Question

Mitigation methods to address CO₂ emissions include both emissions fees (taxes) and tradable emissions permits (Cap and Trade). Describe specific circumstances (A) in which fees would be more cost effective in achieving a target, and (B) circumstances in which tradable permits would likely outperform fees.

Answer 1

The government sets a permissible level of pollution that a firm can produce along with the goods that it produces. The firm that produces below or equal to that level does not face any penalty.Some firms may find it easy to reduce pollution levels below the permissible level and some may find it difficult. The firm that can easily reduce pollution below emission levels set can sell their remaining 'right to emit' to the firm that is not able to do so. Each firm in the market will compare the market price of emission credit to the cost of reducing emissions and decide whether its more cost effective to reduce emission or purchase the emission credit from the other firm. At equilibrium the market price of emitting one unit of pollution will be equal to the marginal cost of reducing emissions by one unit; condition characterising the optimal level of emission.The market of permits produces efficient pattern of emission. This is how externality is internalised. In emission fees,a firm faces a cost of producing pollution. The cost of per unit of pollution is fixed but the quantity of emission is uncertain whereas n tradable permits the level of emissions is fixed.

a. Market based policies are based on optimum allocation of goods and market is divided between all the pollutant firms equally or based on the level of emissions which gives an efficient and optimum allocation. On the other hand command and control policies are not based on efficient and optimum allocations and impose fines and penalties and thus lead to an inefficient allocation.

b. Cost effectiveness means that the firm which is emitting pollutants in the air should bear the entire cost of the emissions and thus marginal damage from the pollution has to be equated to marginal social cost of the firm. Technology standard and uniform standard will not lead to an efficient outcome and firm will not be bearing the full burden of the damage imposed on the society. Imposition of Pigouvian taxes will raise the cost and thus cover the marginal damage and reduce the output produced equal to social optimum.