pollution permits

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Government Policies to Achieve Efficient Resource Allocation and Correct Market Failure

Pollution Permits (Cap‑and‑Trade) – Overview (AO1)

  • Definition: A market‑based instrument that gives firms a legally enforceable right to emit a specified amount of a pollutant. The total number of rights (the cap) is fixed by the government, and firms can buy and sell these rights.
  • Rationale: Internalises the external cost of pollution by turning the right to pollute into a tradable commodity, thereby combining a price signal with a quantity target.
  • Link to the wider syllabus: Pollution permits sit alongside other government tools for market failure – pollution taxes, subsidies for clean technology, command‑and‑control regulation, property‑rights allocation and behavioural “nudge” measures (Topic 8.1).

How the System Works – Mechanism (AO1)

  1. Set the environmental target. Identify the socially optimal level of emissions where MSC = MB (or where marginal social cost equals marginal benefit of production).
  2. Fix the cap. The cap is set equal to this optimal level, guaranteeing that total emissions cannot exceed the target.
  3. Allocate permits.
    • Grandfathering (free allocation) – based on historic emissions or output.
      • Pros: politically palatable; protects export‑competitiveness.
      • Cons: may reward high‑polluting firms; raises equity concerns.
    • Auction – firms bid for permits; the government receives revenue.
      • Pros: generates revenue; allocates to firms with the highest willingness to pay.
      • Cons: can increase costs for smaller firms; perceived as less “fair”.
  4. Trading. A secondary market allows firms to buy or sell permits. The market price reflects the marginal cost of abatement (MAC). Transaction costs, market liquidity and price elasticity of demand for permits affect how closely the price mirrors the true MAC.
  5. Compliance. At the end of each compliance period firms must surrender enough permits to cover their actual emissions. Failure triggers penalties (fines, revocation of permits).

Diagram – Permit Market (AO1)

A supply‑and‑demand diagram for permits:

  • Vertical axis: Permit price (£/tonne).
  • Horizontal axis: Quantity of emissions (or permits).
  • Supply curve (upward‑sloping): Aggregate marginal abatement cost (MAC) of all firms.
  • Demand curve (downward‑sloping): Aggregate marginal benefit of emitting (or the cost of buying permits).
  • The intersection gives the market‑clearing price and the quantity set by the cap, illustrating efficient allocation.

Economic Theory (AO1)

  • Negative externality: Without intervention, market equilibrium satisfies MPC = MPB, leading to over‑production and over‑emission.
  • Socially optimal equilibrium: Achieved where MSC = MPB.
  • Under cap‑and‑trade each firm chooses abatement where its marginal abatement cost equals the permit price:
    MACi = p for every firm i.
  • The permit price that clears the market therefore equals the marginal cost of the *last* unit of abatement, ensuring that low‑cost abaters reduce more while high‑cost abaters purchase permits.

Advantages – Evaluation (AO2)

  • Environmental certainty: The cap guarantees that total emissions will not exceed the target.
  • Cost‑effectiveness: Abatement is allocated to firms with the lowest MAC, minimising total abatement cost.
  • Flexibility & innovation: Firms can decide whether to abate or trade, encouraging investment in cleaner technologies.
  • Revenue potential (if auctioned): Funds can be used for green R&D, subsidising affected households, or offsetting distributional impacts.
  • Transparency: A central permit registry records ownership and transfers, providing clear information.
  • Real‑world example: The European Union Emissions Trading System (EU ETS) – the world’s largest cap‑and‑trade scheme, covering power plants, industry and aviation.

Disadvantages, Limitations and Government‑Failure Risks (AO2/AO3)

  • Allocation controversy: Grandfathering may entrench historic polluters; auctions may disadvantage small firms.
  • Administrative & monitoring costs: Need for a robust registry, third‑party verification, and enforcement mechanisms.
  • Price volatility: Uncertainty about future permit prices can hinder long‑term investment decisions; price elasticity of demand for permits determines how firms respond to price swings.
  • Hot‑spot risk: Concentration of permits in a region can lead to localized pollution problems (e.g., a cluster of factories in one area still emitting at high levels).
  • Transaction costs & market liquidity: High brokerage fees or ill‑liquid markets may prevent the price from reflecting the true MAC.
  • Government‑failure considerations:
    • Political pressure may lead to a cap set too high, reducing environmental benefit.
    • Lobbying by industry can influence allocation rules (regulatory capture).
    • Frequent adjustments to the cap can create policy uncertainty.

Equity, Revenue Use and Distributional Impacts (AO2/AO3)

  • Auction revenue: Can be earmarked for:
    • Funding renewable‑energy research and development.
    • Compensating low‑income households or communities disproportionately affected by pollution (addressing equity).
    • Supporting transition programmes for workers in carbon‑intensive industries.
  • Distributional trade‑off: While auctions raise revenue, they may increase costs for small firms; grandfathering protects incumbents but may reward past polluters.

Comparison with Other Government Instruments (AO1)

Instrument Mechanism Environmental Certainty Cost‑Effectiveness Administrative Burden
Pollution Tax Fixed price per unit of emission Low – emissions depend on firms’ response to the tax High if tax equals marginal external cost Moderate – requires emission measurement
Subsidy for Clean Technology Financial support for abatement inputs Low – depends on uptake and diffusion Variable – may fund inefficient technologies High – verification of technology use needed
Command‑and‑Control Regulation Specific limits or standards for each firm High – strict limits per firm Low – does not allocate abatement to lowest‑cost firms High – detailed monitoring and enforcement required
Pollution Permits (Cap‑and‑Trade) Fixed total emissions; tradable permits High – cap guarantees total level High – market finds lowest‑cost abatement Moderate – permit registry, reporting and compliance checks

Numerical Example (AO1 – Worked‑out)

Scenario: Government sets a cap of 1 000 tonnes of CO₂. Two firms have the following marginal abatement cost (MAC) functions (where Q is the amount of emissions reduced):

$$\text{MAC}_A = 20 - 0.02Q_A$$

$$\text{MAC}_B = 10 - 0.01Q_B$$

  1. At equilibrium \text{MAC}_A = \text{MAC}_B = p.
  2. Express each firm’s reduction in terms of p:
    • Q_A = \dfrac{20 - p}{0.02}
    • Q_B = \dfrac{10 - p}{0.01}
  3. Use the cap: Q_A + Q_B = 1\,000.
    $$\frac{20 - p}{0.02} + \frac{10 - p}{0.01} = 1\,000$$
    $$50(20 - p) + 100(10 - p) = 1\,000$$
    $$1\,000 - 50p + 1\,000 - 100p = 1\,000$$
    $$2\,000 - 150p = 1\,000$$
    $$150p = 1\,000 \;\Rightarrow\; p \approx £6.67\text{/tonne}$$
  4. Calculate reductions:
    • Q_A = \dfrac{20 - 6.67}{0.02} \approx 667\text{ t}
    • Q_B = \dfrac{10 - 6.67}{0.01} \approx 333\text{ t}
  5. Interpretation:
    • Permit price ≈ £6.67 per tonne.
    • Firm A (lower MAC) reduces more and sells excess permits.
    • Firm B reduces less and purchases permits.

Evaluation Checklist (AO2/AO3)

Criterion How Pollution Permits Perform Possible Short‑comings
Efficiency (cost‑effectiveness) Abatement allocated to lowest‑cost firms → lowest total cost. Transaction costs, imperfect information, market power, price volatility.
Equity (distributional impact) Auction revenue can be redistributed; permits can be allocated to protect vulnerable groups. Grandfathering rewards historic polluters; small firms may struggle to purchase permits.
Environmental certainty Cap guarantees an emissions ceiling. If the cap is set too high (political pressure) the environmental benefit is limited.
Administrative burden Requires a permit registry and periodic reporting – less detailed than command‑and‑control. Initial set‑up costs and ongoing verification can be substantial.
Flexibility & innovation Firms choose abatement or trading, encouraging technological change. Uncertainty about future permit prices may deter long‑term R&D.
Government‑failure risk Cap can be set based on scientific advice. Lobbying, regulatory capture, and politically motivated caps may undermine effectiveness.

Key Take‑aways (AO2)

  • Pollution permits provide a certain environmental outcome (the cap) while allowing the market to find the cheapest way to achieve it.
  • The permit price acts as a signal of the marginal cost of abatement, guiding firms toward efficient reduction strategies.
  • Successful design depends on:
    • Setting an appropriate, scientifically justified cap.
    • Choosing an allocation method that balances equity and revenue generation.
    • Providing a transparent, low‑cost trading platform.
    • Robust monitoring, reporting and enforcement mechanisms.
  • When evaluating, consider efficiency, equity, environmental certainty, administrative costs, innovation potential, and possible government‑failure influences.

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