Question

Briefly Explain why firms have an incentive to monitor each other's permit usage under a TEP policy

Answer 1

An effluent tax requires that some central public authority establishes a tax rate, monitors the performance of each polluter, and then collects the tax bills. It is essentially an interaction between polluters and public authorities in which we might expect the same type of adversarial relationship we get in any tax system. In this chapter we will take a look at a policy approach that, while incorporating economic incentives, is designed to work in a more decentralized fashion. Rather than leaving everything to a centralized public agency, it works through the decentralized market interactions of polluters themselves. It’s called the system of transferable emission permits (TEPs).

When a large number of firms is involved, the TEP system works in the same way, but trading patterns will of course be more complicated. The initial distribution of emission rights will now include many firms, with many potential buyers and sellers. In order for the equimarginal principle eventually to be satisfied in this case, it is obviously necessary that all permit buyers and sellers be trading permits at the same price. What this requires is a single overall market for permits where suppliers and demanders may interact openly and where knowledge of transaction prices is publicly available to all participants. We can then expect that the normal forces of competition would bring about a single price for permits. The permits would in general flow from sources with relatively low marginal abatement costs to those with high marginal abatement costs. Market institutions should develop—and indeed have in the real-world cases of permit trading. In the U.S., there are permit brokers and bankers and emission trading on commodity exchanges, see, for example, the Green Exchange. These markets, if competitive, should work like any other market where the permit price and quantity transacted is determined where the demand for permits equals the supply of permits. The demanders in this market can be new firms that wish to begin operations in the trading area or existing sources that wish to expand their operations and require more permits to cover expected increases in emissions. Supplies of permits would include firms leaving the area or going out of business, and most especially firms who have invested in better abatement techniques and now have excess permits to sell.

Like a tax, transferable permits that are traded in a competitive market are a cost-effective policy. Regulators do not have to know each polluter’s MAC curve to find the right “price” that achieves cost-effectiveness. The market does this automatically, because polluters set the permit price equal to their MAC. If the market clears, the permit price equals the MAC of each polluter. Once the target level of pollution is set, the market will reveal a polluter’s MAC curve. Trading occurs if the MACs of polluters are sufficiently different so that some will become sellers of permits and the others, buyers. The exchange of permits provides each trader with cost savings compared to their initial permit allocation from the regulator.