else.

The Roberts court says it is.

Didn't the last cap and trade bill die in a Democratic Senate after it passed the House in 2009?

Yes, Waxman-Markey cost a few congress critters their jobs in 2010, so the Senate wouldn't touch it with any length of pole.

I was merely responding to the always objective Boonton who put on his team shirt and claimed the GOP scuttled the idea that was so good that even a comfortably double-D congress (at the time) wouldn't touch it.

True, a Democratic Congress and President doesn't mean you will get action on carbon.

Likewise, a Republican President and Congress doesn't mean abortion is going to be outlawed.

Yet, oddly, people who want abortion outlawed always seem to think voting Republican is a good idea. Why is that? Did not Bush fail to outlaw abortion when he briefly enjoyed a likeminded Congress? A pro-lifers stupid for voting Republican?

If you want to tell us that Obama and Dems deservie a frowny face for failing to do something about climate change back in 2009, I'm fine with that. But don't try to con us into thinking there is one party that is very clearly against doing anything and one party that is clearly for doing something.

I'm not trying to con or tell you anything, I'm merely saying that the last time a bill was passed in the House that had a chance it died in a D-Senate due to lack of votes. So saying "the GOP scuttled the bipartisan effort" is a bit of a joke without mentioning the last time it was an issue.

BTW please read Roe v Wade.

You seem to be under the impression that Congress is a binary institution, it isn't. Having 51% of the votes is not the same thing as having 91% of the votes since parties are rarely unified. That is why, for example, Congress didn't aggressively move to ban abortion nationwide last time Republicans controlled everything. Likewise failing to have a supermajority cost Dems the opportunity to have climate change legislation *because* party uniformity is rarely achievable.

Nonetheless, the fact remains there's a party to vote for if you think something should be done about climate change and a party to vote for if you don't. Nothing you've posted refutes that fact.

If you think that's why they didn't move to ban it then you're insane, they CAN'T ban it even if they tried due to Wade. They're much happier letting the states regulate it while only the media and party flag waivers like you think it is doomsday for women if the R's get in office. As Waxman-Markey showed, there really isn't a party to vote for right now if you want a move on cap and trade.

Actually they could pass a lot of laws that skirt around Wade by raising lots of roadblocks (as many Red states like Texas are doing now). If they had a large enough supermajority they could overturn Wade entirely via an amendment or by packing the Court.

There is a reason why pro-life groups campaign for voting Republican. It is because they know more republican victories will get them closer to their goal. Certainly you are not unaware of this?

Likewise I suspect a supermajority Democratic Congress and White House would have much greater odds of passing a cap-n-trade like reform than the opposite. I suppose the only way to know for sure is to elect one and find out. I'm game.

How can you trade pollution permits? That is a bad idea. Why should government condone pollution? If you have an issue with companies punching citizens too much, you don't give companies permits to trade the right to punch someone. You don't allow them to do it in the first place.

Did you even watch the video? It answers all the questions that you are asking.

The optimal level of pollution is much greater than zero. The free market level of pollution is much greater than the optimal level of pollution.

I think Parson's argument is a moral one (pollution without consent of the affected is coercion, an coercion is immoral), while you're making a utilitarian one (coercion, in the form of pollution rights, can be optimal). You're talking past each other.

Longevity has increased as pollution has. Industrialization has caused both.
How is Parson taking the moral argument when he wants to limit my lifespan?

"How can you trade pollution permits?"

They have been shown to be the most effective way of reducing pollution, and the most socially optimal method of reducing pollution. If you are actually interested in reducing pollution, instead of empty moral grandstanding, you too would embrace them.

If you want something that does not work and destroys wealth in the process, you will opt for command and control.

Nice video and a great lesson. I would add, however, that pollution taxes are a viable, and in some cases even preferable, pollution reduction policy. The issue with permits is that all uncertainty feeds into permit price volatility, which leads to unpredictability for firms. Instead, a tax allows for better planning, since the uncertainty feeds into pollution level volatility. (Cf: Marty Weitzman's "Prices vs Quantities")

I thought the general consensus is that pigovian taxes are almost always preferable but are almost always politically unfeasible.

Kind of. Weitzman's famous result is that taxes are preferable when the marginal benefits curve (of pollution reduction) is "flatter" than the marginal costs curve. It just turns out that for many applications, that condition tends to hold. Hence the general consensus.

The system of tradable pollution permits is a remarkably simple way to regulate pollution at a cost that is optimal to society. Perhaps the most difficult aspect of implementing a policy of tradable pollution permits lies in the initial allocation of the permits.

Under most circumstances (primarily, perfect competition in both the permit and output markets), the initial allocation doesn't matter from an efficiency standpoint. (Of course, there are distributional implications.)

I would say that most difficult aspect of implementing tradable permits is actually determining the optimal number of permits to issue, which requires knowledge of the marginal cost and benefit curves. Determining the optimal tax level seems relatively easy; you set it equal to the marginal benefits of pollution reduction, which is easier to measure in practice.

Interesting. So is that analogous to a Coase Theorem? Who you grant the initial permits does not affect efficiency?


Say a cement kiln produces CO2 and a power plant does too. Who gets how many permits? To me that's the question that this video didn't address at all.

What's the optimal / fair way to allocate permits initially?

Man, the profit in providing online education for free must be extraordinary.

The Koch brothers pay them for it in the tears of orphans and widows, the most valuable of currencies to libertarians.

You try polishing your monocle without orphan tears. Cant be done.

I don't think I believe the idea that a price can be used to communicate information in the way depicted in the video -- not in a "opinions differ" way, but rather in a "that violates information theory"-way.

Unless the puzzle pieces represent a one-dimensional distribution, one-dimensional prices simply don't have the information carrying capacity to faithfully reproduce collective information.

Another point not covered by the video is the spatial scale of averaging. Things like acid rain, smog, etc. can be quite sensitive to local NOx / SOx / particulate levels. So nationwide permits might be to blunt a tool to target that.

Rahul, bingo!

A ton of CO2 is a ton of CO2 regardless of where it is released.

The same cannot be said for all pollutants. Dumping a barrel of radioactive waste into the Seine River is worse than dumping that same barrel of waste into the middle of the Atlantic Ocean.

Governments should be smart enough to understand the difference and design policy accordingly.

I think the Governments are smart. No one sells permits for total radioactive waste emission (I hope).

I guess MRU was making a pedagogic simplification?

Perhaps they should.

Nevada is fairly empty. The world produces radioactive waste and needs a place to store this waste.

The entire industry has produced around 70,000 tons of spent nuclear fuel waste. Stored as a solid block, this would fill a football field up to 20 feet deep.

If Nevada agreed to accept the storage responsibility for this waste in exchange for, say, a million dollars per ton, they could set up a sovereign wealth fund to pay for Medicaid costs FOREVER.

Surely that is something at least worth considering.

I guarantee you that opposition to the Yucca Mountain project would be diminished if it came with the carrot of "we will pay for all of your Medicaid costs forever".

Yeah, that's why the SCOTUS rejected a permit trading program for mercury and other HAPs, but has embraced such programs for criteria pollutants. Some parts of government aren't always as dumb as you think.

You can do a tradeable scheme on a local scale, say covering just a river or section of a river or a particular type of waste in the river.

Great video of the power of emissions trading to reduce compliance costs for regulated firms. But compliance costs should not be conflated with the total costs of pollution control, which also include administrative costs, including costs of monitoring, which are not addressed in the video. What made acid rain program possible in 1990 (but not in 1970 or even 1980) was the availability of reliable and cost-effective monitoring technologies, which allowed EPA to keep track actual emissions to ensure the integrity of the quota limits.

Life on earth would not be possible without CO2, so presumably the scientists are talking about some 'correct' level of CO2 in the atmosphere. Has that level been determined? If so, then I'd be more comfortable with the government just capping the amount of CO2 emissions at that level. No need for a gamed, rent-seeking scheme, just like we don't gin up a market for tradeable lead paint permits.


That wouldn't work for CO2. The pollution sources are far too dispersed.

Sulfur dioxide pollution was easy to fix. Virtually all the "bad guys" had huge smoke stacks and large wallets.

CO2 has to be tackled higher up the production chain. Maybe put a $1/gallon tax on gasoline and a $10/ton tax on coal extraction with a payroll tax offset to balance distributional impacts?

The higher up the production chain, the fewer the players. Tell them they have to shutter a plant for a year. Or just ban SUVs. Or regulate the amount of airplane flights. Only so much coal burning allowed, etc.

All these contrived 'market-based' schemes strike me as a way for economists' wealthy friends to line their pockets while actually doing nothing to reduce CO2 emissions.

Also, it's funny how "higher up the production chain" really means "make consumers pay it."


The same consumers who are burning it.

Or more like "move production and economic activity elsewhere".

@Derek - come to think of it, this is another area where the climate change-ists find themselves on the horns of a dilemma. Globalism means we offshore factories, where we can't insist they be LEED-certified and use clean energy sources, and are reliant on diesel-burning container ships chugging back and forth. Just like it's counter-productive to dole out subsidized protein paste to countries which already have more people than they can carry, then open the borders to the excess so they can drive a 4-door sedan to the strip mall and toss their obsolete gadgets into the landfill like we do.

Choosing between the environment and globalism exposes the environmentalists to the toxic accusation of racism, so they have to come up with these contrived rent-seeking schemes to try and please everybody.

The legal payer of a tax is not the same thing as the tax incidence. "Corporations" are technically responsive for paying the corporate income tax but the actual tax burden is paid by shareholders and consumers.

Life on earth would not be possible without CO2, so presumably the scientists are talking about some ‘correct’ level of CO2 in the atmosphere. Has that level been determined?

Not but the answer would be 'less than what we are at now and less than where we are heading'.

Human activity only can increase the amount of CO2 in the atmosphere so barring a sci-fi level technology, you are not going to eliminate CO2 from earth's air. Instead you are only going to get closer to what would be a natural level that would be maintained by earth's lifecycle.

That wouldn’t work for CO2. The pollution sources are far too dispersed.

True for a universal cap-n-trade program but you could do less dramatic ones. For example, you could do cap-n-trade with the generation of electricity that applies to units greater than a home generator. Since a good fraction of CO2 is due to generating electricity savings here would apply towards the planetary scale. Since the major players are big their solutions could include more individualized incentives (like smart meters that encourage people at home to target their electric use towards low peak hours). Couple that with a straight tax on oil and you have a lot of major sources of CO2 covered.

But you are right, the person who likes burning a candle every night is releasing CO2 and that isn't being captured by the cap-n-trade system but fortunately useage at that level is trivial enough when compared to the major sources of 'low hanging fruit'.

Human activity only can increase the amount of CO2 in the atmosphere so barring a sci-fi level technology, you are not going to eliminate CO2 from earth’s air.

Again, who but a nihilistic madman would want to eliminate CO2 from the atmosphere?

Instead you are only going to get closer to what would be a natural level that would be maintained by earth’s lifecycle.

Determining that "natural level" of CO2 would be the logical starting point, like determining a threshold level of PCBs. If the situation is as dire as everybody claims, then it's an easy matter to just say things like, no more coal for energy generation, no more SUVs, x # of airplane flights per year, x # of container ships chugging back and forth, and if you can't make it to Davos that year or have to wait for your new iPad, tough. And if human activity is the problem, and it is, then we reduce rapacious human activity by shutting the borders and cutting off foreign aid from the West. And if the West isn't feeling enough of the pain, then ditch its model of permanent economic growth thru artificial credit expansion.

Again, who but a nihilistic madman would want to eliminate CO2 from the atmosphere?

Indeed but then you raised it. Perhaps you were under the delusion that some were advocating eliminating CO2 from earth or perhaps you simply were trying to set up a strawman.

Determining that “natural level” of CO2 would be the logical starting point, like determining a threshold level of PCBs

I think this is a bit like someone who is 600 pounds asking his doctor how much weight should he loose. The doctor could try to calculate some ideal weight for him based on his height, age, structure etc. But practically the best advice would be to tell him to simply start losing weight. He might some day get to a point where losing additional weight would be counter productive to his health, but that's a bit like someone in a burning building worrying about whether they are putting enough away in their 401K.

If the situation is as dire as everybody claims, then it’s an easy matter to just say things like, no more coal for energy generation, no more SUVs

I disagree. Let me give this hypothetical, suppose a UFO landed and informed the earth that unless carbon emissions were reduced to the level of 1950, they would blow up the earth. Would the 'easy' answer be to simply reproduce 1950?

I would say it would be far easier to use incentives to find the optimal way to reduce to a 1950 level. The optimal solution is almost certainly not simply restoring 1950. For example, instead of having a handful of cars that get horrible mileage, we could enjoy more cars that get great mileage. Instead of people having to walk, take busses, or hitch rides, we could use uber like services to make sure every mile driven gets as many people from a to b as possible. As painful as the UFO's demands would be, they needed be as painful as asking the creators of Mad Men to implement a great rollback on a global scale.

The claim is that CO2 is a "pollutant," which is wildly imprecise. Therefore, I assume the brilliant scientists calling for this massive scheme of transfer payments know what the "natural level" of CO2 in the atmosphere is (apparently, 1950 levels). Again, I trust this is clear-cut and principled enough that this level is known and nobody's cynically using vague, shifting standards in order to engage in rent-seeking.

Let me give this actual, according to your camp: CO2 levels are excessive, growing, and a threat to life on earth on a par with lead paint, asbestos, groundwater pollution, etc. If that's the case, we've got to reduce the level of human carbon-generating activity and we've got to do it quickly. I can tell you with confidence that tacking on an extra few cents at the store register or even an extra dollar per gallon of gas won't do it. I'll also hypothesize that from this "natural level" of CO2 we can determine with relative alacrity what needs to go on the chopping block, just like we didn't screw around with tradeable lead paint and tradeable leaded gasoline permits when we wanted to get rid of lead.

The fact that this isn't being done leads me to suspect this is more a rent-seeking scheme than an actual solution to a problem.

The claim is that CO2 is a “pollutant,” which is wildly imprecise

This is laughable since you then produce a list of what I assume you think are 'precise' pollutants; lead paint, asbestos, 'groundwater pollution' (by which I think you mean things like oil and other chemicals dumped or spilled in ground water). Yet many of these things too are part of nature (lead does exist in the ground, there are natural springs of oil) or have their uses if they are carefully controlled (asbestous need not automatically send everyone running away screaming). A pollutant is an imprecise terms because whether something is or isn't depends upon context and contexts can change.

massive scheme of transfer payments know what the “natural level” of CO2 in the atmosphere is (apparently, 1950 levels).

What massive scheme? There is hardly any actual regulation, tax or policy to actually reduce CO2 emissions. We are literally like the 600 pound man being told by his doctor he should loose a little turning around and screaming that he may soon starve to death.

Perhaps if someone did propose a program to revert to 1950's levels we could have a real debate about whether that is excessive...whether its benefits would far exceed the costs or not. But no such proposal is anywhere near the table. Instead people are pretending even the slightest curbs on our increases of emissions are grand philosophical debates about whether we should revert to the Middle Ages.

Or they are assert the 600 pound man need not loose a single ounce until his doctor can assert what his ideal weight target should be down to the picogram and until that consensus is reached with absolute, metaphysical proof, there is absolutely no reason for him to deviate in the slightest from his habits to date.

My thinking here is simple. If you are 600 pounds, losing the first 50-100 is going to be easy and require the least bit of pain. You should do so first. After that keep going and up your game...perhaps at 180 lbs you've done enough and you'd be better off concentrating on other goals.

There may not be agreement about whether the 600 lb person is in immediate danger or long term danger. Loose the easy weight first. if it turns out the danger is more immediate than you feared, you're going to have to loose that anywy. If the long term danger turns out to be less remote, you've done no damage taking on the easy things.

So do a cap-n-trade for electricity and something else for transprotation fuels. No it won't 'solve the problem' but it will start the process of taking off the 'easy pounds'. Making the good the enemy of the perfect is a strategy that never works.

My thinking here is simple.

No, your thinking is Rube Goldberg-ish. My thinking is simple: less cars, less coal, less airplanes, less container ships.

Actually my thinking is even simplier. To get less CO2 impose a price on emitting CO2. The market will find the best way to accomodate that price.

Except it's not a market and there's no supply-demand curve. It's government saying there has to be a market and fixing the price.

Actually there is both a supply and demand curve. Simple example. Suppose there are 10 chicken farms that are along a major river. The farms let the waste wash into the river, which ruins the ecology downstream. Each one puts out 51 tons of waste per year for a total of 510 tons. Government imposes a cap of 500 tons of waste per year and auctions off them to the highest bidder.

What's the demand? Well anyone who wants permits. What's the demand curve? How valuable the permits are. Perhaps some farms could easily divert the waste into a holding tank rather than pay a lot for a permit. Perhaps there is a club downstream that would get more members if the river flowing through it was cleaner. Whats the supply curve? Well since permits are now valuable, you can effectively create more by coming in under. Suppose one farm is able to entirely divert all of its waste away, it now needs no permits at all, the supply of permits goes up driving the price down all else being equal.

Of course there are lots of ways to do this. One could start by simply giving each farm a permit for 50 tons and letting them trade between themselves to cover the other one ton they had previously been releasing. The farm that could easily reduce its waste by a lot would be the supply curve since it finds it is cheaper to divert waste rather than using a permit. This much less painfull solution would be uncovered with a permit system but would not be discovered with, say, a simple mandate that each farm release no more than 50 tons. The easy farm would just divert a single ton while all the others would pay lobbyists and lawyers to frustrate the regulation.

Of course if you need to go from 510 tons to 0 tons per year, it is going to be much harder. But the first tons lost are the easiest and least painful tons to loose. That's why this works.

It's not the permits that reduce the pollution, it's the "banning anyone who doesn't have one" from pollution, and it's not exactly a counterintuitive result.

I think the way the mechanism is presented is confusing. It assumes (or implies) both firms have somehow been granted an equal number of permits (for free it seems) and that each firm has some kind of equal production target, then the efficient plant switches to a less polluting process and sells the permits it doesn't need. So it comes across as the inefficient firm not only stays in business but possibly keeps on polluting just as much as before. It just has to pay the other plant for the privilege.

But wouldn't it be clearer to say the government has 10 permits to sell and the more efficient firm is able to outbid the other firm for permits, since starting from zero production it can produce more units of the good with more profit for every ton of pollution it needs to offset? In the extreme the inefficient firm could even be shut down.

Also i wish the video would not use "the invisible hand of the market" - that is awful. Just say the "market."

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