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Marketable Permits Essay Format

There is general agreement that we must control pollution of our air, water, and land, but there is considerable dispute over how controls should be designed and how much control is enough. The pollution control mechanisms adopted in the United States have tended toward detailed regulation of technology, leaving polluters little choice in how to achieve the environmental goals. This “command-and-control” strategy needlessly increases the cost of pollution controls and may even slow our progress toward a cleaner environment.

In 1970, popular concern about environmental degradation coalesced into a major political force, resulting in President Richard Nixon’s creation of the federal Environmental Protection Agency (EPA) and the first of the major federal attempts to regulate pollution directly—the Clean Air Act Amendments of 1970. Since then, the federal role in regulating pollution has grown immensely, unleashing many regulatory responsibilities on the EPA and a cascade of regulations on local governments and the business community. But that has begun to change somewhat as environmentalists have increasingly realized that markets can work to allocate pollution reduction responsibilities efficiently among firms and across industries. Although the command-and-control approach is still the norm, environmental lobbyists and legislators have, on occasion, considered market-based approaches to pollution control. Most of the proposals for limiting global warming, for example, explicitly include market-based approaches for controlling carbon dioxide emissions.

Regulatory Standards

In virtually every antipollution law, Congress has instructed the EPA to establish and enforce specific pollution standards for individual polluters. The EPA generally bases these standards on some notion of the “best available” or “best achievable” technology for each source of pollution in each industry. Because each pollutant has many sources, the EPA often sets literally hundreds of maximum-discharge standards for any single pollutant.

Existing pollution sources (such as old factories) are generally required to meet less onerous standards than those applicable for new sources, largely because it is considered more costly to retrofit an old factory than to build pollution control devices into a new one. However, even the definition of “new” requires further regulations because the EPA must distinguish between, for example, when a utility simply repairs or refurbishes an “old” fossil-fuel-fired boiler and when it replaces enough components to make it a “new” boiler. Complicating matters further, standards for both existing and new sources are often stricter in regions with a higher-quality environment (i.e., cleaner air, cleaner water, etc.). Because the tighter standards on new or upgraded sources may reduce the incentive to replace the dirty, older facilities, in 2003 the EPA revised its rules to allow power plants and other major polluting facilities to be modernized without triggering the full panoply of “new-source review” requirements if the modernization involved did not involve a major design change and did not cost more than 20 percent of a completely new facility.

The Cost of Pollution Controls

The way pollution controls are often built into the production process makes any estimation of their cost extremely difficult. In addition, pollution controls often discourage new investment and production, but because the value of what is not produced is not seen, no one currently calculates such indirect costs. The federal government has, however, estimated a subset of costs—namely, direct expenditures on pollution controls. These expenditures cost governments and private entities an estimated $50 billion plus in 2002 alone. Some thirty-one billion dollars was spent on air-pollution abatement, seventeen billion on water-pollution controls, and eight billion for a variety of solid waste, hazardous waste, and other programs.

The most costly and complex federal pollution-control policy has been the motor vehicle emissions-control program. In order to enforce automobile standards set by Congress, the EPA must test each model line of new cars and must also test a random sample of vehicles already on the road. The EPA imposed the first federally mandated exhaust emission controls on new cars in 1967 and tightened these controls several times in the next twenty-five years. The Clean Air Act requires that emission controls on new cars work for at least the first eighty thousand miles driven or for eight years. The EPA estimated that the direct expenditures for compliance with the new-vehicle emissions standards totaled nineteen billion dollars in 2002.

Among the federally funded programs, two have been especially costly. The larger of these is the Municipal Sewage Treatment Construction Grant program begun in 1973. Through this program, the federal government directly underwrote grants totaling more than forty-three billion dollars by 1983 to pay for municipal sewage-treatment plants. Over time, the number of municipal sewage-treatment plants requiring major upgrades was reduced, and the federal contribution has now declined to less than two billion dollars per year.

The second program is better known. In 1980, Congress established the Superfund to finance the cleaning of hazardous waste sites. This program required private entities responsible for hazardous dumps to clean them up. But if these parties could not be found, the cleanup would be funded by the government through general revenues and a tax on petroleum feedstocks. In 1986, a new statute—the Superfund Amendments and Reauthorization Act—levied a federal tax on all corporations with taxable income over $2 million to help fund these remedial actions. Thus, corporations that had nothing to do with old hazardous waste sites or that do not even generate toxic waste were required to pay for the pollution others left behind. The Superfund program has been plagued with delays and a lack of detailed monitoring of its results. The EPA estimated its cost at $7.7 billion in 2002, but the EPA cannot estimate the program’s benefits because it does not have the requisite evidence that the program has improved the ecosystem. Moreover, the EPA admits that it could not place a value on such improvements even if it had the requisite data.

The Economic Effects of Pollution Controls

Pollution controls divert economic resources from other economic activities, thereby reducing the potential size of measured national output. As long as the increase in the value of the environment is at least one dollar for each additional dollar spent on controls, the total value of goods, services, and environmental amenities is not reduced. Unfortunately, that seldom happens, for at least three reasons.

First, the Congress or the EPA may decide to control the wrong substances or to control some discharges too strictly. Congress’s own Office of Technology Assessment concluded, for example, that attempting to reach the EPA’s goal for urban smog reduction could cost more than $13 billion per year but result in less than $3.5 billion in improved health, agricultural, and amenity benefits. Attempting to use invariant national pollution standards to control smog, which varies substantially across geographic regions and over the seasons of the year, continues to be a very inefficient policy.

Second, regulatory standards can result in very inefficient patterns of control. Some polluters may be forced to spend twenty-five thousand dollars per ton to control the discharge of a certain pollutant, while for others the cost is only five hundred dollars per ton. Obviously, shifting the burden away from the former polluter toward the latter would result in lower total control costs for society for any given level of pollution control.

Third, pollution controls can have deleterious effects on investment in two ways. First, by making certain goods—chemicals, paper, metals, motor vehicles—more expensive to produce in the United States, they raise the prices of these goods and thereby reduce the amount of each demanded. Second, because controls are generally more onerous for new sources than for older, existing ones, managers are more likely to keep an old plant in use rather than replace it with a new, more efficient facility, even though the new facility would produce the same goods as the old one.

The command-and-control approach is flawed in other ways, too. It does little to encourage compliance beyond what is mandated. Regulations are introduced only after noticeable damage has occurred, and they may be difficult to enforce. Polluters who manage to avoid legislative scrutiny continue to pollute.

Market-Based Approach to Pollution Control

Problems like these have led policymakers to look for more efficient means of cleaning up the environment. As a result, the 1990 Clean Air Act Amendments look very different from their predecessors of the 1970s because they include market-based incentives to reduce pollution.

Market incentives are generally of two forms: pollution fees and so-called marketable permits. Pollution fees are simply taxes on polluters that penalize them in proportion to the amount they discharge into an airshed, waterway, or local landfill. Such taxes are common in Europe but have not been used in the United States. Marketable permits are essentially transferable discharge licenses that polluters can buy and sell to meet the control levels set by regulatory authorities. These permits have been used in the United States because they do not impose large taxes on a small set of polluting industries, as would be the case with pollution fees.

The 1990 Clean Air Act allows the EPA to grant “emissions permits” for certain pollutants. These are, in effect, rights to pollute that can be traded among polluters. Imagine a giant bubble that encloses all existing sources of air pollution. Within that bubble, some emitters may pollute more than the control level as long as other polluters compensate by polluting less. The government or some other state or regional authority decides on the desired level of pollution and the initial distribution of pollution rights within an industry or for a geographic region—the “bubble” that encloses these sources. Purchases and sales of permits within the “bubble” should reduce the total level of pollution to the allowable limit at the lowest total cost.

For example, a St. Louis study found that the cost of reducing particulate emissions for a paper products factory was $4 per ton, while the cost to a brewery was $600 per ton. The Clean Air Act could require St. Louis to reduce its emissions by a certain amount. Under the traditional approach, the brewery and the paper factory would each be required to cut emissions by, say, ten tons. The cost to the paper factory would be only $40, while the cost to the brewery would be $6,000. But with tradable permits, the brewery could pay the paper factory to cut emissions by twenty tons so that the brewery could continue to operate without reducing emissions at all. The net result is the same emission reduction of twenty tons as under the command-and-control approach, but the total cost to society of the reduction is only $80 instead of $6,040.

The tradable permits work. The most notable success has been in reducing sulfur dioxide emissions from electric utility plants. The 1990 Clean Air Act Amendments contained a provision that set a cap on total sulfur dioxide emissions that would decline over time to about half their 1980 level. Instead of requiring all power plants to meet a technology-based standard, electric utilities were allocated a share of the maximum allowable national emissions. They could then buy or sell emission allowances, depending on their needs and their marginal costs of abatement. The program has worked spectacularly well, reducing total control costs by an estimated $750 million to $1.5 billion per year relative to the cost of the former technology-based standards, while meeting or exceeding the environmental goals of sulfur dioxide reductions.

Marketable permits also were used to phase down the use of chlorofluorocarbons (CFCs) in order to preserve the stratospheric ozone layer and to phase out the use of lead in gasoline in the 1980s. The CFC policy was instituted in 1990 and succeeded in mitigating the opposition to a phase-down of CFCs in developed countries, particularly the United States. The lead phase-down was designed to allow smaller refineries to acquire marketable permits rather than employing technologies that the larger refineries could implement more efficiently. This program saved hundreds of millions of dollars per year, promoted technological progress, and allowed a more orderly transition of refinery capacity without sacrificing environmental quality. Protecting our environment does not have to put an end to economic progress. Free markets in permits to pollute, like free markets for other resources, can ensure that pollution is controlled at the lowest cost possible.

About the Author

Robert W. Crandall is a senior fellow at the Brookings Institution in Washington, D.C. He served as acting director of the Council on Wage and Price Stability during the Carter administration and was previously an associate professor of economics at MIT.

Further Reading

Carlson, Curtis, Dallas Butraw, Maureen Cropper, and Karen Palmer. “Sulfur Dioxide Control by Electric Utilities: What Are the Gains from Trade?” Resources for the Future, Discussion Paper 98–44, revised April 2000.

Hahn, Robert W., and Gordon L. Hester. “Where Did All the Markets Go?” Yale Journal on Regulation 6, no. 1 (1989): 109–153.

Newell, Richard G., and Kristen Rogers. “The Market-Based Lead Phasedown.” Resources for the Future, Discussion Paper 03–37, November 2003.

Schmalensee, Richard, Paul M. Joskow, A. Denny Ellerman, Juan Pablo Montero, and Elizabeth M. Bailey. “An Interim Evaluation of Sulfur Dioxide Emissions Trading.” Journal of Economic Perspectives 12, no. 3 (1998): 53–68.

Tietenberg, Thomas H. Emissions Trading: An Exercise in Reforming Pollution Policy. Washington, D.C.: Resources for the Future, 1985.

U.S. Department of Energy. Office of Environmental Analysis, Assistant Secretary for Environmental Safety and Health. A Compendium of Options for Government Policy to Encourage Private Sector Responses to Potential Climate Change. October 1989.

U.S. Environmental Protection Agency. 2003–08 Strategic Plan. Appendix 1. 2004.

U.S. Office of Management and Budget. 2005 Report to Congress on the Costs and Benefits of Federal Regulations. 2005.

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  • Pollution permits involve giving firms a legal right to pollute a certain amount e.g. 100 units of Carbon Dioxide per year.
  • If the firm produces less pollution it can sell its pollution permits to other firms.
  • However, if it produces more pollution it has to buy permits from other firms or the government.
  • This crease a market for pollution permits with the price set by demand and supply.
  • The aim of pollution permits is to provide market incentives for firms to reduce pollution and reduce the external costs associated with it. For example, it is argued carbon dioxide emissions contribute towards global warming.
  • Pollution permits can also be a way for the government to raise revenue, by selling firms these permits to allow pollution.

Diagram for pollution permits

A very simple diagram showing the fixed supply of pollution permits. If demand for pollution increases, the cost of tradeable permits rises from P1 to P2.

Pollution permit scheme

In this case, the government reduces the number of permits over time. This means the price will steadily increase and create a growing incentive to reduce pollution over time. The idea is that it gives firms time to try and invest in different technology which creates less pollution.

Pollution permits and social efficiency

If firms produce carbon as a side-effect of production, it is classed as a negative externality. In this case, the social marginal cost of the polluting industry is greater than private marginal cost. In a free market, we get over-production of pollution and social inefficiency. (see: negative externality)

Pollution permits are a method to try and reduce output to a more socially efficient level. The aim is to make the price of pollution permits as close as possible to the social marginal cost

Pollution permits vs carbon tax

  • Pollution permits have a similar goal to carbon tax. They both aim to increase the cost of producing pollution and create an incentive to reduce the quantity of pollution.

  • The diagram on left shows how a tax can shift supply to the left and make firms pay the full social marginal cost of pollution. It raises the market price to P2.
  • The diagram on the right shows how pollution permits have a similar effect. If the quantity of permits is set to Q2, the market price rises to P2

Problems of Pollution Permits

  • It is difficult to know how many permits to give out. The government may be too generous or too tight.
  • It can be difficult to measure pollution levels. There is potential for hiding pollution levels or shifting production to other countries, with looser environmental standards. In a globalised world, multinationals increasingly shift production around.
  • There are administration costs of implementing the scheme and measuring pollution levels.
  • For global pollution permits, countries who pollute more than their quotas can simply buy permits from other countries. Therefore rich developed countries can simply buy permits from less developed countries. This does not significantly reduce pollution but shifts it from the richer countries to poorer countries.
  • The biggest carbon trading scheme is the EU Emissions Trading Scheme (ETS), however political interference has created a glut of permits and it has done little to reduce carbon dioxide and reverse global warming.
  • Environmentalists have argued a higher price of carbon is insufficient to reduce carbon dioxide to levels necessary to stop global warming. Demand for carbon permits is often price inelastic and too slow to act.
  • Some carbon trading schemes have a component called ‘carbon offsetting. This means if pay to plant trees, this can count against carbon emissions. However, critics argue carbon offsetting effectively enables firms to keep polluting with no guarantee planting trees will on their own solve the pollution problem.

Examples – Sulphur Trading scheme

In 1990, the US pursued a form of sulphur trading scheme which gradually reduced the number of permits to pollute sulphur. (a cause of acid rain).

  • It was relatively straight-forward as sulphur emissions came predominantly from coal-burning power stations. This made it easy to monitor
  • There was no scope for ‘sulphur offsetting’
  • The scheme was successful in reducing sulphur dioxide by 40%.
  • Though critics note sulphur dioxide also fell in other countries who pursued more standard regulatory legislation to limit the amount of pollution – rather than carbon trading.

China’s national cap-and-trade program

  • The biggest carbon trading scheme will be in China, who have sought to learn from the EU’s experience with ERS
  • The scheme will give a cap to polluters – this is the amount of pollution that can be created without cost. If polluters go above this ‘free’ cap, they have to buy allowances on the market for permits.
  • The scheme set the initial carbon allowances to 3 -5 billion tones per year



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