Governments often face challenges in accurately estimating the environmental costs of pollution caused by individual firms. Setting appropriate taxes or quotas for each firm can be complex and inefficient. A practical solution to this problem is the introduction of tradable permits. This allows the firms, with full knowledge of their own production and emissions abatement costs, to efficiently pursue their most efficient level of production and emissions through mutually advantageous trade with other emitting firms.

What Are Tradable Permits?

Tradable permits are government-issued rights that allow firms to emit a certain amount of pollution. Each permit corresponds to a specified quantity of pollutants, such as sulfur dioxide (SO2). Firms that are more efficient at reducing their emissions below the permitted levels can sell their unused permits to other firms that are less efficient at emissions reductions and expect to exceed their emissions limits. This creates a market for pollution control, where companies can trade their emissions permits based on their relative efficiency in achieving improved environmental performance.

How the System Works

1. Permits Allocation: First, the government sets an optimal, overall cap on the amount of pollution that can be released into the environment by a given industry. It then distributes a certain number of permits to each of the firms that allow for the emission of a set quantity of pollutants to be emitted. The total of these permits is equal to the overall cap.
2. Trading Mechanism: Firms that can reduce their emissions at a relatively lower cost to other firms in the industry now have an incentive to invest in cleaner technology. They can then recoup some of their emissions reduction costs by selling their surplus permits to those firms that find it relatively more expensive to reduce their emissions.

This market-based system not only ensures that pollution stays within the government's set cap, but it also encourages the most cost-effective reductions for achieving the socially optimal emissions cap.

Example of Tradable Permits in Action

Consider two firms, X and Y, that are both involved in producing the same output. While they use different production technologies, both firms produce SO2 emissions. The government determines the optimal level of total annual SO2 emissions for the industry and sets a cap of 200 tons of SO2 per year. It then issues 100 permits to each firm. Firm X finds that it can afford to adopt a new production technology, thereby reducing its emissions to 80 tons annually without reducing output. This means Firm X now expects to have 20 extra emissions permits for the year. Firm Y, however, finds it too costly to adopt a new production technology without significantly reducing output. As a result, it expects to exceed its emissions allowance by producing 120 tons of emissions annually. However, Firm Y can purchase the 20 extra emissions permits from Firm X to comply with government regulations. There may be a market price for the permits that is cheaper for Firm Y than adopting the cleaner, new production technology, and helps Firm X recoup some of its costs for adopting the new, cleaner production technology. In this way, tradable permits create a market that benefits both parties while achieving the government goal of reduced total emissions each year.

Success in the U.S.

The U.S. has successfully implemented a tradable permit system to reduce SO2 emissions, which has been particularly helpful in controlling acid rain. This approach has demonstrated how market incentives can effectively manage pollution emissions while allowing businesses to exercise flexibility in how they collectively meet socially beneficial environmental standards.