Pollution Permits: Pricing And Impact

Pollution permits are a method to reduce pollution output to a more socially efficient level. The concept was first developed by Canadian economist John Dales and American economist Thomas Crocker in the 1960s. Pollution permits are issued to firms in industries where a reduction in emissions is desired. The total number of permits issued is limited to the amount of pollution allowed throughout the industry, and they are priced based on the social marginal cost of pollution. The aim is to incentivize firms to reduce emissions or purchase permits from another firm. Over time, the existence of pollution permits should reduce demand for pollution and, consequently, the price of permits. However, critics argue that this system does not address the issue of pollution and instead rewards the most polluting firms with the largest number of permits. The pricing of pollution permits is a complex issue that involves various factors such as supply and demand, economic growth, and government intervention.

Cap-and-trade systems

The trade part of the system gives companies flexibility and increases the pool of capital available to make reductions. Companies that cut their pollution faster can sell allowances to companies that pollute more, or "bank" them for future use. This encourages companies to cut pollution faster and rewards innovation. As the cap falls, total pollution drops.

However, there are some challenges and criticisms associated with cap-and-trade systems. There is a lack of reliable data on emissions, and it can be costly and time-consuming to obtain accurate information. It can be difficult to achieve an international consensus on emissions and caps, as each country has different priorities and standards. Additionally, opponents argue that it could lead to an overproduction of pollutants up to the maximum levels set by governments, as allowable levels may be set too generously.

Tradable permits

The first application of tradable permits was in the United States during the early 1970s, where new sources in air non-attainment areas had to obtain emissions reduction credits or offsets from existing sources. These credits could be banked for future use. Another example is the state of Washington's grass-burning tradable permit system.

The Kyoto Protocol, which allows for greenhouse gas trading through several provisions, is another example of the use of tradable permits. The Joint Implementation provision enables larger developed countries to acquire emissions reduction units from other similar countries. These units can be based on projects that reduce emissions or increase sinks for greenhouse gases.

Tradable permit systems can be quite volatile, especially when government policies change or other factors impact the value of carbon permits. This can reduce investors' willingness to rely on tradable permit prices. For instance, ETS carbon prices from April 2005 to August 2019 were heavily affected by allocation issues, driving the price to almost zero in 2007.

Despite the challenges, tradable permits offer a potential solution to environmental issues by creating a market-based approach to incentivize the reduction of negative externalities.

Carbon markets

Voluntary carbon markets, on the other hand, are not formally obligated to achieve a specific target. Instead, non-state actors such as companies, cities, or regions voluntarily offset their emissions to achieve targets such as climate neutrality or net-zero emissions. The current supply of voluntary carbon credits comes primarily from private entities that develop carbon projects or governments that implement certified emission reduction programs. Demand for these credits arises from private individuals seeking to offset their carbon footprints, corporations with sustainability targets, and other actors aiming to trade credits for profit.

The Paris Agreement, through Article 6, enables the use of international carbon markets with multilateral governance under the UNFCCC. This establishes common global standards and guidance for the development and trading of emission reductions. The aim is to enhance the ambition of climate actions and promote sustainable development and environmental integrity. As of 2023, 143 out of 154 Parties stated their intention to use carbon credits from cooperative approaches under Article 6 to finance climate action and achieve national targets.

Carbon taxes

A carbon tax is a monetary cost imposed on carbon emissions, usually in the form of a tax on carbon content in fuels. This is done to encourage polluters to reduce fossil fuel combustion, the main driver of climate change. The aim is to allow market forces to determine the most efficient way to reduce pollution. It is a type of Pigovian tax, which taxes negative externalities, such as the production of greenhouse gases, to reflect the true cost of the goods to society.

The design of a carbon tax involves two primary factors: the level of the tax and the use of the revenue. The level of the tax is based on the social cost of carbon (SCC), which calculates the numeric cost of the externalities of carbon pollution. The tax can be set at a specific amount per tonne of CO2 emitted, with the price increasing over time. For example, in Canada, the federal minimum tax was set at CA$80 per tonne of CO2 equivalent in 2024, set to increase to CA$170 in 2030.

To make carbon taxes fairer, policymakers can redistribute the revenue generated to low-income groups, effectively making it a carbon fee and dividend rather than a plain tax. In provinces where a carbon tax is levied, 90% of the revenues may be returned to taxpayers. However, some experts observe that carbon taxes can negatively affect public welfare, particularly low- and middle-income households, by driving up prices for necessities such as petrol and electricity.

Carbon permit costs

Carbon pricing is a policy tool that puts a tax or price on carbon emissions, usually expressed as a value per ton of carbon dioxide equivalent (tCO2e). This price captures the external costs of greenhouse gas (GHG) emissions, such as damage to crops, healthcare costs from heatwaves, and property loss from flooding. By assigning a cost to carbon emissions, those responsible for the emissions bear the burden of the environmental impact. This provides an economic incentive for emitters to reduce their emissions, either by transforming their activities or by paying for their emissions through taxes or permits.

There are two main types of emissions trading systems (ETS): cap-and-trade and baseline-and-credit. In a cap-and-trade system, a cap or absolute limit is set on the emissions within the ETS, and emissions allowances are distributed, typically for free or through auctions, up to the amount equivalent to the cap. This creates a supply and demand for permits, with the resulting carbon price depending on this market dynamic. Emitters who cannot cost-effectively lower their emissions must purchase additional permits from those who can, incentivizing all emitters to invest in emissions reduction.

In a baseline-and-credit system, baseline emissions levels are established for individual entities, and credits are issued to those that reduce their emissions below this level. These credits can then be traded in the carbon market, allowing entities to buy or sell credits to meet their emission targets at the lowest cost. This flexibility enables emitters to choose the most economically efficient methods to lower their emissions.

The revenue generated from carbon pricing can be used to benefit taxpayers, particularly those with low incomes, by helping to offset the increased costs of energy and other goods that may result from the carbon price. Additionally, this revenue can be reinvested in low-carbon technologies, infrastructure, and training for green jobs, further supporting the transition to a decarbonized economy.

Carbon pricing is already implemented in several states, countries, and regions, including the European Union, China, California, and a group of states in the Northeast US as part of the Regional Greenhouse Gas Initiative. It is a powerful tool to address climate change as it can influence every sector of the economy, from electricity to transportation, and encourages the development of clean technologies and market innovation.

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