Some economists believe that a
tax-subsidy solution to externalities rarely works effectively and
without distortions to the way a market operates. They believe that the free
market mechanism offers a better solution.
are a combination of command and control and market-based
approaches to the task of limiting pollution emissions. Polluters can bid for
a permit that allows them to
create a fixed amount of pollution. These permits can be resold: The
government can gradually reduce the number (volume) of pollution permits
available so that total pollution emissions can be controlled.
If you can sell a
permit for more than it is worth to you -- you do so
If you can buy a
permit for less than it is worth to you -- you do so
If a company (X) has a high marginal benefit from pollution emissions –
it will be willing to buy some permits from another business (Y) who has a
lower marginal benefit from emitting pollution.
Assume initially that both firms X and Y are producing 20 units of a
pollutant each from their output. The government may decide that only
eighteen units of pollution is permissible for each firm. If firm X manages
to reduce pollution emissions to sixteen units it would be a given a credit
of 2 units.
This permit could be traded with firm Y – allowing Y to continue
producing twenty units of the pollutant. The effect is that total pollution
emissions still falls to thirty six units (for the two firms combined) - but
the systems of traded permits means that pollution reduction is concentrated
in the firms where pollution reduction can be achieved at the lowest cost.
The market for permits will reach a market-clearing price where the
marginal benefit of pollution emissions is equal. Businesses can either buy
permits or invest in technology to reduce pollution emissions - whichever
approach saves them money. Gradually the total amount of pollution allowed
can be reduced – as the stringency of pollution limits is tightened, so the
value of permits may rise, they will be more valuable to companies that can
bring down pollution levels at lowest marginal cost.
have been tried in several countries – including Singapore
where an auction mechanism has
been introduced for the trading of ozone-depleting substances. For the system
to be effective there needs to be common acceptance of the legal framework
for the trading of permits and regulation of the amount of pollution
produced. The Kyoto Summit on
Climate Change (held in December 1997) witnessed a decisive move towards a
greater use of internationally traded
pollution permits – based on the idea that each country is required to
achieve a specific percentage reduction in pollutants such as C02.
POTENTIAL PROBLEMS WITH TRADED
How are permitted
levels of pollution decided? If based on current production levels they may
be no advantage for firms that have already taken steps to
control their pollution emissions
Traded permits may see
pollution being concentrated in
certain geographical areas. At the Kyoto Summit, developing countries
were not required to make reductions in pollution – but could be given
credits for “certified reductions” in pollution that could be then traded
with other countries. This might allow countries such as the United States to
buy up pollution permits from LDCs (including many form high polluting
countries in Eastern Europe) – and avoid the need to reduce pollution
There are likely to be
high administrative costs
associated with monitoring pollution emissions – particularly if the number
of firms involved is very large.