Comparative Analysis of Tradeable Permit Schemes

Honors Thesis | Comparative Analysis of Tradable Permit Schemes Sanjay Zimmermann
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A Comparative Analysis of Tradable Permit Schemes
By: Sanjay Zimmermann
Honors Thesis for June 2014 – May 2015
Advisor: Professor Neal Harris & Professor Vikki Rodgers
Liaisons: Professor Vincent Onyemah and Professor James Hoopes
Awarded April, 2015
Prof. Neal Harris Prof. Vikki Rodgers Dr. Henry N. Deneault Prof. Virginia Soybel

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Table of Contents
Abstract.........................................................................................................................................................6
Literature review...........................................................................................................................................7
Ecological impacts.................................................................................................................................7
Standard environmental economics theory .......................................................................................10
Distortions between theory and reality..............................................................................................11
Findings concerning initial design of tradable permit scheme...........................................................12
Findings relating to enforcement and monitoring of tradable permit scheme..................................13
Ex-post analysis methodology ............................................................................................................14
Opportunity to contribute to the field....................................................................................................15
Part 1: Introduction to tradable permits ....................................................................................................17
Environmental Economics.......................................................................................................................17
Effects of pollution externality on the production possibility frontier...............................................19
The externality nature of pollution.....................................................................................................20
Optimal level of pollution ...................................................................................................................23
Command and control vs market based instruments ............................................................................26
History of air pollution control mechanisms ......................................................................................26
Timeline of significant U.S. air pollution legislation............................................................................27
Command and Control (CAC)..............................................................................................................28
Market based instruments..................................................................................................................32
How tradable permits programs work....................................................................................................35
Cap and trade programs vs credit trading programs..........................................................................35
CAP program example ........................................................................................................................36
Tradable permits and the equimarginal principle ..............................................................................36
Dynamic Efficiency of tradable permits..............................................................................................39
Why are tradable permits so attractive?................................................................................................42
Part 2: Characteristics of a tradable permit system ...................................................................................43
Initial Design Characteristics...................................................................................................................44
Scope...................................................................................................................................................44
Carbon offsets.....................................................................................................................................45

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Cap ......................................................................................................................................................47
Commodity being traded....................................................................................................................47
Distribution of tradable permits (initial allocation)............................................................................52
Trading ratio........................................................................................................................................55
Banking and Borrowing.......................................................................................................................56
Monitoring and enforcement .............................................................................................................57
Environmental Benefit........................................................................................................................63
Part 3: Criteria to evaluate Tradable Permit Schemes................................................................................63
Ex-Post Evaluations.................................................................................................................................63
Environmental Effectiveness ..................................................................................................................65
Economic Efficiency ................................................................................................................................68
Compliance Costs................................................................................................................................72
Soft Effects..........................................................................................................................................73
Dynamic effects...................................................................................................................................74
Part 4: Comparative evaluation of tradable programs...............................................................................75
1. U.S. SO2 Program.................................................................................................................................75
Scorecard Overview............................................................................................................................75
1.1 Environmental Effectiveness.........................................................................................................76
1.2 Economic Efficiency ......................................................................................................................81
1.3 Compliance Costs..........................................................................................................................83
1.4 Soft effects ....................................................................................................................................84
1.5 Dynamic Effects.............................................................................................................................85
2. EU Emissions Trading Scheme (EU ETS)..............................................................................................87
Scorecard Overview............................................................................................................................87
2.1 Environmental Effectiveness.........................................................................................................88
2.2 Economic Efficiency ......................................................................................................................92
2.3 Compliance Costs..........................................................................................................................95
2.4 Soft Effects ....................................................................................................................................96
2.5 Dynamic Effects.............................................................................................................................97
3. New Zealand Emissions Trading System (NZ ETS).............................................................................100
Scorecard Overview..........................................................................................................................100

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3.1 Environmental Effectiveness.......................................................................................................101
3.2 Economic Efficiency ....................................................................................................................105
3.3. Compliance Costs.......................................................................................................................107
3.4 Soft Effects ..................................................................................................................................108
3.5 Dynamic effects...........................................................................................................................109
4. Santiago, Chile ETS............................................................................................................................112
Scorecard overview...........................................................................................................................112
4.1 Environmental Effectiveness.......................................................................................................113
4.2 Economic Efficiency ....................................................................................................................116
4.3 Compliance Costs........................................................................................................................118
4.4 Soft Effects ..................................................................................................................................119
4.5 Dynamic effects...........................................................................................................................119
Part 5: Findings and key policy recommendations...................................................................................121
Key Findings Summary..........................................................................................................................121
Key Findings – Positive Elements......................................................................................................123
Key findings – Negative Elements.....................................................................................................124
Policy recommendations ......................................................................................................................125
Conclusion.............................................................................................................................................127
Limitations of this thesis ...................................................................................................................128
Future areas of study........................................................................................................................128
Final Words .......................................................................................................................................130
Appendix ...................................................................................................................................................131
Exhibit 1: History of Air pollution (based on Students for Clean Air) ...................................................131
Exhibit 2: Two forms of emission trading compared............................................................................133
Exhibit 3: Ecological impact of SO2 and NOX emissions ........................................................................133
Exhibit 4: Ecological impact of CO2 emissions ......................................................................................133
Exhibit 4: Keeling Curve data ................................................................................................................134
Exhibit 5: Direct and Indirect forms of linked exchange systems.........................................................135
Exhibit 6: Different “Commodity being traded” based on tradable permit program...........................135
Exhibit 7: Types of greenhouse gas emissions (data based on EPA) ....................................................136
Exhibit 8: Likelihood of exceeding a temperature increase at equilibrium..........................................137

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Exhibit 9: Estimates for pollution reduction attributable to EU ETS.....................................................138
Exhibit 10: Studies estimating impact of EU ETS on investment and innovation activities..................139
Exhibit 11: How participants in the NZ ETS have met their surrender obligations ..............................140
Exhibit 12: Compliance levels in Santiago ETS......................................................................................141
Exhibit 13: Trading activity in Santiago ETS ..........................................................................................142
Exhibit 14: Effects of NZ ETS price ceiling .............................................................................................142
Exhibit 15: Map of Existing, emerging and potential emissions trading schemes................................143
Exhibit 16: Timeline of different ETS programs ....................................................................................144
Exhibit 16: Scope of Emissions trading programs around the world....................................................145
Exhibit 17: Carbon permit prices around the world .............................................................................146
Exhibit 18:Atmospheric CO2 concentrations in PPM taken from Mauna Loa Observatory.................147
Works Cited...............................................................................................................................................148

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Abstract
Tradable permit programs are a form of market based instruments that can be used to reduce
pollution. They work by setting a cap on emissions to a fixed amount of units, allocating these units to
various polluters and then allowing them to trade these units with each other. In theory, for most
pollutants, tradable permit programs are the most cost effective and dynamically efficient manner to
mitigate pollution. However, in practice there are several characteristics and contextual elements that
can lead to either the success or failure of a program. The following thesis outlines these characteristics,
presents a set of criteria and rubric used to assess programs and then evaluates in depth four different
tradable permit programs. These programs are the U.S.SO2 program, EU ETS, New Zealand ETS and Chile
ETS. The last part of this thesis synthesizes the findings from these four programs into aggregate
conclusions that can be drawn from this sample. The key findings are that homogeneous and
heterogeneous pollutants must be treated differently, auctioning is economically superior to
grandfathering and that strict monitoring, enforcement and verification guidelines as well as efficient
markets are essential to the success of a program. The findings in this thesis serve to be used by
policymakers who are planning to design and operate new tradable permit programs around the world.

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Literature review
Over the last two decades, tradable permits have become an increasingly popular pollution
control mechanism amongst policy makers, leading to a surge in research and academic publications on
this topic. In my analysis of the existing literature, I have chosen to break down the research into five
different sections that are in line with the overall structure of my thesis. First it is important to consider
the ecological impacts that air pollution has on the planet and why pollution control policies are needed.
Second I looked at research surrounding the general economic theory behind pollution control
mechanisms. Third, I will consider the specific components of a tradable permit scheme and how several
key elements differ in practice from theory. Fourth, I will discuss the ex-post methodologies that have
been developed by various scholars and compiled by the OECD to assess the effectiveness of pollution
control policies. This will lead into the research opportunity and how the following work can contribute
to the field by combining and interpreting findings from multiple programs.
Ecological impacts
Three major types of air pollution emissions that cause ecological damages are (1) SO2 and NOx
emissions which are responsible in part for acid rain, (2) carbon based emissions such as CO2 which are
responsible for climate change and (3) particulate matter emissions which cause direct damages to
human health. These emissions are generated by various industries such as transportation, electricity
production and agriculture. While every type of air pollutants are of concern, they each need to be
addressed differently to be effectively mitigated.
Sulfurdioxide emissions have considerable indirect impacts to human health through acid rain
and soil acidification1
. Kuylenstierna et al. (2001) describes several different methodologies that have
1
Kuylenstierna et. al. 2001

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been used to determine the critical load of acidity within a given aquatic and terrestrial ecosystem.
Building on this Azevedo et. al. (2013) published a study that outlined the risk terrestrial acidification
poses to declining plant diversity. The study concluded that vascular plant species were especially at risk
and that acidifying air emissions posed a significant threat to biodiversity by encouraging trophic
cascades and the growth of invasive species. The collapse of these ecosystems will pose a threat to
human health as the loss in biodiversity will ultimately create degraded and unsustainable ecosystems
yielding losses in vital ecosystem services. Although the effects of acidification are alarming (as seen
earlier), several scholars shown that policies in the U.S. aimed at reducing SO2 emissions since the 1970s
have had a profound impact in reducing acidification. Driscoll et. al. (2001) examines the effects of three
decades of SO2 emission control reductions on the Northeastern U.S. ecosystem. Their analysis is based
on a counterfactual situation where no policies for emission reductions would have taken place
(scenario A) and comparing it to the emission reductions observed (scenario B). They conclude that the
reductions in SO2 since 1970 had a statistically significant effect on reducing ecological effects of acid
deposition. Similarly, Likens et. al. (2001) report on observations of acidification of the ecosystem within
the Hubbard Brook experimental forest in NH, the longest continuous record of precipitation chemistry
in North America. Their findings similar to those found by Driscoll et al. (2001), show that in the long
term there is a significant correlation between SO2 emissions reduction and lower soil acidic levels of
aquatic and terrestrial ecosystems.
Carbon dioxide (CO2) is in large part responsible for climate change. Schmitz et. al. (2003)
developed models looking at climate-ecosystem linkages and concluded that global climate change will
have significant impacts on the world’s ecosystem. For instance, the melting of the polar ice-caps is
leading to rising sea water levels which will put millions of residents at risk of floods and sink entire
nations such as the Maldives. The main piece of evidence linking human activities to the rise in
atmospheric concentrations of CO2 can be found in the Keeling curve data which indicates a significant

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increase in particles per million of CO2 in the atmosphere since the industrial revolution (see exhibit 4).
Similarly, Taub (2010) and Dukes & Mooney (1999) suggest that higher atmospheric concentrations of
CO2 will affect certain plant species more than others, leading to shifts in the ecosystem favoring
invasive species or causing trophic cascades and ecosystem decline. Recently, Myers et. al. (2014) found
that increased levels of CO2 also threatened human nutrition as crops grown in such environments were
associated with “significant decreases in the concentrations of protein, zinc and iron” which is a
deficiency that affects an estimated two billion people2
(see exhibit 4). Overall, most scholars have
examined the negative impacts of air pollution and urge the need for pollution control mechanisms to
reduce current levels of SO2 and CO2.
In addition to carbon dioxide and sulfur dioxide emissions, there is another category of air
pollutants that has direct impacts on human health. Particulate matter or PM-10 emissions refer to type
of air pollutant that contains solid or liquid particles that originate from various stationary or mobile
sources3
. PM-10 emissions can directly be emitted from the source or formed in the atmosphere as a
resulting mixture of SO2 and NOX pollutants4
. The PM-10 designation is used to reference any particulate
matter with a diameter of 10 micrometers or less. These emissions pose a major threat to human health
due to their exposure can cause “…effects on breathing and respiratory systems, damage to lung tissue,
cancer and premature death”5
. In the U.S. major steps have been taken to eliminate the risks of PM-10
emissions. In other emerging countries however, such as Chile, these risks are still very high and
pollution control mechanisms are needed to reduce these emissions.
2
Myers et. Al., 2014, p. 139
3
http://www.epa.gov/airtrends/aqtrnd95/pm10.html
4
Ibid
5
Ibid

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Standard environmental economics theory
Before getting into the specifics of tradable permits, it’s important to consider the economic
theory surrounding pollution control mechanisms that could be found in the field of Environmental
Economics. Kahn (2005) presents the effects that pollution has on the production possibility frontier of
an economy highlights the issue of pollution as a negative externality. The concept of pollution as a
negative externality is further developed by Tietenberg and Lewis (2009) and Field and Field (2013). The
latter three books as well as Pearce and Turner (1990) define the optimal level of pollution in similar
terms and propose various command and control (CAC) or market based instruments that can be used
to reach this optimal level. Each of these sources argue the pros and cons of these different approaches
with Kahn (2005) outlining exceptional circumstances and situations in which CAC is the only viable
solution. Tietenberg and Lewis (2009) and Field and Field (2013) illustrate well how market based
instruments are superior to CAC in terms of cost efficiency and incentives for innovation. Charles D.
Kolstad also published a book on environmental economics which outlines the complete theoretical
framework behind marketable permits and illustrates mathematically that firms will be compelled to
trade with each other and invest in pollution abatement until their marginal abatement cost reaches the
permit cost6
. This is known as the “equimarginal principle” and is one of the fundamental arguments
supporting the economic effectiveness of tradable permits regimes7
.
Professor Robert Stavins (Stavins 1998) in writing about one of the earliest and most successful
SO2 cap and trade programs, describes how permits were initially perceived negatively by
environmentalists “as licenses to pollute”8
. In an effort to shift these negative and misconceived views,
the academic community was at first bent on proving that tradable permits will achieve environmental
6
Kolstad, 2000
7
Field & Field, 2013, p. 59
8
Stavins, 1998, p. 72

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efficiency at least cost. By the time the SO2 cap and trade program was implemented (1990) “the phrase
‘market-based environmental policy had evolved from being politically problematic to politically
attractive” in part due to rising pollution control costs9
.
Distortions between theory and reality
Given that the theoretical merit and validity of tradable permits is now more widely accepted,
scholars have focused their efforts on examining the discrepancies between theory and reality. One of
the key issues between theory and reality highlighted by Field & Field (2013), and Tietenberg (2006) is
the fact that pollution in the form of emissions is not a homogeneous commodity. They argue that there
are “spatial considerations, specifically the fact that the location of the emissions or resource use can
matter”10
. For instance one ton of SO2 emitted in Alaska would not have the same negative impact as if
it were emitted in New York City. This may be due to different wind patterns, human exposure and
variable absorption qualities of different ecosystems. Another issue highlighted by Tietenberg (2006) is
that the learning curve for firms in practice is not as steep as predicted by theory. Markets and trading
between firms do not suddenly appear. Experience and time is needed before stakeholders “behave
effectively in the market for permits”11
. Abrell, Faye & Zachmann look at firm level data from over 2000
firms in the EU ETS scheme and find that the choice of method for initial allocation of permits had an
“impact on the firm’s behavior”12
. Firms that had to buy initial permits in an auction rather than receive
them for free contributed more towards emission reductions. This empirical finding contradicts the
Coase theorem which holds that an efficient outcome would be achieved regardless of the initial
allocation of property rights13
. These inconsistencies between theory and reality represent a sample of
9
Stavins 1998 p. 76
10
Tietenberg, 2006, p.6
11
Tietenberg, 2006, p.8
12
Abrell, Faye & Zachmann, 2011, p. 12
13
Coase, 1937

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the many issues currently being identified by scholars. Several of these studies are aimed to help
improve tradable permit regimes in practice and provide guidance to policy makers.
Findings concerning initial design of tradable permit scheme
Given that practice and theory diverge, several issues must be considered when deciding on the
initial design of the regime. A large part of the literature covering this issue has been focused on the
initial allocation of the permits at onset of a tradable permit scheme implementation. Policy makers
must choose between auctioning permits to the highest bidders or grandfathering them to firms based
on historical pollution levels. Cramton & Kerr (2002) argue strongly in support of auctioning permits
claiming that it is economically more efficient and that it “reduces the need for politically contentious
arguments” (p. 339). In practice the grandfathering system may provide a perverse incentive for firms to
increase their pollution in anticipation of a tradable permit scheme. Political economy considerations
also imply that bigger firms will attempt to lobby policy makers to gain a larger initial allocation.
Nonetheless Cramton & Kerr’s views are not shared by all scholars. In fact, Abrell, Faye & Zachmann,
2011 argue using empirical evidence that auctioning permits will increase the final price.
Another area of debate by scholars concerning the initial design relates to deciding on a linked
or confined exchange system. For example the EU ETS program is according to the European
Commission moving towards a linked exchange with Australia. Several researchers are in favor of a
completely linked exchange system for carbon permits. Such a system would enable the creation of an
international price for carbon emissions allowing firms from any country to trade these permits.
McKibbin et al. (1999), built a model based on these assumptions and found that the “U.S. emerges as a
large seller of emission permits” (p. 344) and that the net benefits from trade would be upwards of $40
billion a year. Although the economic efficiency and gains from trade of a linked system are
acknowledged by most scholars, some have argued that a closed system is best on the basis of equity

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considerations. Rose & Stevens (1993) created a similar model to McKibben et al. and agreed that the
overall net welfare gain would be upwards of $20 billion a year. However they argue that this would
have severe negative effects “in countries like China”, where abatement technologies are not as
advanced and the economy is highly reliant on carbon intensive products14
. Finally, another contentious
issue with regard to the initial design lies in deciding the quantity of permits to allocate at the start of
the program. If too many are issued the price per permit will be too low to have a tangible effect on
pollution reduction, if too few are available as it was the case with the RECLAIM program in 2001, price
shocks may cause great harm to the economy.
Findings relating to enforcement and monitoring of tradable permit scheme
Noting the many challenges at the onset of a tradable permit program, the situation
unfortunately does not get any less complicated once the program is up and running; the focus merely
shifts towards finding the right balance in enforcement, monitoring and transaction costs. In theory,
monitoring should be flawless, enforcement should be clear and immediate and transaction costs should
be minimal; in practice studies have revealed that this may not always be the case. For some emission-
specific trading programs there are third parties who monitor pollution levels and the efficiency of the
given regime. For carbon emissions the World Bank publishes an annual “State and Trends” report which
contains data on pollution levels and updates on new initiatives. In most cases the monitoring task falls
under the responsibility of policy makers. Monitoring activities are responsible for a large fraction of the
administrative costs related to tradable permits. Accurate and timely monitoring is important not only
so that the government can impose sanctions on firms exceeding their permit allocation but also in
order to create a transparent and efficient market “that is accessible by eligible users on a real-time
basis”15
. Stavins (1998) review of the SO2 allowance trading program in the U.S. serves as an example to
14
Rose & Stevens, 1993, p.128
15
Tietenberg, 2006, p. 6

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illustrate best practices regarding these three operational issues. In contrast, Coria & Sterner’s (2010)
review of the tradable permit system in Chile serves as an example of how things can go wrong with
these three issues. Stavins, found that stiff penalties and continuous emissions monitoring “helps build
market confidence”16
. On the other hand, the Chile study revealed that the high non-compliance rate
was in large part due to inadequate measurement of emissions and “the lack of enforcement”17
. Similar
findings were made with relation to transaction costs, where the SO2 program proved that “if properly
designed, private markets will tend to render transaction costs minimal”18
. In Chile however, “high
transaction costs” were cited as being one of the main hindrances to achieving better efficiency with
their tradable program19
.
Ex-post analysis methodology
Many of the findings in the previous paragraph regarding optimal enforcement, monitoring and
transaction costs would not have been made without proper methodology to conduct ex-post
evaluations of tradable permits. Ellerman (2003) was one of the first scholars to build a robust
methodology for evaluating the effectiveness of tradable permit schemes. One of the key parts of this
method is the need to construct a “credible counterfactual situation” of what essentially would have
been done if the tradable permits program had not been implemented20
. This counterfactual situation is
meant to serve as a baseline to which actual results following the policy implementation can be
compared against. Ellerman also noted that the two key measures of success of a pollution control
mechanism are economic efficiency and environmental effectiveness. These two measures were also
referenced in 2004 by an OECD publication on best practices for policy evaluation of tradable permits.
16
17
Coria & Sterner, 2010, p. 26
18
19
Coria & Sterner, 2010, p. 3
20
Ellerman, 2003, p.6

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This publication defines environmental effectiveness as “the extent to which the policy meets its
intended environmental objective” and defines economic efficiency as the extent to which this goal is
achieved “at minimum cost”21
.The publication also goes on to examine other performance metrics such
as soft effects, dynamic effects, administrative costs and social impacts. One big caveat with ex-post
evaluations of tradable permits, mentioned in almost every study conducted, is the fact that these
policies unfortunately are never implemented in a vacuum. In fact, they are often implemented in
conjunction with other environmental protection policies which means that there is always an element
of uncertainty and risk of confounding data.
Opportunity to contribute to the field
The ex-post evaluation methodology outlined by the OECD and Ellerman has thus far only been
used in studies looking at individual programs. Therefore, there is a lack of comparative analysis studies
looking at several different programs. Thus there is a void in the literature in the sense that several
pieces of a puzzle are being examined by these authors but no one has yet attempted to put these
pieces together to examine the effects across various systems. According to the International Carbon
Action Partnership (ICAP), there are now “16 countries in the world with active emissions trading
schemes” and several others with programs in the pipeline22
. Over the last two decades, several authors
have conducted ex-post evaluations on some of these programs individually. For example, Stavins
(1998) and Ellerman (2003) wrote about the U.S. SO2 cap and trade program, Harrison (2004) looked at
the LA RECLAIM, Kerr (2004) about the New Zealand fisheries scheme, Coria & Sterner (2010) examined
tradable permits in a developing country and Dumont (2013) is looking at the new Quebec program. It
would be false to assume that each of these studies completely ignores the findings of one and another,
however they are all mainly written for the purpose of evaluating one independent system. The OECD
21
OECD, 2004, p. 11
22
ICAP, 2014, p.21

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has come close to addressing this void through its 2004 publication titled “Tradeable permits: policy
evaluation, design and reform”. However, the data and examples from the OECD only apply to
developed countries as they fail to include any ex-post evaluations from developing countries. Also this
study was conducted more in the form of a repertoire of individual analysis rather than a
comprehensive comparative analysis tying together findings across systems.
Part of the reason why a comparative study of a variety of tradable permit programs has not
been attempted is due to the fact that to date we are unaware of any index or scale that can be used to
measure objectively the success of a given program. In extreme cases as the comparison between the
Chilean program and the U.S. SO2 program, there is no need for a complicated index or scale to
determine that the SO2 program is clearly more effective. However it would be quite difficult to
compare the SO2 program to the EU ETS and objectively claim that one is superior to another. Examining
the total reduction in pollution alone would not be a fair measure of success, other considerations, such
as abatement costs, “administration costs, dynamic effects etc.” must be considered as well. Form an
ecological standpoint, examining reduction is emissions is misleading as well given that this may not
always lead to a healthier ecosystem23
. Likens et al. (2001) recommends using bulk deposition of SO2 in
aquatic and terrestrial ecosystems as a measure of environmental effectiveness. Although the current
literature has focused mainly on identifying each of these individual considerations, few have managed
to place weights on them in order to form an index. In 1993 Rose and Stevens created a mathematical
programming model that was “used to estimate the welfare implications” of tradable permit systems
across different countries24
. A welfare model similar to this one, updated in order to reflect the most
recent data and evaluation methodologies would be needed in order to compare tradable permit
programs from one country to another.
23
OECD, 2004, p. 11
24
Rose & Stevens, 1993, p. 118

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Part 1: Introduction to tradable permits
Environmental Economics
Tradable permits exist as a solution to efficiently reduce pollution, however before further
exploring this method it is important to first understand the nature of the problem from an
environmental economics perspective. Environmental economics is a branch of economics that is
defined by the National Bureau of Economics Research as the undertaking of theoretical or empirical
studies of the economic effects of national or local environmental policies around the world25
. For the
purpose of this thesis it is also worth contrasting the difference between environmental economics,
ecological economics and simply the land ethic perspective as proposed by Aldo Leopold. The latter is
based on the concept that “environmental degradation is the result of human behavior that is unethical
or immoral26
” and that by this logic any level of pollution is bad. Leopold holds that the land ethic
“reflects the existence of an ecological conscience, and this in turn reflects a conviction of individual
responsibility for the health of land”27
. Annie Leonard, the current president of Greenpeace, is a typical
example of a contemporary follower of Leopold’s land ethic and a fervent environmentalist. In 2009, she
put together a video criticizing cap and trade as an evil market designed by financial institutions that
solely benefits their interests and provides polluters with a license to pollute28
. This view although
shared by several extreme environmentalists is based mainly on various conspiracy theories,
misinformation and is not supported by scholarly sources29
. This leaves us with the classic debate of
ecological economics vs environmental economics. Environmental economics is based on neoclassical
economics which “emphasizes maximizing human welfare and using economic incentives to modify
25
"Environmental Economics". NBER Working Group Descriptions.
26
Field and Field, 2013, p. 3
27
Leopold 1949, p. 55
28
http://storyofstuff.org/movies/story-of-cap-and-trade/
29
http://grist.org/article/2009-12-01-annie-leonard-misses-the-mark-her-new-video-story-cap-and-trade/

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destructive human behavior30
” while ecological economics uses a variety of different methodologies
that are not all based on neoclassical economics. Essentially, the main difference between these two
schools of thought is that while from an economics perspective it may always be possible to attribute a
monetary value to a natural resource, from an ecological perspective some resources, due to the risk of
extinction and irreversibility, may have an infinite value. Professor Eric Neumayer, from the London
School of Economics published a book titled Weak Versus Strong Sustainability that essentially outlines
the differences between these perspectives. In short economists tend to believe in weak form
sustainability where any natural resource has a monetary value and can be replaced by human capital,
whereas ecologists believe in strong form sustainability which holds that not all natural capital can be
replaced by human capital and it must therefore be preserved at any cost31
. Throughout this essay, I will
be analyzing tradable permits based on the environmental economics framework set out in the
following sections.
30
Titenberg and Lewis, 2013, p. 7
31
Neumayer, 2013

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Effects of pollution externality on the production possibility frontier
In economic terms, the pollution problem arises as a negative externality leading to market
failure which affects the efficiency of an entire economy by shrinking its production. To illustrate this
point, consider the following example of an economy based solely on the production of cotton and steel.
If we assume that pollution arising from the emissions of the steel plant will have no effect on the
cotton production, then the production possibility frontier (PPF) of this economy would be equal to P1
in the figure below. However, this is a rather unrealistic assumption as these emissions will affect the
health of the cotton crop and potentially also the health of the labor force in the economy leading to a
smaller PPF illustrated by P2. The shift in PPF represents a technological externality which according to
Kahn (2005), is to be distinguished with a pecuniary externality32
. As the latter would reflect merely a
movement along the PPF curve affecting the individual prices of the goods in the economy, a
technological externality is characterized by a shift in the PPF curve leading to reduced production and a
net welfare loss.
Figure 1: Effects of pollution as technological externality on PPF
32
Kahn 2005 p. 28

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In figure 1, the only scenario where PPF is unaffected by pollution is where the economy solely
focuses on the production of one good. However this a once again an unrealistic scenario and therefore
the question becomes, how can we get P2 as close as possible to P1. The answer to this question is not
as straightforward as a reduction in pollution given that resources would need to be devoted to creating
this reduction leading to an equivalent loss in production possibilities33
. The only way to reduce
pollution without taking resources out of the economy is by improving pollution abatement
technologies. For example if using old technologies it costs $10 to reduce 1 ton of carbon emissions and
with newer abatement technologies it now costs $5 to reduce the same amount, the P2 curve would
move halfway closer to P1. Following this logic in order to get P1 = P2 the abatement cost of pollution
needs to be zero. The key lesson here to bear in mind for later sections in this essay is that an optimal
pollution control mechanism in the long run does not only force a reduction in emissions but also
incentivizes technological innovation leading to lower abatement costs. In short, the cotton and steel
example and figure above illustrates that pollution is problematic because it creates a technological
externality that takes production resources out of the economy34
. The following section will take a
deeper look at the nature of such an externality and some of the causes for its existence.
The externality nature of pollution
The concept of a technological externality illustrated how pollution impacts an economy. This
can be explained by the fact that excess pollution leads to a negative externality which causes a net
welfare loss in the economy. An externality is present whenever “A’s” utility or production capacity is
affected by the actions of “B” without particular intention of “B” to affect “A’s” welfare35
. Therefore if
33
Kahn 2005 p. 29
34
Kahn 2005 p. 28
35
Baumol and Oates 1988

21 | P a g e
the steel factory intentionally placed pollutants in the water to harm cotton producers, this would not
be considered an externality, however if the same factory unintentionally leaked pollutants into the air
that would be considered a negative externality arising from steel production. In a world without
environmental regulation the costs incurred by the cotton farmers due to the steel factory’s emissions
would have no impact on the financial bottom line of the steel factory, hence the managers of the
factory would have no economic incentive to reduce pollution. This type of situation is a classic example
of pollution as a negative externality and is illustrated by figure 2 below:
Figure 2 above shows that the mismatch between marginal private cost (MPC) and marginal social cost
(MSC) equal to the marginal external cost (MEC), leads to a quantity of emissions of q1 at a price p1
that is beyond the optimal level of Q* and p* leading to a net welfare loss equivalent to the area shaded
in red. Considering once again the steel factory example, the difference between the MSC and MPC of
steel production is the cost of pollution that is externalized to the cotton farmers. As a result of this
situation we can infer several conclusions about this economy: too much pollution is produced, the

22 | P a g e
price of steel is too low, as long as the costs are external there is no incentive to reduce pollution, and,
finally, recycling and reuse of pollutants is discouraged because emissions are inefficiently cheap36
.
Property rights, market failures and public goods
The previous section defined pollution as a form of market failure, although there may be
several different reasons for market failure, the root cause is the absence of clearly defined property
rights. According to Titenberg and Lewis 2009, well defined property rights must be exclusive,
transferable and enforceable37
. Air is considered a public good because property rights cannot
inherently be imposed on it, meaning that it is hard to exclude others from having access to it and the
consumption of it by someone does not reduce the amount available for others. As air is a public good,
most pollutants are all open-access resources which are equivalent in nature to a public bad38
. This
means that they are both non-excludable and non-rivalrous in consumption thus, as with air, no one can
be excluded from the effects of pollution and the consumption of pollution by one individual does not
reduce the amount of pollution consumed by others. Considering this public bad, the fundamental
question becomes: does the public have a “right” to clean air or do the firms have a “right” to pollute.
Ronald Coase in 1960 explores this question and comes to the conclusion that it does not matter which
party is assigned the “right” as long as property rights are clearly allocated39
. He argues that even if the
right is assigned to the firms allowing them to pollute, there would be an incentive for citizens to
increase their overall welfare by paying the polluters to reduce their pollution output without the need
for government intervention40
. Such a direct interaction between a polluter and the population is
referred to as Coasian bargaining. Although Coase’s theory has come under criticism due to its
unrealistic assumptions of no transaction costs and perfect information, the fact remains that the first
36
Titenberg and Lewis, 2012, p. 26
37
Ibid, p. 66
38
Ibid, p. 29
39
Coase 1960
40
Ibid, p. 2

23 | P a g e
and most important step towards resolving the pollution market failure is the assignment of clear
property rights. Left unregulated, the existence of such open-access resources often leads to scenarios
as outlined by Hardin 1968 “Tragedy of the Commons” where firms continue increasing emissions and
degrading the environment until the ecosystem is fully destroyed. Several decades ago, Hardin did not
only perfectly describe the problem but he also had a clear understanding of the solution. He stated that
given “the air and the waters surrounding us cannot readily be fenced, and so the tragedy of the
commons as a cesspool must be prevented by different means, by coercive laws or taxing devices that
make it cheaper for the polluter to treat his pollutants than to discharge them untreated”41
. Therefore,
in order to avoid this tragic outcome, governments on behalf of the public interest must intervene using
either regulations or market based approaches to environmental protection.
Optimal level of pollution
Proponents of the moral approach and many individuals unfamiliar with environmental
economics may believe that the optimal level of pollution is zero. However in most cases this would be
both economically inefficient and unnecessary. In fact the optimal level for pollutants such as CO2 is far
greater than zero. Because nature has the ability to absorb and recycle most pollutants to some extent.
In environmental economics terms, the optimal level of pollution will be a function of the social costs
and benefits the pollution provides. Specifically, environmental economists look at this situation in
marginal terms and illustrate social costs via the marginal damage cost (MDC) curve and use the
marginal abatement cost (MAC) curve as a proxy for benefits to society42
.
To explain how the MAC curve can be used as proxy for benefits to society, take the example of
a steel factory: the more steel the factory produces the more it pollutes. If this factory decided to reduce
41
Hardin 1968, p. 1245
42
Field and Field 2013, p. 99

24 | P a g e
its pollution output from x to x-y the easiest option would be to reduce the amount of steel it produces.
As a result of this decision the firm would lose out on potential profit and society would lose due to a
smaller supply of steel leading to higher steel prices. These combined private and social costs would
make up the total abatement costs needed for a reduction in pollution of y. Alternatively the steel
factory could invest in scrubber stack systems that would also reduce the pollution output by y; doing so
however also implies a cost as in order to invest in such a system resources would need to be taken out
of the economy. The MDC curve can be explained intuitively as every increase in pollution output leads
to an increase in environmental damages which represents a cost to society. The relationship between
the MAC curve and the MDC curve is illustrated by figure 3 below.
Figure 3: Optimal level of pollution
*MC, MB = Marginal Cost and Marginal Benefit
*

25 | P a g e
Based on figure 3 above, the efficient level of pollution is found at the level of emissions where
the MDC and MAC curve intersect. At this point, the cost of one unit increase in pollution in terms of
environmental damages is equal to the cost of one unit decrease in terms of abatement costs. This level
of emissions which we will refer to as Eefficient (E*) reflects a point of pareto-efficiency: where no increase
in emissions can create abatement cost savings sufficient enough to compensate for the extra damages
it will create and vice-versa43
. Furthermore, the sum of the area under the curve represented by a+b
reflects the total social costs arising from the efficient level of pollution. Note that the area is minimized
at the Eefficient level of pollution and that at any other quantity of emissions this area would be greater
indicating higher total social costs. Additionally the MDC curve does not necessarily begin at the origin
as for several pollutants such as CO2 the ecosystem will have a certain assimilative capacity allowing for
several tons of pollution to have essentially no damage costs to society44
. The key point of this section is
the theoretical framework that environmental economists use in order to assess the optimal level of
pollution. This is important because the first step for government looking to implement a pollution
control policy is to examine the relationship between these two curves and determine what the optimal
level pollution is. Once this is determined, government then needs to decide whether to use a command
and control or market based approach to reach this level of pollution.
43
Neumayer class notes
44
Pearce and Turner, 1990

26 | P a g e
Command and control vs market based instruments
History of air pollution control mechanisms
Before getting into the debate of command and control vs market based instruments it is
important to first consider some of the history surrounding pollution control. Government regulation
towards pollution control as we know it today has evolved from past theories and programs over the
last century. Problems with smog and the burning of coal date as far back as the medieval times in
England45
. Air pollution had such a massive effect on the quality of life in cities such as Manchester and
London that 1306 King Edward I was forced to issue proclamations to regulate the use of coal46
. In 1881,
Chicago and Cincinnati adopted air legislation in order to reduce the smoke emissions from local
factories47
. The decisions from these cities as well as King Edwards proclamations are both examples of
the earliest forms of command and control (CAC) programs. Another approach towards pollution control
known today as market based instruments (MBI) was initially proposed by an economist named Arthur
C. Pigou. He essentially was looking for a market based approach to reduce the negative externalities to
society of a new factory as discussed in the externality section. He proposed what is known as the
Pigouvian tax which forces firms to internalize the society costs of their pollution48
. Also known as
emission charges, the first example attempt to implement such a tax in the U.S. arose in 1970 when
“President Nixon recommended a tax of 15 cents per pound on sulfur-emissions from large power
plants”49
. Tradable permits on the other hand are another form of market based instruments that were
discovered following a series of micro-economic computer simulation studies conducted in 1967 for the
National Air Pollution Control Administration (predecessor to EPA)50
. The first large scale
45
Bowler, Catherine and Peter 2000, p. 80
46
ibid
47
http://www.ametsoc.org/sloan/cleanair/
48
Pearce and Turner 1990
49
50
Burton, Ellison, and William Sanjour 1967

27 | P a g e
implementation of tradable permits under the 1990 Clean Air Act which was meant to cut 50% of SO2
emissions responsible for acid rains by 2007. Although we will develop further on the history or
tradable permits in the following sections, this essentially provides an overview of the early history of
command and control policies and market based instruments.
Timeline of significant U.S. air pollution legislation
After understanding the history behind the tools that can be used to control pollution, we now
consider a history of air pollution legislation that has shifted over time from one side to the other on the
debate of CAC vs. MBI. Exhibit 1 in the appendix presents a detailed history of legislation from the
1950s onwards. The 1963 Clean Air Act was a law that initially provided funding for national air pollution
research and acted as the foundation for most of the U.S. air pollution legislation. In 1965 the Motor
Vehicle Air pollution control Act was the first major nationwide legislation to be implemented in order to
set vehicle emission standards. Five years later, in 1970 the EPA was created and the Clean Air Act was
amended to create a national campaign to reduce air pollution while still giving states the power to
choose the tools they would use to meet clean air standards. Prior to the 1990 Clean Air Act states and
the federal government overwhelmingly chose CAC policies over MBI’s. Stavins (1998) provides several
key reasons for why this was the case: first of all existing firms preferred CAC instruments as these
would often cost less than MBI’s to them and that CAC’s would often be more stringent on new sources
offering existing firms the advantage of higher barriers to entry in their industry51
. Legislators also had a
preference towards CAC as the setting of strict standards provided opportunities for symbolic politics
and more certain outcomes52
. At that time even environmental advocacy groups did not have a perfect
understanding of MBI’s and “frequently portrayed pollution taxes and tradable permits as licenses to
51
Stavins 1998, p 72
52
McCubbins, Noll and Weingast, 1989, p. 22

28 | P a g e
pollute”53
. These environmental groups also feared that MBI’s would be more difficult to tighten over
time as tax increases are never politically popular. Then in the late 1980s as the government began to
shift in favor of deregulation and began to look for ways to reduce its pollution control costs, MBI’s
started being reconsidered. In fact Stavins describes that “by 1990, the phrase “Market-based
environmental policy” had evolved from being politically problematic to politically attractive”54
. The
biggest driver for politicians shifting their mindset being the EPA estimates that a tradable permit
program would be 50% more cost effective than CAC55
. In 2014 the consensus seems to be that with the
exception of extremely harmful pollutants or crisis events, MBI’s are better than CAC policies due to the
economic and dynamic efficiencies they provide.
Command and Control (CAC)
53
Stavins 1998 p.72
54
Stavins 1998 p. 76
55
U.S. Environmental Protection Agency, Washington, D.C., 1989.

29 | P a g e
Figure 2 illustrates the straightforward manner in which CAC can be used to reach Eefficient. By outlawing
emissions beyond Eefficient, firms will be forced to spend on abatement costs (b) in order to reduce their
emissions to a legal level. The steepness of the MAC curve will in this case determine the level of
abatement costs needed to conform to CAC; the steeper the curve, the higher the compliance costs56
.
There are three different types of CAC environmental standards: ambient, technological and
performance based. Ambient standards set the maximum amount of pollutants that are allowed to be
emitted in a given area. For example, in 1970 the Clean Air Act specified “a system of national ambient
air quality standards (NAAQS)” that was applied across the country57
. Technological standards are based
on imposing the use of a given technology to reduce pollution. The requirement of catalytic converters
in cars is an example of a technology standard58
. Finally, there are performance based standards
otherwise known as emission standards which specify metrics such as the emission rate (pounds per
hour), emission concentration (parts per million) etc…59
.
Situations where CAC is the best option
In cases where the marginal damage costs (MDC) exceed the MAC even at the origin as shown
by figure 4 below, CAC becomes the optimal policy. It is important to take note of these situations
because in terms of policy recommendation, marketable permits such as tradable permits should not be
used under such circumstances.
56
Field and Field, 2013 p. 207
57
Ibid, p.307
58
Ibid, p. 214
59
Ibid, p.214

30 | P a g e
For example, figure 4 depicts the situation with chlorofluorocarbons (CFC’s), a pollutant that is a
dangerous contributor to ozone layer pollution and that has been banned in several countries following
the 1987 Montreal Protocol60
. CAC’s used here in the form of a production and consumption ban of
CFC’s because the efficient level of pollution was simply zero. Canadian researchers actually measured
the costs and benefits of the ban on CFC’s and noted that assuming the value of one human life being
$10 million, the future costs of CFC’s would be equal to over $3.2 billion, whereas the costs of
substituting CFC’s would only be about $194 million for Canada alone61
. Thus, in this particular situation
CAC is optimal. Two variants of figure 4 and this example occur either in a crisis situation as with smog in
L.A. where temporarily MDC becomes very high or when monitoring costs are exuberantly high, in each
of these scenarios CAC is optimal62
.
60
Turner et al., 1994, p.197
61
Smith and Vodden, 1989, p.420
62
Kahn, 1998, p.69

31 | P a g e
Issues with Command and Control policies
There are two major issues with CAC policies which pertain to its inability to achieve pollution
reduction at least cost and the lack of incentives for innovation that it provides. First, CAC does not
adhere to the equimarginal principle and therefore does not provide cost minimization. The
equimarginal principle holds that costs will be at minimum when production is allocated such that the
marginal costs of all polluters are equal63
. Figure 6 below illustrates how CAC creates a loss in efficiency
in situations where firms have different MAC’s.
Figure 6: CAC and Equimarginal principle
Firm 1 Firm 2
Firm 1 in figure 6 has a steep MAC curve meaning that it is a lot more expensive for this firm to reduce
pollution than for the average firm. The efficient level of emissions for firm 1 is actually A and not the
level imposed by the CAC policy. However given that firm 1 is obliged to comply with the CAC regulation,
it will need to spend extra amounts on abatement resulting in a net welfare loss equivalent to (a). Firm 2
is in an opposite situation, its MAC curve is less steep meaning that this it is cheaper for this firm to
reduce pollution than the average firm. The efficient level of emissions for firm 2 is once again A but the
63
Kahn, 1998, p. 232

32 | P a g e
CAC regulation allows it to pollute more than this. Given that there is no private incentive for the firm to
abate emissions beyond the regulation level, firm 2 will abate up until the CAC point resulting in a net
welfare loss equivalent to (a). Hence the issue with CAC policies is that they are set based on aggregate
MDC and MAC curves in an economy, because different firms tend to have different MAC curves as
illustrated in figure 6, the lack of flexibility from CAC creates economic inefficiencies.
Furthermore, the binary nature of CAC policies where an emissions level is either legal or illegal
does not allow the creation of any dynamic efficiencies. For example, if regulation holds that firm can
only emit 10 tons of pollution, once this firm reaches this level of emissions, there are no further
incentives for it to find ways to reduce emissions any further. Although in the beginning, once a CAC
policy is first implemented, firms may need to spend on abatement technologies to reach the legal level
of emissions, CAC policies do not provide any additional incentives for innovation after this. There may
even be a move against innovation if polluters fear that the government will set stricter standards if
better abatement technologies are discovered64
. These key contrasts illustrate how market based
instruments are superior in terms of economic and dynamic efficiencies.
Market based instruments
Taxes
MBI’s are theoretically superior to CAC because they respect the equimarginal principle and are
dynamically efficient. The two main types of MBI’s are tradable permits and taxes. The figure below
illustrates how taxes can be used to achieve the efficient level of pollution. Taxes are considered a
64
Neumayer 2013

33 | P a g e
market based instrument because they use the markets to indirectly reach their target by making it
economically inefficient for firms to pollute beyond the efficient level.
Figure 7: Taxes and efficient pollution level
Figure 1 above illustrates how taxes can be used to get the emissions level from Eprivate to Eefficient by
setting a tax at the t* level65
. Given that all firms and polluters are interested in profit maximizing, it will
be in their interest to spend on abatement as long as the marginal abatement cost (MAC) is lower than
the tax (t*), after which they will simply pay the tax for the remaining emissions. Hence the total cost to
the firm is equal to the sum of tax payments and abatement costs (a+b) and the reduction in emissions
will depend on the steepness of the MAC curve; where the steeper the curve, the less will be spent on
abatement66
. The flexibility that taxes provide with regards to firms adjusting their level of abatement
based on the steepness of their MAC is a key differentiator between taxes and CAC policies. Allowing
65
Turner et al., 1994, p.167
66
Field and Field, 2013, p.234

34 | P a g e
firms this flexibility enables taxes to respect the equimarginal principle and therefore achieve the
desired pollution reduction at least cost.
Constraints of tax regimes
Despite the fact that taxes are superior to CAC policies, they may not be the optimal pollution
control instrument. The main challenge with taxes lies in setting the appropriate level of taxation t*. As
illustrated by figure 7 above in order for taxes to be effective a tax of t* needs to be set exactly at the
level where the MAC curve intersects the MDC curve. This implies that in order to set the appropriate
tax level the government needs to know not only about the damage costs that the pollution is causing
(MDC) but also needs to know about the firms individual abatement costs (MAC). Pearce and Turner
(1990) make the argument that in practice due to commercial confidentiality of information the taxing
authority “is in a poor position to extract this information” leading to an asymmetry of information
between the polluter and the regulator67
. Hence the lack of perfect information with regards to the MAC
and MDC curve often leads in practice to a tax t* that is either too high or too low. Regulators often try
to use a trial and error approach to find the optimal level of taxation but in any case this pollution
control instrument leads to inefficiencies in practice. Therefore I would argue that tradable permits
provide a better alternative for achieving the optimal level of pollution as this instrument does not face
the issues of CAC policies and is not restrained by information asymmetry issue that taxes face.
67
Pearce and Turner, 1990, p. 85

35 | P a g e
How tradable permits programs work
Cap and trade programs vs credit trading programs
A cap-and-trade (CAP) tradable permit program allows an economy to reach the efficient level
of pollution by creating a quantity of pollution permits equivalent to Eefficient,, and allowing firms to trade
these permits with each other. Each permit is equivalent to one unit of pollution, i.e. 1 ton of carbon.
Another less common form of tradable permits are credit trading programs (CRE’s) where firms can sell
credits to new entrants or other firms wishing to expand their operations after they reduce their
emissions below their set CAC standard68
. For example, CAC regulation could enforce that a factory only
emits 5,000 tons of pollutants. If this firm wishes to build a new plant at another location that will emit
2,000 tons of emissions, it can do so by reducing its emissions by the same amount at its first plant.
Essentially, CRE’s provide flexibility to existing CAC programs in order to make them more cost efficient.
However, CRE programs are less popular because they imply the setting of firm specific standards rather
than an aggregate or region wide cap on emissions which implies higher administrative costs thus
reducing the economic efficiency of such programs in comparison to CAP programs69
(See exhibit 2). For
the purposes of this essay and the remainder of this analysis we will therefore focus solely on CAP
programs.
Illustration of CAP vs CRE (Project Based)70
68
Field and Field 2013 p. 258
69
EPA, 2003
70
EPA, 2003

36 | P a g e
CAP program example71
Consider the case of a region with various power plants producing sulfur (SO2) emissions.
Assume the power plants are emitting 150,000 tons of sulfur per year. A government agency (EPA in the
U.S.) has just come out with a study of the effects of sulfur in the ecosystem of the region concluding
that the optimal level of emissions is only 100,000 tons. Policymakers choosing to implement a CAP
program would therefore issue only permits equivalent to 100,000 tons of sulfur per year and distribute
these permits amongst the existing power plants. This will most likely result in power plants receiving
permit allocations that are less than their past levels of emissions. For example a plant that was emitting
7,000 tons of sulfur may now only receive permits worth 5,000 tons; the manager of such a firm would
face three choices. First, abate emissions by 2,000 tons and reach the level of emissions granted to him
by his permits. Second, buy 2,000 tons worth of permits from other firms to keep emitting at past levels.
Third he could abate beyond the 5,000 tons of permits he possess and sell off the excess permits to
other firm. The decision the manager will take would depend on the MAC curve of the firm relative to
other firms in the industry. Note that the choice to buy or sell permits, increasing or decreasing the
emissions a firm is allowed to produce is one of the key differentiators between tradable permits and a
simple command and control policy forcing firms to reduce emissions to 5,000 tons72
.The existence of
such a choice plays an important role in increasing the economic efficiency of the pollution reduction.
Tradable permits and the equimarginal principle
As mentioned in the previous paragraph, the ability to trade permits greatly improves the
economic efficiency as it allows tradable permit schemes to adhere to the equimarginal principle which
is essential to achieving pollution reduction at least cost. The equimarginal principle holds that in order
71
Adapted from Field and Field 2013 p. 258 example
72
Kahn 2005 p. 77

37 | P a g e
“to get the minimum aggregate marginal abatement cost curve, the aggregate level of emissions must
be distributed amongst the different sources in such a way that they all have the same marginal
abatement costs”73
. Given that firms do not all have the same MAC curves this creates an economic
incentive for firms to trade permits with one and other in order to minimize their pollution reduction
costs and satisfy the equimarginal principle. This is important because pollution control policies that do
not meet this principle (such as CAC) create an artificial inefficiency in the economy. If polluters cannot
reach their optimal level of pollution at least cost, the excess resources that are required to meet the
pollution control target are taken out of the economy reducing its overall output.
Consider two power plants from the previous example and figure 5 below where one plant
(source 1) is reflected by MAC1 and the other (source 2) by MAC2. Suppose that the government decided
to cap total emissions at 25 tons of sulfur in aggregate and initially allocated 15 permits to source 1 and
10 permits to source 2. Considering that both firms initially were emitting 25 tons of sulfur this implies
that source 1 will have to reduce emissions by 10 tons to reach its permit allowance and source 2 would
have to reduce emissions by 15 tons. In this scenario, the pollution abatement costs for source 2
represented by C would be a lot higher than the costs for source 1 represented by A. Source 2 would
therefore have an incentive to buy permits from source 1 as long as the cost is lower than C. On the
other hand source 1 would have an incentive to further reduce its pollution and sell excess permits to
source 2 as long as the price was higher than A. Hence an incentive for trade exists until the marginal
abatement costs of both firms are equal at price B which is the point on figure 5 where the two MAC
curves intersect, thus respecting the equimarginal principle where MAC1 = MAC2. In this situation source
1 would essentially have abated 15 tons of sulfur emissions and sold 5 tons worth of permits to source 2
which only would have abated 10 tons of sulfur emissions.
73
Field and Field 2013 p. 99

38 | P a g e
Figure 5: Cost Effectiveness and trading incentives74
The example illustrated by figure 5 is a simplification of the mechanism which outlines reaches the
desired level of pollution reduction at least cost. However a more comprehensive model can be
developed by considering an economy with multiple firms either seeking to buy additonal permits or
looking to sell. This would lead to a typical supply and demand model for permits as represented by
figure 6 below, where “in any particular year there would be a tendency for a market price to establish
itself such as p* and for certain number of permits to change hands such as q*”75
.
74
Adapted from Titenberg and Lewis 2009, p.374
75

39 | P a g e
Figure 6: Market for tradable permits
In order for figure 6 to reflect an optimal market there would need to be no transaction costs for trade
and perfect information on all buyers and sellers in the market. The latter is an important assumption
for which theory and practice may differ as it will be explored further in this essay. Essentially once such
a market for permits is created, polluters whose abatement costs are greater than the price of a permit
will choose to reduce costs by purchasing permits and polluters whose abatement costs are below will
make a profit by further abating and selling excess permits76
. In either case through the two firm
example of figure 5 or the more realistic market wide scenario of figure 6, one of the greatest
advantages of emissions trading is its ability to reduce emissions at least cost by respecting the
equimarginal principle.
Dynamic Efficiency of tradable permits
A second advantage of tradable permits is that such a policy provides firms with an incentive to
innovate and improve pollution reduction technologies. Referring back to the section on pollution’s
impacts on the production possibilities frontier, recall that the only way to reduce the impact that
76
Kahn 2005 p. 77

40 | P a g e
pollution has on an economy’s production output is by improving pollution reduction technologies
which allow for a greater amount of reduction using less resources. This is why an important criteria for
environmental policy is the level of incentives it creates for technological innovations otherwise known
as dynamic efficiency77
. To illustrate how tradable permits provide firms with an incentive to innovate
consider figure 7 below where MAC1 represents the initial abatement cost curve of a firm and MAC2
represents the cost curve following a technological improvement. Note that following this improvement
the steepness of the curve diminishes as it now requires less resources (costs less) to reduce a similar
amount of pollution. With a permit price of p the firm would reduce its overall pollution from e1 to e2.
Initially its total pollution control costs were reflected by its abatement costs (a+b) and its permit costs
of (c+d+e). With this technological improvement its total pollution control costs would only be (e+d+b),
implying cost savings of (a+c) to the firm. In addition to these cost savings, the cap and trade approach
leaves to the firm the option to choose the manner in which it improves its MAC curve. This further
encourages innovation as firms who can develop and patent superior pollution control technologies can
gain a competitive advantage over competitors.
Figure 7: Dynamic efficiency of tradable permits78
77
78

41 | P a g e
Thus the main argument that figure 7 provides in terms of the dynamic efficiency of tradable
permits is that so long as the R&D costs for a firm to improve from MAC1 to MAC2 are less than (a+c)
there is a strong economic incentive for the firm to so. A secondary positive benefit of this technological
improvement is that the firm ends up polluting less at it emits at e2 rather than e1. However the
counterargument to this case would be that governments could use these technological improvements
as an argument to further reduce the overall emissions cap which could drive up permit prices and
reduce the incentive for a firm to innovate. Overall however most tradable permit schemes operate
based on phases where the cap is reduced based on a pre-determined schedule independent of the
technological changes and therefore it is important to consider the incentives for dynamic efficiencies as
the second biggest advantage of tradable permits.

42 | P a g e
Why are tradable permits so attractive?
Following the success of the 1990 clean air act for SO2 trading as well as the launch in 2005 of
the large scale EU ETS program, governments have begun to increasingly consider and implement
tradable permit programs around the world. According to the International Carbon Action Partnership
(ICAP), there are now “16 countries in the world with active emissions trading schemes” and several
others with programs in the pipeline79
. There are several reasons why tradable permit use is on the rise,
the first being described by Stavins 1998 who indicated that over the last two decades policy makers
have been increasingly in favor of market based approaches80
. Furthermore, Pearce and Turner (1990)
highlight six key attractions that tradable permits have over other policies. The first two being the cost
minimization and technological incentives provided through the equimarginal principle and dynamic
efficiency concept respectively. Third, permit provide opportunities for new entrants to either buy
permits or invest in pollution control equipment. Fourth, non-polluters are also empowered to purchase
permits which can allow environmental groups to buy and retire permits from the market reflecting the
true socially optimal level of pollution. Fifth, the price of permits will automatically adjust for elements
such as inflation which is a key advantage that tradable permits have over taxes. As with taxes, finding
the optimal tax rate can be tricky as abatement costs and the economy changes. Finally, tradable
permits can be adopted using zoning to avoid the spatial problem of location sensitive emissions.
Essentially, tradable permits are an attractive and increasingly popular approach to pollution control
which is why it is relevant to study the elements that enable a given tradable permit program to succeed
or fail.
79
ICAP 2014, p.21
80
Stavins 1998, p 72

43 | P a g e
Part 2: Characteristics of a tradable permit system
The previous section outlined the pollution issue from an economics perspective, presented
various broad mechanisms that can be used to mitigate this issue and ended by suggesting that tradable
permits are the optimal solution for pollution control. The following section aims to take a deeper look
at the characteristics and nuances that make up different tradable permit systems. Because in order to
compare various tradable permit systems it’s important to first understand the underlying features that
make up these programs.
The EPA in 2001 set out eight basic parameters that can be used to characterize the key features
of trading systems81
. This section will be structured around these features and look broadly at three
distinct categories: characteristics relating to the initial design, characteristics relating to program
operation and characteristics relating to the macro-economic environment. Features relating to initial
design are defined as the elements of the program that policy makers must decide on to first implement
the program. These first elements answer questions such as: what is being regulated, with whom can a
firm trade, how permits will initially be allocated and how many permits will be available. Characteristics
relating to program operations will dictate how the latter is managed and regulated. These features will
address issues such as: how are emission levels regulated, what are the penalties for non-compliance
and how are they enforced. Finally the macro characteristics will look at broader indicators that can be
used to understand the macro-economic environment in which a given policy is being implemented.
81
EPA 240-R-01-001

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Initial Design Characteristics
Scope
The first key characteristic refers to the scope of permitted trading activity, defining with whom
a given firm can trade permits with. The scope of the tradable permit regime can go from extremely
limited to somewhat flexible and completely broad. A system in which one firm can only trade emission
permits with itself within a single product location would be an
example of an extremely limited scope. This scope could be widened
by allowing the same firm to trade emission permits across several of
its own production facilities within a broader region. For example a
power company could choose to reduce pollution by 20 permits at
location A and thus increase pollution by the same amount at
location B without facing any penalties. This type of scope however is
still quite limiting and economically inefficient given that the power
plant cannot trade emission permits with other firms in the region.
Thus a broader type of scope would allow for trading of permits
amongst various firms in a given region or country82
. Most of the
tradable permit schemes covered in this comparative analysis will
follow this scope. As expressed in section 1 it is the ability to trade
with other firms possessing different MAC’s that allows tradable
permit mechanisms to follow the equimarginal principle and achieve
pollution reduction at least cost83
. Hence it appears that the broader
the scope of the tradable permit scheme the more economically
82
OECD, 2006, p. 34
83
Field & Field, 2013, p. 59

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efficient it is. This makes sense in theory as in any given market; an increase in players within the market
would lead to an increase in liquidity and efficiency.
Carbon offsets
A different way to extend the scope of a tradable permit programs dealing with greenhouse gas
emissions is through the use of carbon offsets. These offsets are generated by carbon negative activities
such as reforestation, carbon capture or other activities of this nature84
. Companies, governments or
other entities can in some tradable programs purchase these offsets in order to reduce their overall net
emissions and comply with the cap. Because greenhouse gas emissions have global impacts, the offsets
can be purchased from anywhere else in the world. The most widely used type of offsets are CDM-
approved certified emissions reductions. These were established as part of the Kyoto Protocol which
created the Clean Development Mechanism (CDM) that is mandated to validate and measure projects in
order to ensure that they produce real benefits85
. This validation is important because there have been
several cases of fraud or malpractice with carbon offsets, where farmers sold offsets for forests that
either did not exist or were protected against deforestation regardless. For these reasons, carbon offsets
have been quite controversial due to their low prices and inability to be accurately measured. The
Carbon Trust therefore recommends careful due diligence before purchasing offsets and that the
government limit and further control their use in tradable permit programs86
.
84
States and Trends of Carbon Market, 2014
85
Stern, 2006, p.613
86
CarbonTrust Organization

46 | P a g e
Linked vs confined emissions trading system
Following this logic some scholars and policy makers have suggested increasing the scope
beyond geographical boundaries through the use of linked-exchange systems. The EU announced in
August 2012 that it will be linking its cap and trade exchange system with Australia by July 201587
. This
linked exchange will allow Australian firms to trade carbon permits with European firms and vice-versa.
Jaffe and Stavins identified two separate forms of linking: direct links and indirect links88
. Exhibit 5
illustrates the differences between these two types, where in a direct link program trade is done directly
between two parties and in an indirect link trade program, trade is facilitated by a third party89
. In
either system, demand or supply changes in one of the programs will ultimately affect the other
program resulting in a uniform price per permit across the two systems. Due to arbitrage pricing theory,
the price per permit in one area cannot be different than that in another area as since these areas are
linked an arbitrageur could buy permits in the cheaper area and sell them in the more expensive area
and yield a riskless return. The main advantage of linked exchange systems is that it can improve market
liquidity and reduce compliance costs as economies are generated by having to regulate one larger
market instead of two separate ones90
. Jaffe and Stavins however also raise some concerns about linked
exchange systems stating that “it can reduce national control over the design and impacts of domestic
tradable permit system”91
. Ross and Stevens, (1993) found that linked exchange systems could raise
equity concerns when trading with countries that are not as advanced in pollution abatement
technologies92
. Therefore, linked exchange systems may not always provide the best solution and policy
87
European Commission, Climate action website
88
Jaffe and Stavins, 2008
89
Ibid, p.8
90
Ibid, p. 10
91
Ibid, p.11
92
Rose & Stevens, 1993, p.128

47 | P a g e
makers must carefully consider whether or not too link with other programs when setting out the scope
of their tradable permit scheme.
Cap
A second element of as set out by the EPA in 2001 refers to the use of an explicit limit on
aggregate emissions. This characteristic was discussed previously and outlined as branching out into two
wide categories: cap and trade programs and credit trading programs. To reiterate, the difference
between the two lies in how the cap is set. For credit trading programs, the administrator of the
program would set individual caps for each individual firm and then if a firm pollutes less than their cap
they can make a profit by selling the difference to a new entrant. A cap and trade program on the other
hand is a lot less complex as the administrator only needs to set the total amount of permits available
for all firms within a region and then can allow firms to trade amongst themselves. Policy makers must
choose between these two types of programs as well.
Commodity being traded
Different permit programs are characterized by the types of pollutants that are being traded.
Tradable permit systems have been used to manage a wide range of environmental issues, from
fisheries to water resource protection and solid waste management. Depending on the use, the
“commodity being traded” will differ and the tradable permit system must be adjusted accordingly. For
example there are heterogeneous, location based, pollutants such as SO2 and NOx and there are
homogeneous pollutants such as CO2, N2O, PFCS, CH4, HFC, SF6. The difference between heterogeneous
and homogeneous pollutants is important because a given tradable scheme cannot treat both pollutants
the same way.

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Heterogeneous pollutants (SO2 and NOx)
Heterogeneous pollutants are problematic for tradable permit programs as the location from
which the emissions come down affects the severity of the damage that these emissions cause.
Consider the situation illustrated by figure 8 below of a region where multiple emission sources are
located around a highly populated area and the prevailing winds are blowing in the direction of the
arrow. If each source is emitting SO2 or NOx emissions, it would be false to assume that the impacts of
one ton of emissions from a source to the right of the highly populated area is equivalent to the impacts
of a source to the left. This is due to the fact that acid rain, which is the main negative byproduct of
these emissions has local effects. Considering the relationship between acid rain and the increased risk
of “illness and premature death from heart and lung disorders, such as asthma and bronchitis”,
emissions that will affect a highly populated area will cause higher total damage costs than emissions
that come down at a distance from these areas93
. Thus considering the figure below, if firms to the right
of the populated area are allowed to trade permits with firms to the left, on a one for one basis, a
tradable permit scheme where even though the total amount of emissions is reduced could make
matters worse for this region: this issue is referred to as a the hot spot problem94
. To overcome this
problem, administrators might decide on fixed trading ratios for each permit trade based on the location
of the trading parties95
. For example, administrators could state that for every 2 permits sold from a firm
to the right, a firm to the left would receive the equivalent of 1 permit worth of emissions. In theory,
setting such rules in proportion with the damages caused by the location of the emission source would
eliminate the hot spot problem, but in practice it would become highly complicated to implement as
each trade between hundreds or thousands of different firms would need to be examined. Hence
proponents of tradable permits for heterogeneous pollutants have proposed using a zoned system to
93
EPA
94
Kahn, 2005, p.78
95

49 | P a g e
overcome these issues. A zoned system would consist of grouping sources around a similar location and
then either only allow trade to occur between firms that are in the same zone, or apply the trading ratio
methodology discussed previously for firms that are trading across zones96
. For example, in figure 8
below, A, B, C and D delimit the various zones that can be created in order to overcome the hot spot
problem without creating impractical complexities.
Figure 8: “Hot spot” problem caused by heterogeneous pollutants
Homogeneous pollutants (CO2, N2O, PFCS, CH4, HFC, SF6)
Homogeneous pollutants on the other hand are much easier to manage as they are not prone to
the hot spot problem. The location of the firm is irrelevant to the level of damage that one unit of
emission will cause. This is due to the fact that each of these emissions is considered a greenhouse gas
which mixes in almost instantly into the atmosphere and has global rather than local impacts97
.
Greenhouse gases are problematic as they lead to a warming up of the atmosphere as they trap infrared
radiation. Thus one ton of CO2 emitted would have the same total damage cost regardless of the
96
97
EPA

50 | P a g e
location in which the emissions source is in figure 8 above. By this reasoning, it would make sense to
have a global price for carbon dioxide or methane. Therefore, for such pollutants administrators can
allow for non-location based, one for one permit trading, and broaden the scope of a given tradable
program to global proportions.
Differences amongst various greenhouse gases
In the U.S. carbon dioxide accounts for about 82% of all U.S. greenhouse gas emissions from
human activities according to the EPA, however there are three other major types of greenhouse gases
with harmful effects98
. These gases are methane, nitrous oxide and fluorinated gases. Each of these
affect the atmosphere in different ways as they each have a different lifetime in the atmosphere and
different global warming potential. For example, one pound of methane (CH4) has a global warming
potential equivalent to 21 pounds of CO2 but only has a 12 year lifetime in the atmosphere99
. Further
details and information on each of the gases can be found in exhibit 8. Essentially, the key message is
that the different characteristics of these gases must be considered and although the location of these
emissions does not matter, the chemical makeup does, therefore a permit for one ton of CO2 cannot be
interchanged with a permit for one ton of methane (CH4). Careful consideration of the total damage
costs of the commodity being traded is crucial to the initial design of a tradable permit scheme.
Proportion of greenhouse gases
Source: EPA
98
http://www.epa.gov/climatechange/ghgemissions/gases/co2.html
99
http://www.epa.gov/climatechange/ghgemissions/gases/ch4.html

51 | P a g e

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Distribution of tradable permits (initial allocation)
Potentially one of the most controversial characteristics of a tradable permit program is the
manner in which permits are initially distributed. For the last few decades, academics and politicians
have been debating on the “optimal allocation method”. The administrator of a tradable permit scheme
faces two options, one they can auction off the permits or they can allocate them to existing firms
following a set of rules100
. From a purely theoretical perspective, Cramton and Kerr (2002) argued that
auctioning off permits is economically more efficient and a superior methodology to any other
approach. However, Abrell, Faye & Zachmann (2011) found some empirical flaws with the auctioning
approach. Part of this debate was picked up in the literature review section of this paper, however
below are the main advantages and disadvantages of each approach.
Auctioning
The mechanics of allocating initial tradable permits through an auctioning process are fairly
simple and straightforward. For example, if a government decides to implement a CO2 cap and trade
program and wants to initially allocate permits using an auction, here are the steps that they would
take. First they would need to set the units of what a permit represents, in this case one permit could
equal one metric ton of carbon. Then they would announce their desire to sell a fixed supply of identical
permits and allow buyers to express “their willingness to buy various quantities at various price levels by
submitting bids at auction”101
. There are three different types of auction methodologies that can be
used at this stage: sealed-bid auctions, ascending auctions or ascending-clock auctions (for further
details see Cramton and Kerr, 1998). Cramton and Kerr (1998) recommend that “carbon permits should
be auctioned off on a quarterly basis using a standard ascending-clock design. This type of auction sets a
price per permit and asks for bidders to submit a quantity that they are willing to buy at that price, if the
100
101
Cramton and Kerr, 1998, p. 5

Comparative Analysis of Tradeable Permit Schemes

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