Can Markets Set Caps for Cap-and-trade Pollution Permits? Ted Bergstrom Economics Department...
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![Page 1: Can Markets Set Caps for Cap-and-trade Pollution Permits? Ted Bergstrom Economics Department University of California Santa Barbara.](https://reader036.fdocuments.in/reader036/viewer/2022062417/5517ee2e550346c6568b4a59/html5/thumbnails/1.jpg)
Can Markets Set Caps for Cap-and-trade
Pollution Permits?Ted Bergstrom
Economics DepartmentUniversity of California Santa
Barbara
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Alternate Title:
Arrow, Coase, Missing Markets,
and the Easter Bunny
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Economists have lots of good ideas that politicians and
public don’t like as well as we do.
• Gasoline Tax• Congestion Tolls• Legalize and tax recreational drugs• Legalize trade in body organs• Subsidize surstrőmming?
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Tradable pollution permits: an economists’ idea that got
popular
• Endorsed by Clinton, Edwards, Obama, and McCain
• By major energy companies • Some Environmental Groups– Environmental Defense Fund, Union of
Concerned Scientists– But not Sierra Club
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A Coasian Solution to Externalities?
• A fond hope of many economists is that externalities can be internalized by establishing property rights and market institutions.
• Achieved with a minimum of government regulation.
• Reduce politicians’ chances for corruption and bribery.
• Is this Easter Bunny economics?
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What is cap-and-trade?
• Government requires a permit for every unit of pollution produced.
• Issues a fixed number of tradable permits.• Permits typically issued to original
polluters in proportion to historic pollution.–Wouldn’t have to be this way. Could be
auctioned.
• Number of permits decreases over time.
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Los Angeles Air Quality
• Typical example: Southern California’s RECLAIM market started in 1992.– Tradeable permits for SOx and NOx issued to
large polluters in L.A. in proportion to emissions they produce at full capacity.
– Number of permits issued reduced by 8% per year 1992-2003.• Large brokerage firms handle trades
– Coasian Transaction costs? Commissions: 1-3.5 percent
• L.A. air quality has improved drastically.
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Other Cap-and-trade markets
• Acid Rain SOx markets in Eastern US States
• Water pollution in Wisconsin and Colorado
• Fisheries in Australia and New Zealand
• Tradable permits to own cars in Singapore. – Number increases by 3% per year.– New permits auctioned in “Walrasian
auction”
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Alternatives to Cap-and-Trade
• Command and control measures• Pigovian Pollution tax• Why do energy companies like cap-
and-trade?– Preferable to C and C or pollution tax if
they get the permits.– Especially if abatement technologies are
cheaper for them than for others.
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Advantage of Cap-and-Trade
• Decentralizes firms’ decisions about whether to install abatement devices, change technologies, cut back output, move away.
• Marginal benefits from polluting are about the same* across all firms and equal to marginal costs of abatement.
• Conditional on aggregate level of pollution,
if market is competitive, outcome is Pareto efficient.
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Further advantage
• Endowing current polluters, reduces opposition, makes change nearly Pareto improving– Except for grouchy people at Sierra Club
• Even grouches may concede that they need to buy off polluters to get reform.
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What is missing
• Cap-and-trade policies do a good job of allocating chosen level of cap, but cap is currently chosen by political bodies.
• Can the caps also be determined by markets?
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Arrow’s suggestion
• Arrow (1969) stated:
“By a suitable and not unnatural reinterpretation of the commodity space, externalities can be regarded as ordinary commodities and all of the formal theory of competitive equilibrium is valid, including its optimality”
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Arrow’s formalism
• Treat pollution of each victim as a separate commodity.
• These are joint products of pollutant produced by a polluter.
• Competitive equilibrium would exist in this imaginary economy and would be the same as a Lindahl equilibrium, which would be Pareto optimal.
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Does this mean that decentralized markets can optimize externalities ?
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Not so fast, says Arrow
• The existence of Lindahl equilibrium prices for pollution does mean that they can be implemented in a working market.
• Two problems.– 1) Free-riders cannot be excluded from
benefits of air quality purchased by others.– 2) Personalized markets are thin markets.Competitive outcome is unlikely.
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Do Arrow’s 2 problems doom a full market solution for
pollution control methods?
• Rays of hope from mechanism design.–Weakly dominant Groves Clarke
Mechanism – Nash implementation
• Groves-Ledyard• Mark Walker and others
• Not like markets, but maybe some kind of market will work.
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Is there a way around these problems?
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Multiple polluters, single victim
• Assume there are many firms, each produces a single pollutant as a bi-product and could reduce the ratio of pollutant to output at some cost.
• There is only one pollution victim. • Government monitors pollution and
requires a permit for each unit of pollutant emitted.
• Government issues enough permits for total pollution produced before permits required.
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Permits given to Polluters
• Government issues permits to original polluters equal to their previous emissions.
• Pollution victim can buy permits and retire them.
• Outcome will be efficient and Pareto superior to status quo ante.
• Damage to victim of marginal unit of pollution equals marginal benefit of polluting and marginal cost of abatement for each polluter.
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Permits given to victim
• We may think that the victim had a right to a clean environment and should not have to pay.
• Coasian argument : No worries. Just endow the victim with the permits. Outcome will be the same except for income distribution.
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Not so fast, Mr. Rabbit
• Victim will now be a monopoly seller of permits.
• Marginal cost of selling a permit is victim’s disutility of pollution.
• Firms’ demand for permits will be downward sloping. Marginal revenue will exceed price.
• Victim will sell too few permits for efficiency.
We could use a Pigovian tax, but how high should the tax be set?
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Many Polluters, Many Victims
• Assume many polluters as before, but now let there be many pollution victims.
• Suppose that pollution permits are required and permits issued to current polluters allowing pre-permit pollution levels.
• This establishes property rights to air quality. Victims can buy and retire permits. Markets give us efficiency, right?
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Not so fast, Mr. Rabbit
• Nash equilibrium in this market will be the voluntary provision of public goods outcome.
• The equilibrium price in this market will be equal to the marginal cost of pollution to any individual victim who buys tickets.
• Each retired premit reduces pollution for all victims, yet purchasers consider only their own gains.
• Efficiency requires price of permit equals sum of marginal costs to victims. Equilibrium has far lower price, equal to maximum of marginal costs to victims.
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Endowing the victims
• Can we cure the problem by endowing the victims rather than the polluters?
• Suppose the total supply of permits was divided equally among victims. Market would be competitive now: many victims
• Victims would be willing to supply at their marginal damage. Equilibrium price would be marginal damage to a single person. Again far below efficient price. And total
revenue received by victims far less than total damage caused by pollution.
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Personalized permits
• Suppose that the government endows each pollution victim a number of pollution permits equal to the total amount of pollution produced before permits were introduced.
• For each unit of pollution that a firm produces, it must have one personalized permit from each victim.
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Unanimous consent?
• What goes wrong when many victims are endowed with tradable permits?
• Each victim can sell permission to pollute not only himself but everyone in the community.
• Lets try market devices that require unanimous (or near unanimous consent) of victims.
• (Wicksell suggested that near unanimity might be required for tax-funded projects.)
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Too many commodities?
• Think of a global market with a small number of nations acting on behalf of their citizens. Polluters need a permit from each country for each unit of pollution they produce.
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Complementary monopoly problem
• Each victim is the monopoly supplier of his own permits.
• Permits are perfect complements. • This is the complementary monopoly
model of Cournot.• Output is even smaller than with a
single monopoly. – Total markup as percentage of sum of
prices is N/|E|, where E is elasticity of demand and N the number of victims.
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Fixing Arrow’s Problem 2
• We could have personalized permits without monopoly by spreading initial endowments of each victim’s permits among many participants – either victims or polluting firms,
depending on distributional goals.• There would be many demanders for
these permits—several firms and one victim.
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Lindahl equilibrium
• Endowment of X personalized permits for each person is distributed.
• In equilibrium, each victim buys the same quantity Q of his own permits and firms buy a total of X-Q of each kind of permit.
• Each person’s personalized price is his marginal rate of substitution between pollution and private goods.
• Cost to a firm of producing a unit of pollution is sum of prices of personalized permits.
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Can we implement Lindahl with competitive permit market?
• The Lindahl equilibrium would be a competitive equilibrium if each victim experienced X-Qi units of pollution when he retires Qi permits.
• But in the actual market we have proposed, firms can only produce
X-max{Qjj} units of pollution.
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Lindahl equilibrium is not supported by a competitive
equilibrium in pollution tickets
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But is there some other kind of equilibrium and is it any good?
What if we make the amount of pollution that a producer is allowed some c.e.s function of the numbers of each type of ticket that he holds?
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Hope springs eternal
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Had enough?