CHAPTER 13

Incentive-Based Strategies: Market Trading Systems

An effluent charge requires that some central public authority

establish a charge rate, monitor the performance of each polluter, and
then collect the tax bills. It is essentially an interaction between polluters
and public authorities in which we might expect the same type of
adversarial relationship we get in any tax system. In this chapter we take
a look at a policy approach that, while incorporating economic incentives,
is designed to work in a more decentralized fashion. Rather than leaving
everything to a centralized public agency, it works through decentralized
market interactions in which polluters may buy and sell emission permits,
and pollution is controlled by linking emissions with the number of
permits held.
These programs have proliferated in recent years. The most well
known in the United States is the sulfur dioxide (SO2) trading scheme
introduced as part of the Clean Air Act of 1990. A nitrous oxide (NOx)
trading plan was started among a group of eastern states in 1999.
California has started several programs within its own borders. The
countries of the European Union have recently inaugurated a
multicountry trading plan to reduce carbon dioxide (CO2) emissions.
General Principles
We can distinguish three types of trading systems for achieving more
efficient pollution control:
. Offset trading
. Emission rate trading
. Cap-and-trade (CAP)

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Offset trading initially came about to address a very practical problem:
how to limit environmental pollution but still be able to accommodate
economic growth. Under the original Clean Air Act of 1970, situations
evolved (especially in Southern California) where all existing firms were
subject to regulatory emission standards, but the air quality in the region
was nevertheless still below standard. How to allow the growth of new
firms, but avoid making air pollution worse? The answer was to allow
new firms to pay existing firms to reduce their emissions below standard
so as to offset the added emissions of the new firms. Trades of this type,
since it involved transactions between two firms subject to regulatory
control, were sometimes called credit trading. But offset-type trading can
also occur between any two, or more, entities, whether or not they are
under regulatory control. For example, if the selling firm is not under
regulatory limits, they may be able to reduce their emissions below the
level that would exist if an agreement was not reached, and sell the
resulting offset to another entity that wishes to offset its emissions, either
because it is required to, or it voluntarily choses to. One of the most well-
known examples of offset trading is the Clean Development Mechanism
under the Kyoto Protocol to reduce greenhouse gases. We will encounter
this in Chapter 18.
Emission rate trading takes place in terms of the rate that a pollutant
constitutes in total output. For example, a greenhouse gas emission rate
might be defined in terms of tons of CO2 per 1,000 megawatt hours of
power production. After a base rate is set, either voluntarily or through
regulation, trading would take place between sources. Sources that are
willing and able to reduce their emission rate below the base would sell
allowances to sources that want to continue to operate at a rate higher
than the base. We will discuss this in more detail later in this chapter.

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Cap-and-trade programs work a little differently. The first step in a CAP
program is to make a centralized decision (by a regulatory agency or
some other collective entity) on the aggregate quantity of emissions to be
allowed. Permits are then written in accordance with this quantity. These
permits are then dis-tributed among the sources responsible for the
emissions. Some formula must be used to determine how many permits
each source will receive; we will comeback to this problem later.
Assuming that the total number of permits is less than current total
emissions, some or all emitters will receive fewer permits than their
current emissions.

Cap-and-Trade
Suppose, for example, that a CAP program has been instituted to reduce
the amount of sulfur emitted by a group of power plants. Current total
emissions are, say, 150,000 tons of sulfur per year, and policymakers
have decided that this must be reduced to 100,000 tons per year. Let’s
focus on the situation of one of the power plants, which is depicted in
Figure 13.1. We suppose it is emitting 5,000 tons of sulfur currently.
Under the program, the plant is initially given 2,500 discharge permits.
The plant manager now has three choices:
1. Reduce the emissions to the level covered by the number of permits the
plant was initially awarded.
2. Buy additional permits and emit at levels higher than the original
award level (e.g., buy 1,000 permits to add to its 2,500 initial distribution,
so its emissions would now be 3,500 tons/year).
3. Reduce emissions below the level of the original award, then sell the
permits it doesn’t need (e.g., reduce emissions to 1,800 tons/year and sell
1,000 permits).

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 Note that whether the firm is a buyer or seller of permits depends
on the relationship of the price of permits and their marginal abatement
costs at the emission level corresponding to their initial permit holding.

1. If the original award is 1,800 permits, the firm’s marginal abatement

costs would be $60/ton; with a permit price of $40, it can improve its
situation by buying 700 permits and increasing its emissions to 2,500
tons.
2. If its original allocation is 3,500 permits, its marginal abatement costs
would be lower than the permit price; it can improve its situation by
selling 1,000 permits and reducing its emission to 2,500 tons.

Now think of a situation involving an industry where there are a

large number of firms and each one is emitting a pollutant we wish to

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control with a cap-and-trade program. An overall level of aggregate
emissions is set by the authorities, and transferable permits are allocated
to each firm according to some formula. Marginal abatement costs can be
expected to differ among firms, based on different production and
pollution-control technologies available to each.
Some sources will be potential buyers of permits (MAC > permit
price), and some firms will be potential sellers (MAC < permit price).
There are gains from trade to be had by the sources, by buying and selling
permits, in effect rearranging the total number of permits (which has been
fixed by the authorities) among the plants.
It is important to note, now, that each firm will be in a situation
analogous to the one depicted in Figure 13.1. By buying or selling
permits, they move to a situation where marginal abatement costs are
equal to the price of permits. Assuming there is a single overall market
for permits, and therefore a single market price for them, this means that
the trading of permits among the firms will result in a cost-effective
reduction in total emission, because each firm will end up equating its
marginal abatement costs to the single permit price. Cost-effectiveness in
cap-and-trade programs requires that that there be a single market for
permits, where suppliers and demanders may interact openly and where
knowledge of transactions prices is publicly available to all participants.
The normal forces of competition would then bring about a single price
for permits. The permits would in general flow from sources with
relatively low marginal abatement costs to those with high marginal
abatement costs.
A permit market is depicted in Figure 13.2. The demand for
permits is simply the aggregate marginal abatement cost functions of all
the firms participating in the market. The supply of permits is the quantity

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in the cap as initially established by public authorities; the supply curve is
vertical at that quantity.

As in any competitive market, the price of permits is determined by

the interaction of supply and demand. If the cap is set at q1 in Figure
13.2, the price of permits will settle at p1. A more restrictive cap, such as
q2, would give a higher permit price, the case at p2.
It’s important to understand that the permit price in a CAP program
is what provides the incentive for emission reductions by participating
firms. In this sense it is analogous to the emission tax as discussed in
Chapter 12. But note that the two approaches proceed differently. With a
cap-and-trade program, a quantity restriction (the cap) is set, and a permit
price results as firms adjust their emission levels. In an emission charge

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program, authorities first set the tax level, and firms adjust their emission
levels, leading to a change in the quantity of aggregate emissions.
In recent years, the idea of transferable discharge permits has
become quite popular among some environmental policy advocates, as
well as among policymakers themselves. Table 13.1 lists a few now in
effect. Some of the largest programs have to do with air pollution. On the
water pollution-control side there has been a proliferation of programs for
particular water bodies.
Unlike effluent charge approaches, which basically make people
pay for something they were once getting for free, CAP programs begin
by creating and distributing a new type of right. These rights will have a
market value as long as the total number of permits created is limited.
From a political stand-point, it is perhaps easier for people to agree on a
pollution-control policy that begins by distributing valuable new rights
than by notifying people they will be subject to a new tax. Of course, like
any pollution-control policy, CAP programs have their own set of
problems that must be overcome if they are going to work effectively.
What looks in theory like a neat way of using market forces to achieve
efficient pollution reduction must be adapted to the complexities of the
real world.

The Initial Rights Allocation

The success of the CAP approach in controlling pollution depends
critically on limiting the number of rights in circulation; this is the “cap.”
Because individual polluters will no doubt want as many as they can get
in the first distribution, the very first step of the program is one of
potentially great controversy: what formula to use to make the original
distribution of emission rights. Almost any rule will appear to have some
inequities. For example, they might be distributed equally among all

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existing sources of a particular effluent. But this would encounter the
problem that firms vary a lot in size. Some pulp mills are larger than
others, for example, and the average size of pulp mills, in terms of value
of output, may be different from the average size of, say, soda bottling
plants. So giving each polluter the same number of permits may not be
fair.
Permits might be allocated in accordance with the existing emissions of a
source. For example, each source might get permits amounting to 50
percent of its current emissions. This may sound equitable, but, in fact, it
has built-inincentive difficulties. A rule like this does not recognize the
fact that some firms already may have worked hard to reduce their
emissions. One easily could argue that those firms that, out of a good
conscience or for any reason, have already invested in emission reduction
should not now be penalized, in effect, by receiving emission permits in
proportion to these lower emission levels. This tends to reward firms that
have dragged their feet in the past. It could go even further. If polluters
believe that permits will soon be allocated in this way, they may have the
incentive to increase today’s emission rate because this would give them
a larger base for the initial allocation of permits.

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TABLE 13.1 Selected Trading Programs Existing in 2015
Program
1990 Clean Air Act
Southern California Reclaim
California Trading Program
New Zealand Trading Program
Kyoto Protocol Clean Development
Mechanism
European Trading Scheme
Regional Greenhouse Gas Initiative
Renewable Energy Certificates
(in states where renewable energy
portfolio standards exist)
Illinois Emission Reduction
Market System
China Trading Program
Long Island Sound Nitrogen
Trading Program
Chesapeake Bay Agreement
San Francisco Bay Offset Program
Ohio Wetlands Mitigation Program
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Item Traded
Tons of SO2 emissions from power
Plants
Tons of SO2 and NOX from large
industrial sources
Tons of greenhouse gases
Tons of greenhouse gases
Tons of greenhouse gases from projectsin
developing countries
Tons of greenhouse gases from large
power, industrial, and cement plants
Tons of greenhouse gases from large
plants in northeastern and mid-Atlantic
United States
Certificates for each 1,000 kWh of
renewable energy produced
Tons of volatile organic compounds
emitted from large sources in eight
Illinois counties
Tons of CO2 emissions
Pounds of waterborne nitrogen emissions
from wastewater treatment plants
Pounds of waterborne nutrients
(nitrogen and phosphorus)
Kilograms of waterborne mercury
emissions
Acres of restored, enhanced, or
preserved wetlands
 Each allocation formula has its problems, and those setting the cap
must find some workable compromise if the approach is to be widely
accepted. Closely related to this issue is the question of whether the rights
should be given away or perhaps sold or auctioned. In principle it doesn’t
matter as long as the permits get distributed fairly widely. Subsequent
market transactions will redistribute them in accordance with the relative
marginal abatement costs of polluters, whatever the original distribution
may have been. But free distribution of permits will confer windfall gains
on the recipients, the amount of which would depend on the market price
of the permits. What a sale or auction would do is transfer some of the
original value of the rights into the hands of the auctioning agency. This
might be a good way for public agencies to raise funds for worthy
projects, but it has to be recognized that a plan like this would create
political objections. A hybrid system would be to distribute a certain
number of permits free and then auction some number of additional
permits. Or a small surcharge might be put on permits in the original
distribution.

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