How Marketable Permits Can Tackle Pollution Problems Economics Essay

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Pollution is a serious problem of the 21st century, a problem which will not disappear, or fix itself. The level of economic activity across the world is constantly on the increase, as firms attempt to satisfy the demands of an exponentially growing human population. The polluters of the world need to stop their reckless behaviour and think about whether they are willing to sacrifice the survival and well-being of future generations in order to satisfy the insatiable needs of the current generation. The ravaging effects which reckless polluting behaviour has on the earth is visible in the form of global warming. Global warming has already been set into place with the breaking down of the ozone layer as a result of the excessive quantities of greenhouse gases released into the atmosphere (Oracle, 2002). Whether or not global warming can be stopped and possibly even reversed is a matter for scientific debate, but from an economic viewpoint it must be examined, how best to reduce and regulate the pollution levels generated from economic activity (without crippling the economy in the process).

Global warming is not the only threat to future life faced by the earth as a result of the reckless pollution of the earth and its environment, marine life is suffering, with several species being threatened by extinction, as the seas, oceans and rivers are used as dumping grounds by firms trying to dispose of their toxic waste in a cheap and easy manner (Oracle, 2002). The air responsible for sustaining life is rife with harmful substances released into the air by factories and coal-powered electricity plants, causing people to develop lung cancer, and other respiratory diseases at young ages (, 2010). Taking into to consideration that the imposition of a charge-system on polluting firms has done little to reduce pollution levels, marketable permits pose a more stringent "command-and-control system" (Taschini, 2010: pp 7) which government can use to effectively control and subsequently reduce pollution levels (Taschini, 2010).

With every firm in an economy striving toward market capitalisation, trying to provide the best goods and services to customers at the lowest cost, many firms have little or no regard for the negative externalities generated by their pollutive production processes (Taschini, 2010). Subjected to a competitive market, with free and ready access to environmental resources, firms will continue to employ their pollutive production processes until the marginal return yielded from their production is zero (Taschini, 2010). The initial economic solution derived to tackle the problem of externalities generated by firms, was to impose a tax or levy on these firms thereby providing an incentive for them to internalise as much of the externalities as possible, an example of a such a tax is the "Pigouvian tax" (a levy equating to the marginal social damage) (Taschini, 2010). As illustrated by the diagram below, the implementation of the tax would cause the firms Marginal Cost curve to shift upward, from MC1 to MC2 by the value of the tax burden, presenting the avoidance of high taxes as an incentive for firms to decrease production from qn to qt, producing at the social optimum, reducing their tax liability, and reducing their emissions (Taschini, 2010).

Image Source: (Taschini, 2010: pp 3)

However this "charge-system" has a major disadvantage. The charging of taxes and levies on pollution only allows government control over the price of polluting the environment and not control over the quantity of pollution in the economy and, with the tax system being extremely intricate, since the tax rate would have to vary based on certain conditions such as an area's assimilative capacity, it will also be necessary to adjust taxes based on synergistic effects arising from different pollutants in an area combining to form much more harmful pollutants than normal (Taschini, 2010). It is possible that there can be an over or under estimation of the tax, thereby setting a tax which is too low, in which case, firms will find it more cost effective to incur the additional tax expense associated with higher levels of pollution than to adopt pollution abatement strategies - resulting in pollution levels exceeding the anticipated level (Taschini, 2010).

However, with a system which grants the government control over the quantity of pollution generated, government can easily reach desired pollution standards (Taschini, 2010). An example of such a system would be marketable/tradable permits, which avoids the problem of uncertainty of how firms will respond(as found with the tax/charge system), since whether a firm chooser to reduce production levels, invest in pollution abatement technology or purchase additional pollution permits from surplus holders, the total amount of pollution generated within the economy will not exceed the permitted level unless a firm breaks the law, an action which will be subject to legal consequences (Pearce, 1989:8). The more common form of a permit trading system is the cap-and-trade system, for which a fixed level of permissible pollution is set by authorities (ie. the 'cap') and permits totalling this amount are subsequently issued to firms (Stavins, 2001).

These permits can either be distributed freely amongst firms, or auctioned off to firms (Nash & Revesz, 2002). The permit held by a firm, will allow the firm to legally pollute up to a certain amount (which varies from one economy to another), beyond that amount they will be in violation of pollution and environmental laws and subject to prosecution (Thomas, 2007). To avoid acting in an illegal manner, firms can purchase additional permit units from other firms who have surplus units remaining on their permits (Thomas, 2007).

Those firms with lower abatement costs in comparison to the price of permits will prefer to reduce their pollution levels by investing in pollution abatement technology or reducing their production levels, and possibly sell the surplus units remaining on their permits to other firms (Thomas, 2007). Firms with high pollution abatement costs will have an incentive to continue polluting and purchase additional permits, if permits are the cheaper alternative (Thomas, 2007). Acquiring additional permits will effectively grant a firm a higher permit level as they hold more than one permit, thereby enabling them to continue polluting up to a higher level without worrying about being in violation of laws (Thomas, 2007). The trade-off between pollution abatement and trading permits is ultimately decision based on cost-minimisation. (Pearce, 1989:8).

The permit system is also an extremely efficient means to regulate and maintain a constant level of pollution even when faced with the entry of new (polluting) firms into the industry (Pearce, 1989:8). Pearce made use of figure 1 found below and the following explanation to explain how a marketable permit system will respond to the entry of new firms into the economy, the entry of new firms into the economy causes a rightward shift of the aggregated pollution permit demand curve. Generally, associated with an increase in the number of polluters is an increase in the quantity of pollution, however if the government wants to maintain the amount of pollution at the current level, then they will maintain the prevailing supply of permits(S*). With the supply of pollution permits remaining unchanged, and the demand for pollution permits increasing, the effect will be a subsequent increase in the price of pollution permits from P* to P**. The new entrants, just as with existing firms will need to make a choice between the purchase of pollution abatement technology and marketable permits, based on cost-minimisation (Pearce, 1989:8).

Figure 1. Image Source: (Pearson, 1989:8, pp 113)

With reference to the above diagram, Pearce explained that should the government feel the need to relax the supply of permits, to accommodate for the new entrants into the industry, then they would increase the supply of permits, thereby shifting the supply of permits curve (S*), to the right, resulting in a drop in the price of permits. Conversely, if they feel that the current pollution levels need to be tightened, then they will decrease the future issue of permits, and for a more immediate result, buy back surplus permit units, and keep them off the market, resulting in a leftward shift of the supply of permits curve (S*), resulting in a corresponding increase in its price. (Pearce, 1989:8)

Inflation in the economy would alter the real value of a tax, actually decreasing the effectiveness of the tax, requiring government to intervene and make a relevant change to the tax rate, to adjust for inflation (Pearce, 1989:8). Unlike with a tax on pollution, pollution permits pricing do not need to be adjusted periodically in response to inflation, since they respond to market supply and demand, inflation will automatically be adjusted into the price (Pearce, 1989:8). Taxes would also require adjustment based on entry and exit of firms within the industry (Pearce, 1989:8), as explained with relation to figure 1 above - permit prices automatically adjust to such changes.

The type of market on which the permits are traded is crucial to the effectiveness of the system. An unintended advantage (for non-polluters), is that if permits are allowed to be traded freely on the market, then anyone will be able to purchase them, thereby presenting an opportunity for environmentalists and other individuals concerned about high levels of pollution, to purchase these permits and simply hold onto them, thereby reducing the supply of permits and subsequently the overall amount of pollution which can be emitted (Pearce, 1989:8). "Sandbag" is an example of one such group, the members of which are dedicated to the fight against climate change, and strongly believe in promoting a low-carbon future (Sandbag, 2010). This European group, strongly believes that the European union although quick to adopt the system of marketable permits to fight climate change, lacks efficient administration and as a result there are far too many permits in circulation, thereby having little or no effect on the reduction of pollution (Sandbag, 2010). Sandbag purchases whatever permits they are able to and by simply hold onto them until they expire, destroys them. (Sandbag, 2010).

However it can be deduced that in a country where the permit system is being run efficiently, that this opportunity for non-polluters can be a severe disadvantage for polluters and the economy as a whole. If the system is truly efficient, the total amount of permits issued would have been carefully calculated, taking into account all demand and supply factors as well as the effect posed on the economy's GDP. Amidst an efficient system the buying and holding of permits in order to reduce its supply, could possibly see industries unable to meet demand requirements, and thereby resulting in an unanticipated drop in the economy's GDP. Given that firms are face with a choice between pollution permits and pollution abatement technology, it can be argued that the above scenario will force firms to adopt pollution abatement technology, in order to meet demand requirements and supply targets, thereby effectively reducing pollution levels not only in the current period but in the future also.

With firms being allowed to freely trade permits, government loses control over the prevention of "hot spots" (Nash & Revesz, 2002). "Hot spots," are referral to areas where pollution concentration levels exceed the standard amount (Nash & Revesz, 2002). It is highly possible that while overall pollution statistics will drop following the implementation of a marketable permit system, however as it does not control the concentration of pollution, it is quite possible that certain areas will be subjected to much higher pollution levels than others, if for example the firms in a certain region are engaged in smaller scale production, and are able to abate pollution, then they will probably have a surplus amount remaining on their permit, which can be bought by larger firms from the bigger cities (Nash & Revesz, 2002). With firms buying up additional permit units, the implication will be excessive pollution in the relevant region (Nash & Revesz, 2002). As firms within a specific area may be producing on a relatively smaller scale, and find themselves in possession of surplus permit units, which they may then sell to firms in larger industrial areas, thereby increasing the pollution in that specific region. The total effect achieved may still be the same, ie. pollution reduced to the acceptable level or below (Nash & Revesz, 2002), however, taking into account the assimilative capacity of the region, it may be subjected to excessive levels of air, water and land pollution (Pearce, 1989:4).

There are broadly three types of permit systems, ambient permit system (APS), emissions permit system (EPS) and pollution offset (PO) system (Pearce, 1989:8). The ambient permit system takes into account that different receptor points may handle different concentrations of pollution (assimilative capacity), all receptor points do not share an ambient quality standard (Pearce, 1989:8). Permits are not entirely freely tradable, as you can only pollute as much as the value of your permit allows, if the receptor point concerned can handle the level of concentration (Pearce, 1989:8). The market for permits, under the ambient permit system, may become extremely complex as prices vary from one receptor point to another (Pearce, 1989:8). This system is an extremely efficient one and can be used effectively to control pollution and also prevent the formation of "hot spots" (Nash & Revesz, 2002).

The emissions permit system is a simpler, yet less efficient type of permit system. Permit issues are based on a source's emissions without taking into to account the effect which the emissions have on receptor points (Pearce: 1989:8). Polluters are subjected to a single market and a single price (Pearce: 1989:8). While an APS may be more difficult to administer and control in comparison to an EPS, an APS has its problems. Since it doesn't differentiate between receptor points, it is unlikely that it will differentiate between the damage caused by sources (Pearce: 1989:8). It is because of its failure to discriminate between sources that the system is seen as inefficient (Pearce: 1989:8). The lack of control over sources could result in some areas being faced with concentration levels exceeding the standard, thereby allowing for the formation of "hot spots" (Nash & Revesz, 2002).

To overcome the disadvantages of the EPS and APS, whilst retaining their advantages a third system was developed, the pollution offset (PO) system (Pearce: 1989:8). The PO system is basically a combination of the APS and EPS, as permits are based on emissions, taking into account varying assimilative capacities across the different receptor points and restricting trading so as to maintain an ambient quality standard at receptor points, thereby preventing the formation of "hot spots" (Pearce: 1989:8).

In order for the system to be truly effective in controlling pollution levels, there needs to be an efficient system in place to measure the emissions of a firm. This needs to be applicable to every firm in the economy, or else, it will be possible for firms to manipulate the system and pollute more than the permit amount (Nash & Revesz, 2002).

It is being argued that many firms subjected to marketable permits are manipulating the system in their advantage, such that they are producing "phony reductions" (Beder, 2001). Firms are under a permit system, restricted on the amount they are able to pollute, this amount will be lower than that which would prevail in the absence of such a system, so in other words a compulsory/enforced reduction in pollution (Beder, 2001). However they are able to inflate their baselines and caps, by means of purchasing additional permits from other firms in regions where emissions are being decreased, such as in Russia and other eastern European countries (Beder, 2001). Russia recent economic decline has seen their emissions decrease by approximately 30% since the 1990's, and on the other hand you have countries like Japan and the USA purchasing these surplus permit units, so that they will not need to decrease their own emissions (Beder, 2001). By doing this they are effectively not reducing their pollution - they are merely just purchasing additional permits to keep them out of trouble with the law. The overall effect is that those larger industries which contribute the most toward global degradation arising from pollution are continuing to behave in a selfish, profit-maximising and cost-minimising manner. The overall effect is less than efficient, as the decreases implemented by one firm are merely being set-off against the increases by other firms. (Beder, 2001)

The system of marketable permits if introduced worldwide can be used to efficiently reduce and control worldwide emissions of greenhouse gases, and subsequently slowing down the process of global warming (Taylor & Weerapana, 2009). Developing nations can be allowed a relatively higher amount of emissions (in order to stimulate economic growth) and developed nations a somewhat restrictive permit amount, in order to force them to reduce their emissions (Taylor & Weerapana, 2009). However, with permits freely tradable on the market, it can be argued, that developed nations will exploit developing nations, by purchasing permits from them, and continuing to stimulate their own economic growth and effectively preventing the economic growth and development of developing nations (Taylor & Weerapana, 2009).

With reference to the above bar chart, used to explain a mock scenario regarding the introduction of a permit system and how the manner in which a polluting firm responds to a permit system is crucial to the outcome achieved by a system. Firms need to stop seeing permits systems as a threat to the current profits, and start seeing it as a guarantee for future profits, and make an active attempt to decrease their pollution as much as is possible, with sustenance for motivation. Assuming the market comprised solely of 2 polluting agents Russia and the USA, let's examine what some of the possible outcomes of permit systems can be. Let us assume that initially (No Permit), both agents are responsible for equal amount of the emissions arising from their production processes.

When a permit is introduced, Russia, sees the need to reduce their pollution, and adopts pollution abatement strategies where possible, and thereby emits less than permitted, leaving them with surplus units which can be sold. The USA however, doesn't see the need to reduce their emissions and seeing that the it is cheaper to purchase additional permit units than abate pollution, purchase the surplus units held by Russia, and actually increase the production to capture that portion of the market now lost by Russia, and in the process increase their emissions. The overall effect is still achieved, ie. 80 units of emission, however, lets analyse an alternate scenario and its results. Let's assume thee both Russia and the USA recognise the need to reduce their emissions and subsequently adopt appropriate measures to achieve this, with both firms reducing their emission below the permitted level, the overall reduction on emissions will actually be larger than accommodated for.

Tokyo, a Japanese city, has energy consumption levels equating to those levels of entire North European countries, with its production matching up to the gross national product(GNP) of the 16th largest country of the world (China Daily, 2010). In April 2010 the Tokyo Metropolitan Government (TMG) set into place the first cap-and-trade system on the Asian continent in an effort to reduce CO2 emissions to 25% below its 2000 by the year 2020 (China Daily, 2010). The first phase (2010-2014) of the scheme was intended to show a 6-8% reduction from levels in the base-year, however on 28 December 2010, following a cabinet meeting the scheme was put on hold, in response to the warnings from powerful business groups of large scale job losses as they attempt to compete with foreign rivals subjected to less harsh emission regulations (China Daily, 2010). The sudden and indefinite postponement of the emissions reduction scheme has left European countries hopes of other top polluting nations taking a proactive stance against pollution somewhat shattered (China Daily, 2010). The minister of energy has assured all concern parties that the scheme has only been placed on hold, and that there is no intention of scrapping the emissions trading scheme all together, but there will be a careful study and analysis of the current emission trading scheme, in order to make modifications (China Daily, 2010).

It can be deduced from the above Tokyo, Japan example, that while government might be committed to reducing pollution levels, polluters on the other hand are acting in a selfish manner, not wanting to incur additional expenditure, and are using the possible loss of jobs as a result of higher costs being incurred as a shield to fight off the emissions trading scheme. A point worth noting is that, jobs need not be lost, unless firm owners are unwilling to compromise on their profits, the job market can remain stable, and pollution levels be reduced - if firm owners would settle for smaller net profits.

Tradable pollution permits provide an effective system of control over the level of pollution within a region. Since the permissible amount of pollution is pre-determined, the environments well-being is not left at the mercy of how industries respond to the system, regardless of how a firm reacts, whether the reduce production, invest in pollution abatement equipment, or purchase additional permits - the overall pollution level will still be at most equal to the total amount decided on by policymakers. While the initial impact suffered on implementation may be severe in the form of retrenchments, this is ultimately avoidable at the cost of reduced profits, also, long-term investments in pollution abatement equipment, will see production levels and profits rise again after the system has been in place for a while. The system balances itself off with regard to supply and demand of permits, as firm holding surplus units on their permits can sell the permits to those firms facing a shortage of permitted units of emission.