A Deeper Look at Tradable Allowances

Tradable permits are a kind of combination of costs and command and control. We covered the essential idea in the previous video. In this video, I just want to underline a few key points. Let's get started.

The Clean Air Act was very successful. Under the act, SO₂ emissions have fallen over time, and at the same time, electricity generation has continued to increase. So the market has been able to discover low cost ways of reducing pollution. An important consequence of the tradable allowance system is that firms that generate electricity from clean sources -- they can make money by selling allowances. On the other hand, firms that generate electricity from dirty sources -- they have to buy allowances. The result is that clean energy is subsidized, and not by taxpayers. At the same time, dirty energy is taxed. So a tradable allowance system, implicitly within that system, is a way of encouraging clean energy and discouraging dirty energy.

A very interesting aspect of these markets is that anyone can participate, not just generators of electricity. So Tyler Cowen and I, in fact, purchased the right to emit 30 pounds of sulfur dioxide into the atmosphere. Now we didn't want to do that. So what did we do? Well, we tore it up. Why? Well, when we tore up that right to emit 30 pounds of sulfur dioxide into the atmosphere, we made the air cleaner. Nobody else had that right. So by tearing it up, that's 30 fewer pounds of sulfur dioxide which were allowed to be emitted into the atmosphere. In fact, under the tradable permits plan, environmental groups are free to buy up permits, tear them up, and reduce pollution in that way. If they think that the government, for example, set the pollution permits too high, they're free to buy pollution permits and tear them up. So it's a very efficient way of reducing the amount of pollution.

Let's briefly compare tradable allowances with Pigouvian taxes. They're actually quite similar economically. If the tax is set equal to the level of the external cost, and the number of allowances is equal to the efficient quantity, then they're basically the same economically. Politically however, they're quite different. And the key question is, who gets the initial allowances? Now some people argue that pollution allowances are the same as corrective or Pigouvian taxes plus a little bit of corporate welfare. You're giving away the right to pollute. Now that's really not the best way to look at the issue, however.

First of all, we don't have to give the allowances away. They could be auctioned off, generating revenue for the government. In this case, then politically and economically, the two systems would be very similar. Most importantly, however, is if the allowances are given to the firms initially, pollution control is more likely to be accepted by the large energy firms. If you just come at the large energy firms and say, "We're going to tax you," of course, they're going to lobby against those taxes. If on the other end you say, "We're going to have a tradable allowance system in which you guys are given some right to pollute at, say, historical levels," they're going to be much more willing to accept the program politically. In any case, that's the main difference, politics.

Tradable allowances have worked very well for controlling sulfur dioxide. Could a similar system be used to combat global climate change and the problem of carbon dioxide and carbon emissions more generally? In theory, the answer is definitely yes. All of the advantages of tradable allowances for sulfur dioxide would hold for carbon dioxide as well. The main difference is that global climate change is a global problem. The externalities involved in sulfur dioxide the acidification of lakes, were primarily national. So all we needed was a national plan in order to control sulfur dioxide.

But to control carbon dioxide, we need a global plan, and it's going to be much more difficult to get all the nations of the world to agree to either a Pigouvian tax system or a tradable allowance system than it is just to get one country to agree. The externalities are international making the problem much more difficult to solve.

At the same time, economics is going to be very important for solving these problems, because what we've just seen is that both Pigouvian taxes and tradable allowances give us the most bang for our buck. They give us the most pollution control at the lowest cost. And if we can lower the cost of pollution control or carbon dioxide emissions, we're much more likely to get reductions in carbon emissions. The lower the cost of solving the problem, the more likely we are to solve the problem -- and that's one reason why understanding economics and the economics of Pigouvian taxes and tradable allowances is extremely important.