Question

In 2012, the state of California implemented a system of quanitity regulation of greenhouse gases, which included tradeable permits. This “cap-and-trade” program for greenhouse gas emissions distributes a fixed amount of greenhouse gas “allowances” to large emittes of greenhouse gases, such as electric power stations and large industrial plants. Plants may then purchase additional greenhouse gas emission allowances at auction, or, alternatively, may purchase unused allowances from another polluter. Theory predicts that this trading system will lead to a socially efficient allocation of pollution. Describe how such an outcome would occur.

Answer 1

If the pollution allowance level was correctly determined, an auction would lead to socially efficient distribution of allowances across companies. Companies with the most benefit from the right to pollute – say, because the technology to reduce pollution is very expensive for their specific industries or production – would pay the most for the good. Those companies would therefore offer more at the auction and receive the allowances. Unternehmen, which find it easy, would be less prepared to pay for the rights to pollute, adopt environmentally friendly technologies during the production process and would therefore not bid so much at the auction, receive fewer allowances or even become a net seller of allowances. This would allocate allowances to companies which can not easily reduce their emissions, while firms which can easily reduce their emissions would do so rather than purchase allowances, which continue to pollute. This is the socially effective result: pollution could be reduced and pollution could be reduced as cheaply as possible by companies. The classic solution to the greenhouse gas emissions problem is the coasian one.