38: Sell your sludge
Tradable pollution permits
The problem: heavy-handed controls
Blanket pollution bans are non-discriminatory and drive out or close down businesses that cannot comply. How to reduce pollution, but more sensitively?
The idea: auction the permission to pollute
An innovative answer is to establish total acceptable levels of pollution over the area concerned, and auction the rights to pollute up to this permitted level. Everyone then has an incentive to clean up and avoid the cost of buying these licences: those for whom it is easiest do most, while those who find it harder have to pay more for the privilege. Through a system of tradable permits, businesses that can easily and cheaply cut their emissions will do so, because they can sell their remaining quota on to other firms whose emissions are harder to control.
Results: a trade in pollution
Pollution permits work by obliging polluters to pay for their noxious emissions. Consequently, they have a clear incentive to make real reductions.
Once the acceptable overall levels of pollution in an area are decided, permits to continue discharging polluting emissions are allocated to companies. Those firms which can reduce their emissions below the designated level are allowed to trade the balance of their permits with firms which produce higher levels of the specific pollutant - emissions such as sulphur dioxide, carbon dioxide, and other greenhouse gases.
Accordingly, cleaner companies benefit, while polluters are forced to pay to acquire additional permits. This puts them under pressure to cut back on their emission levels in order to maintain their profitability and competitiveness; and it is a boon to the local environment if they can. If the nature of the production process makes it hard or very expensive for them to reduce emissions, they can only continue doing so by striking a deal with other businesses that have already made cuts. So the environment gains, either way, but firms which cannot reduce emissions are not closed down by insensitive blanket regulations.
In the United States, the Acid Rain Program launched in 1995 allowed companies to trade permits in sulphur dioxide, which is mainly produced by power generators burning high-sulphur coal. The results have been better than planned. So far the initiative is ahead of target with participating firms reducing compliance costs by up to 50 per cent.
The US Acid Rain Program is based on two key criteria which encourage successful emissions trading: first, there needs to be an established regulatory and monitoring regime which pursues explicit reduction targets; and secondly, the source of pollution must be clearly traceable.
The existence of tradable pollution permits leaves local businesses with the problem of how to trade them. As usual, the market has quickly responded, and a number of companies now act as brokers, taking a commission for matching up the polluters' demands for permits with the non-polluters' supply of them. Thus one California-based company, RTCE Exchange, created a sort of stock market for the buying and selling of various environmental credits. In Canada, a public-private panel called PERT does much the same in Quebec.
In the United Kingdom, a government taskforce led by Lord Marshall, chairman of British Airways, lent strong support to the idea of carbon emissions trading. A scheme was introduced in April 2002 - the world's first economy-wide greenhouse gas trading system - run by a new Emissions Trading Authority.
However, the taskforce identified a number of practical obstacles to be overcome. Lord Marshall's team recommended a pilot programme and after much discussion the UK tradeable pollution permit system came into effect in April 2002.
Assessment: incentive, opportunity
From a regulator's point of view, tradable pollution permits provides greater certainty about pollution levels, provided the enforcement regime is sufficiently robust. The system costs less to administer than traditional regulation, and provides a clear commercial incentive on businesses to reduce emissions to the maximum amount that can be justified in terms of commercial cost-benefit.
Ideally, a pollution permits system should enable firms to trade permits directly with each other; then even light polluters have a financial incentive to reduce their emissions even further - an incentive they would not have under blanket emission-levels regulation. The more tradable the permits, the more vibrant will be the brokerage market that arises to facilitate these trades.
Tradable permits also provide a business opportunity for financial centres such as the City of London, Frankfurt and New York. In the UK, the Centre for the Study of Financial Innovation has been advising the City Corporation in London on the creation of a permit-driven carbon trading market.
For further information:
- Cambridge Econometrics, headed by Dr Terry Barker, has specialized in this area and its website can be found at www.camecon.co.uk. '
- United Nations (1995) Controlling Carbon Dioxide Emissions: the Tradeable Permit System: UN Conference on Trade & Development (UNCTAD).
- The Centre for the Study of Financial Innovation can be contacted on +44 20 7493 0173 www.cfsi.demon.co.uk.
- The Competitive Enterprise Institute in Washington DC also regularly issues material on this topic. In December 1998 it published a sceptical presentation on emissions trading by Robert A. Reinstein, an adviser to the UN Intergovernmental Panel on Climate Change, see website at www.cei.org.
- Morris, Julian (ed) (1996) Climate Change Policy Initiatives: Institute of Economic Affairs.
- Walker, John, et al (1997) The Economic Implications of Reducing Carbon Emissions: Oxford Economic Forecasting.
- 'Economic Man, Cleaner Planet' The Economist Sep 29 2001 pp103-5.
Copyright 2002: Adam Smith Institute
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