Markets for Pollution Allowances: What Are the (New) Lessons? (Digest Summary)

The author begins by providing a historical overview of the market and the economic rationale for implementing a cap-and-trade program. He then reviews existing programs to measure their efficacy in comparison with other policy prescriptions and concludes that the programs have been successful overall in reducing pollution to targeted levels while also providing an economic benefit compared with less flexible policy options. Finally, the author identifies where these programs can be improved to take into consideration heretofore unexpected challenges. He focuses on prior research and observations of current events rather than data-driven research.

As climate change and other environmental challenges become more prevalent in many developed economies, policymakers continue to propose policy prescriptions to control pollution excesses. Although many regulatory schematics have been proposed, the most popular and seemingly most efficient form of regulation is cap-and-trade programs. The author presents key lessons about these programs, including pros, cons, and previously unidentified challenges.

He begins by providing a historical overview of cap-and-trade programs, which are functionally simple. First, regulators specify the total amount of aggregate pollutants allowable. Next, the regulatory agency distributes the allowances either through an auction program or through free provision. Finally, the agency provides the ability for firms to trade those allowances. In theory, firms with the highest costs for emissions reduction would rather buy allowances from firms that can reduce their emissions relatively cheaply than comply with existing restrictions. This trading allows market participants to reduce marginal costs until market equilibrium is reached.

The author reviews a number of existing programs, finding several that have been able to reach specified pollution targets or have provided significant cost reductions relative to conventional policy approaches. Programs in which there is definitive oversight and compliance are classified by the author as successful in keeping aggregate pollution or greenhouse gas emissions to targeted levels. In the author’s estimation, difficulty in pollution output monitoring, such as for “nonpoint” sources of water pollution often found within the agriculture sector, and insufficient incentive for compliance, such as with the Kyoto Protocol, limit the efficacy of these programs.

The other measure of success—cost reductions—can only be estimated because the number of cap-and-trade programs versus other regulatory approaches is limited. Nonetheless, economists have been able to estimate the cost savings of these programs; one program in particular yielded cost savings between 15% and 90% versus the savings of conventional forms of regulation.

Although the author identifies benefits of successful cap-and-trade implementation, he also identifies a number of unforeseen challenges. Interactions with other regulations—particularly in the United States where state regulations are sometimes stricter than federal regulations—can offset the aggregate national initiative.

Another issue arises when firms within a cap-and-trade program actually benefit from higher allowance prices. For some electric companies, higher allowance prices can be incorporated into the base rate that they can charge their customers, which yields incremental profits to the companies.

A third unintended consequence comes from the supply inelasticity of the allowances; the supply of allowances is dependent on government policy decisions. As such, during short periods of time, shifts in demand can cause significant price volatility.

A final area that could have a profound impact on the success of a cap-and-trade program is the way allowances are distributed. Currently, the regulating authority can auction allowances, award them freely, or use some combination of both. In a partial equilibrium analysis, this decision is irrelevant because the process of trading allowances will set the market equilibrium price. When taking into consideration the interactions with the fiscal system in a general equilibrium framework, this result no longer holds. By giving away allowances, the government is yielding potential revenues that could then be used to reduce other taxes that may have a distorting effect on the economy. Thus, the overall benefit of the program is reduced. Although allowances have primarily been given away in the past, many cap-and-trade programs are transitioning to an auction-based methodology and economic benefits are shifting from companies to tax payers.

Pollution markets have been around for nearly 40 years, but the actual implementation of these programs is still limited. Thus, it is still too early to consider cap-and-trade programs a panacea for all efficiency-related environmental goals. The author concedes as much and states that other policies are necessary as well.

Up until this point, cap-and-trade has been a popular policy prescription for several reasons that are seemingly not environmentally sound. First, cap-and-trade is not branded as a “tax,” although there is no inherent difference between it and a pollution tax; both approaches effectively impose a cost for each additional unit of emission. Second, with the increased appetite for an auction-based distribution methodology, government agencies are able to collect additional revenues. Finally, there is great appeal for regulators to control the pollution quantity explicitly allowable.