Emissions Trading

Principles and Practice

Thomas Tietenberg, Thomas H. Tietenberg

• Publisher: Routledge
• Year: 2010
• eBook ISBN: 9781136526190
• Topic: Volkswirtschaftslehre
• Subtopic: Umweltökonomie

First published in 1985, Emissions Trading was a comprehensive review of the first large-scale attempt to use economic incentives in environmental policy in the U.S. and of the empirical and theoretical research on which this approach is based. Since its publication it has consistently been one of the most widely cited works in the tradable permits literature. The second edition of this classic study of pollution reform considers how the use of transferable permits to control pollution has evolved, looks at how these programs have been implemented in the U.S. and internationally, and offers an objective evaluation of the resulting successes, failures, and lessons learned over the last twenty-five years.

1
Introduction

Along tradition in economics suggests that treating resources as a commons that are shared jointly by many users could lead to overexploitation in the absence of some kind of access rationing (Ostrom et al. 2002). Since the atmosphere is one such commons, it is not surprising to find that in the absence of some kind of access rationing for polluters, the atmosphere would be excessively polluted. The policy question, therefore, is what form should the control over access take?

One increasingly common form involves the use of emissions trading. In contrast to more traditional regulation, where the regulatory authority specifies a specific maximum level of emissions for each emissions source within a plant, emissions trading is a regulatory program that allows pollution emitters considerable flexibility in how they comply with the regulation. With emissions trading, as long as the total emissions reduction is the same or greater, firms can comply by either: (1) reducing emissions from any combination of sources within the plant; or (2) acquiring emissions reductions from another facility.

The logic behind the growing prominence of this approach is simple. One of the insights derived from the empirical literature is that traditional command-and-control regulatory measures, which depend upon government agencies to define not only the goals but also the means for reaching them, are in many cases insufficiently protective of those resources or economically inefficient. Emissions trading provides, at least in principle, a cost-effective alternative.

Applications of this general approach have spread not only to many different types of pollution in many different countries but are also being used to ration access to many other resources, including fisheries, forests, water, and land use control, among others.¹ Though the lessons from emissions trading are certainly useful for those considering this approach for other resources, this book will focus on the use of this technique to control air pollution.

Early History

By the late 1950s, both economists and policymakers had formed well-developed and deeply entrenched visions of how pollution control policy should be conducted. Unfortunately, the two visions were worlds apart.

Economists viewed the world through the eyes of Pigou (1920). Professor A.C. Pigou had argued that in the face of an externality such as pollution, the appropriate remedy involved imposing a per-unit tax on the emissions from a polluting activity. The tax rate would be equal to the marginal external social damage caused by the last unit of pollution at the efficient allocation. Faced with this tax on emissions, firms would “internalize” the externality. By minimizing their private costs, firms would simultaneously minimize the costs to society as a whole. According to this view, rational pollution control policy involved putting a price on pollution.

Policymakers, particularly, but not exclusively, in the United States, held an equally firm, if substantially different, view. According to this view, the proper way to control pollution was through a series of legal regulations ranging from controlling the location of polluting activities (to keep them away from people) to the specification of emissions ceilings (to limit the amount ejected into the air). Under this regulatory regime, the public sector would be responsible for: (1) figuring out how much pollution to allow each emitter (usually by identifying the specific control technology that should be used); (2) mandating either a specific technology or level of emissions flow achievable by that technology; (3) monitoring emissions to verify compliance with these mandates; and (4) using financial penalties or other sanctions to bring non-complying sources into compliance.

While some exchanges of ideas took place between the two groups, most of it was highly critical and not viewed by the recipients as particularly helpful. Economists would point out, for example, that legal regimes, which became known as “command-and-control” regimes, generally were not cost-effective. Hence, they argued that by simply switching to Pigouvian taxes, more pollution control could be gained with the same expenditure or the same pollution control could be gained with less expenditure.

Policymakers responded that the information burden imposed on the bureaucracy by the design of efficient taxes was unrealistically high. And taxes based upon very limited information might not be any better than legal regulations. Furthermore, they argued, if bureaucrats had sufficient information to set efficient tax rates, they could use the same information to set efficient legal regimes.

The result was a standoff in which policymakers focused on quantity-based policies while economists continued to promote price-based remedies. While the standoff continued, legal regimes prevailed. Taxes made little headway, particularly in the United States.

In 1960, Ronald Coase published a remarkable article in which he sowed the seeds for a different mind-set. Arguing that Pigou had used an excessively narrow focus, Coase went on to suggest:

It is my belief that the failure of economists to reach correct conclusions about the treatment of harmful effects cannot be ascribed simply to a few slips in analysis. It stems from basic defects in the current approach to problems of welfare economics. What is needed is a change in approach. (1960, 42)

His proposed change in approach involved refocusing on property rights:

If factors of production are thought of as rights, it becomes easier to understand that the right to do something which has a harmful effect (such as the creation of smoke, noise, smell, etc.) is also a factor of production…. The cost of exercising a right (of using a factor of production) is always the loss that is suffered elsewhere in consequence of the exercise of that right—the inability to cross land, to park a car, to build a house, to enjoy a view, to have peace and quiet or to breathe clean air. (1960, 44)

Coase argued that by making these property rights explicit and transferable, the market could play a substantial role. To his fellow economists, Coase pointed out that a property rights approach allowed the market to value the property rights, as opposed to the government in the Pigouvian approach. To policymakers, Coase pointed out that control regimes based purely on emissions limits provided no means for the rights to flow to their highest valued use.

It remained for this key insight to become imbedded in practical programs for controlling pollution. Dales (1968) pointed out its applicability for water and Crocker (1966) for air. Among his other contributions, Dales noted that the legal regimes imposed by the government for pollution control in fact had already established a property right in the right to emit. Unlike the property right system envisioned by Coase, however, this property right was not efficient because it was not transferable:

The “regulatory” branches of modern governments create an enormous variety of valuable property rights that are imperfectly transferable, and that tend to be capitalized and monetized in ways that are usually unsuspected by their creators. (1968, 796)

One possibility to correct that inefficiency, of course, would be to make the existing system of property rights transferable. In a section that foreshadows much of what was to come, Dales (1968, 801) suggested a means for doing this:

The government's decision is, let us say, that for the next five years no more than x equivalent tons of waste per year are to be discharged into the waters of region A. Let it therefore issue x pollution rights and put them up for sale, simultaneously passing a law that everyone who discharges one equivalent ton of waste into the natural water system during a year must hold one pollution right throughout the year. Since x is less than the number of equivalent tons of waste being discharged at present, the rights will command a positive price—a price sufficient to result in a 10 percent reduction in waste discharge. The market in rights would be continuous. Firms that found that their actual production was likely to be less than their initial estimate of production would have rights to sell, and those in the contrary situation would be in the market as buyers. Anyone should be able to buy rights; clean-water groups would be able to buy rights and not exercise them. A forward market in rights might be established…. The virtues of the market mechanism are that no person, or agency, has to set the price—it is set by the competition among buyers and sellers of rights.

In his discussion of how this approach could be used to control air pollution, Crocker (1966, 81) noted a more basic point, namely that this approach fundamentally changes the information requirements imposed on the bureaucracy:

Although the atmospheric pollution control authority's responsibilities will continue to be a good deal broader than the basic governmental function of providing legal and tenure certainty in property rights, its necessary work will not have to include the guesswork involved in attempting to estimate individual emitter and receptor preference functions.

When emissions trading is used to pursue a predetermined goal that specifies the level of allowable emissions, the authority does not have to know anything about either damage or cost functions.² Transferability, at least in principle, allows the market to handle the task of ensuring that the assignment of control responsibility ultimately ends up being placed on those who can accomplish the previously stipulated reductions at the lowest cost.

The final stage in this evolution was reached with the publication of a couple of now classic articles. The first, by Baumol and Oates (1971), formalized the theory behind these practical insights for the case of uniformly mixed pollutants, those for which only the level, not the location, of the emissions matters. This was followed shortly by an article by Montgomery (1972) that generalized the results for the more complicated case of non-uniformly mixed pollutants, those for which both the level and the location of emissions matters. These articles were instrumental in legitimizing the concept of emissions trading in the eyes of those theorists who tend to be distrustful of ad hoc arguments until the formal properties of the system are worked out.

Describing the Evolution

Traditional Policy

To understand how these general principles were implemented in the early years in the United States, it is important first to understand the policy environment that gave rise to the reform. Some knowledge of that policy framework helps not only to understand the forces for reform but also the shape of that reform once it began to happen.

U.S. air pollution policy was, and is, designed to ensure that people and ecosystems are protected from harmful levels of pollution. It does this by promulgating ambient air quality standards that specify the permissible legal threshold for concentrations of pollutants in the ambient air and by establishing a process for reaching those standards.

The traditional approach for improving air quality typically involved the bureaucratic selection of desirable control technologies, using those technologies as the basis for specifying permissible emission limits, and forcing emitters to stay within those limits.

In the early 1970s, a group of experts from the academic community familiar with emerging literature on property rights suggested that it might be possible to improve upon this system by allowing firms to trade control responsibility among themselves by means of emissions trading. In this way, firms that could control relatively cheaply would voluntarily control more, selling the excess control to those that, for economic reasons, wanted to control less.

In an important sense, emissions trading changes the nature of the regulatory process. The burden of identifying the appropriate control strategies is shifted from the control authority to the polluter. As a result of the flexibility that becomes possible from this shift, many new control strategies can, in principle, emerge. Instead of the traditional focus on end-of-pipe control technologies, pollution prevention is placed on an equal footing by this program. All possible pollution reduction strategies can, for the first time, compete on a level playing field.

Emissions trading also allows more flexibility in the timing of control investments. Under emissions trading, facilities have the ability to time their expenditures so that they coincide with optimal capital replacement schedules and prevailing market conditions. Forcing every emitter to install control equipment at precisely the same time could cause much higher equipment purchase expenditures than would be the case with a schedule that spread deliveries out over a longer period. Demand would be less temporally concentrated with emissions trading.

Reform, however, has its own costs, and the existing policy was likely to persist unless it could be shown that the difference the new policy would make would be sufficiently large to justify the change. Making that case, of course, required empirical analysis that could begin to get at the magnitude of the potential cost savings involved. Were they large enough to justify the effort?

As discussed in more detail in the next chapter, the initial empirical analysis suggested that the command-and-control policy was very cost-ineffective. (Atkinson and Lewis 1974; Tietenberg 1974). Subsequent analyses involving several different pollutants in several different regions find that the initial empirical results were robust—the control costs from command-and-control allocations were estimated to exceed least cost allocations by a substantial margin (Seskin et al. 1983; Roach et al. 1981; Atkinson and Tietenberg 1982; Krupnick, Oates et al. 1983; Maloney and Yandle 1984; McGartland and Oates 1985). Though based on ex ante computer simulations that dealt more with caricatures of command-and-control than actual regulatory allocations, this literature offered the possibility that the increased flexibility made possible by the reform had the potential to meet the environmental targets with substantially lower control costs.

The Evolution of Emissions Trading

The Offset Policy: The Problem Becomes the Solution

The political opportunity to capitalize on that insight came in 1976. By 1976, it had become clear that a number of regions designated as “nonattainment” regions by the Clean Air Act would fail to attain the ambient air quality standards by the deadlines mandated in the act. Because the statute mandated improvements in air quality in these regions, further economic growth appeared to make the air worse, contrary to the intent of the statute. The Environmental Protection Agency (EPA) was faced with the unpleasant prospect of prohibiting many new businesses (those that would emit any of the pollutants responsible for nonattainment in that region) from entering these regions until the air quality came within the ambient standards.

Prohibiting economic growth as a means of resolving air quality problems was politically unpopular among governors, mayors, and many members of Congress. EPA had a potential revolution on its hands. At this point, they began to consider alternatives. Was it possible to solve the air quality problem while allowing further economic growth?

It was possible, as it turns out, and the means for achieving these apparently incompatible objectives involved the creation of an early form of emissions trading. Existing sources of pollution in the nonattainment area were encouraged to voluntarily reduce their emissions levels below their current legal requirements. EPA could then certify these excess reduct...

Table of contents

• Front Cover
• Title Page
• Copyright
• About Resources for the Future and RFF Press
• Contents
• Figures and Tables
• Preface
• Abbreviations
• 1. Introduction
• 2. The Conceptual Framework
• 3. The Consequences of Emissions Trading
• 4. The Spatial Dimension
• 5. The Temporal Dimension
• 6. The Initial Allocation
• 7. Market Power
• 8. Monitoring and Enforcement
• 9. Lessons
• References
• Index
• About the Author