Micro 17 - Pollution Permits

Question 1

Background - pollution

Answer 1

> The manufacturing industry often entails the creation of negative externalities in the form of pollution.
May include the emissions of harmful gases (CO2, nitrogen dioxide, greenhouse gases). This is particularly common in the energy industry , which is highly dependent on the combustion of fossil fuels.

Question 2

Traditional methods to tackle pollution

Answer 2

> Traditional methods of intervention include taxation and subsidising cleaner alternatives (wind+solar energy).
But there are shortcomings with these methods.
One popular intervention is the introduction of tradable pollution permits.

Question 3

Pollution permits

Answer 3

> The EU carbon emissions trading scheme (EU ETS) was launched in 2005 and applies to all EU members as well as Norway, Liechtenstein and Iceland.
A simple summary of how it works is that industries that emit harmful substances (most often CO2) are periodically issued permits to pollute by the government.
The quantity of permits issued will determine how much pollution can be legally released by firms over the given time period.
The permits can either be auctioned off at the beginning of the year or allocated for free to all firms.
If firms emit more than their permits allow, they’re fined.
This deters firms from exceeding the targets set by the government.
If a firm has a relatively clean production method then it may not require all the permits it has been allocated.
If a firm has a relatively unclean production method then it will run out of permits before the end of the year.
So the ‘clean’ firms can sell their permits to the ‘dirty’ firms as a source of revenue.

Question 4

Consequences of pollution permits

Answer 4

> The consequence is that firms are incentivised to improve their technology and production techniques in order to reduce emissions.
Those who emit less per unit produced may be able to turn these improvements into revenue from sales of permits.
Firms that don’t reduce emissions face higher costs and consequently, may have to reduce production or seek ways of reducing emissions.

Question 5

Market diagram for tradable permits

Answer 5

> The EU ETS, and other tradable pollution permit schemes, work by creating a carbon (or whatever pollutant is being controlled), making companies carefully consider the amount they emit.
Unlike other gov. interventions where we show the market for a particular good that causes the externality, here we can draw the market for CO2 itself, a market that didn’t exist until the introduction of tradable pollution permits.

Question 6

Diagram explained for pollution permits

Answer 6

> Government sets level of pollution allowed.
Permits are issued to match this level.
If permits aren’t used, they can be sold.
If a firm breaks the pollution limit, they’re fined.
Supply curve needs to be vertical as it’s fixed.
Costs of production increase due to permits so supply shifts left, reducing Q.

Question 7

Advantages of pollution permits.

Answer 7

1. Incentive to decrease pollution (can sell permits for profit). Can decrease pollution by investing in new technology, improve efficiency.
2. Government can set Q1 equal to Q* (the allocatively efficient level) so welfare is optimised. I.e. reduces level of pollution to socially optimal.
3. Market-based solution.
4. Efficient and equitable solution for firms. Efficient as it can solve market failure and equitable as it doesn’t hinder firms too much as they still have choices. Firms won’t be overly disadvantaged as CoPs won’t sky rocket as they have the option to invest if cheaper or if investment is more expensive they can just buy permits.

Question 8

Problems - pollution permits

Answer 8

1. Deciding on the level of pollution allowed? How does it know the socially optimal level?
2. High administration costs to distribute and allocate permits. Difficult and expensive to enforce.
3. The fines may not be strict enough. If the fine is less than the cost of reducing pollution or buying permits then the firms will just take the fine.
4. Geographical distribution. May get an area like US where the firms buy all the permits. Pollution concentrated in one place.
5. Need for international cooperation as it’s a global problem. Global market failure.

Question 9

Pollution permits - depnds on…

Answer 9

1. The level of information that the government has. If the information is good and the gov. actually knows what the socially optimal level of pollution is, the policy will be more AE.
2. The number of firms that are able to reduce pollution in the first place. If not enough permits are allocated and lots of firms find it difficult to reduce pollution, the policy will be massively inefficient. Won’t be many spare permits to sell on, costs to firms will be too high, driving them out of business. Mass gov. failure.
   >Increased CoPs = decrease in international competitiveness if other countries don’t use permits.