Question

Explain why emissions permit trading mechanism in general provides relatively weaker incentives for innovation compared with emissions taxes?

Answer 1

An emission trading mechanism, or ‘Cap and Trade’, is a tradeable permit system for reducing pollution emissions. These permits allow firms to emit only up to the levels till which they have permits, ‘capping’ the levels of emissions in the economy. The ‘tradability’ implies an added flexibility, with low emitting firms able to sell their ‘excess’ permits for a profit to firms with high emission requirements, and even open up the possibility of concerned private agents purchasing the permit and retiring it entirely. This is referred to as a market-based pollution control system, using free market incentives to ensure emission standard are met without controlling firm level decisions. This system of tradable permits is usually used as an alternative to a Pigouvian tax on emissions. The government sets the cap across a given industry, or ideally the whole economy.

Market based instruments create significant incentive for innovation of lower polluting production techniques, which has the possibility of severely limiting overall levels of emissions in the near future. Under the ‘Cap and Trade’ mechanism, there is always an incentive for firms to lower emissions, as this would reduce the amount of permits they need and allow them to sell them on the market to other firms for a profit. Similarly, under the Pigouvian tax, Firms are constantly paying taxes on their emissions and thus always have an incentive to innovate lower polluting production techniques which would lower their costs.

However, this incentive is generally lower under the permit trading mechanism than the emission tax. Under the permit mechanism, if a firm observes that it is polluting in excess of its available permits, it always has the option to just purchase permits from other lesser polluting firms. This creates a sort of disincentive to innovate, as long as the price of the permit is lower than the cost of research and development of technology. This disincentive is not present under the emission tax system, since the firm must create new technology to reduce the amount of emissions and taxes being payed. There is no other way around it, which does to an extent exist with the trading mechanism. Therefore, emissions permit trading mechanism in general provides relatively weaker incentives for innovation compared with emissions taxes.