EFFICIENCY LOSS AND TRADABLE PERMITS



EFFICIENCY LOSS AND TRADABLE PERMITS

Introduction

Theoretically, using incentive-based policies, such as a tradable permit system, for
pollution control has been shown to be cost-effective (Baumol and Oates, 1988). A
series of empirical studies have indicated that substantial cost-savings could be
achieved by implementing a tradable permits system. (e.g. Atkinson and Lewis 1971;
Maloney, and Yandle 1984; Krupnik 1986; Johnson and Pekelney 1996). Atkinson and
Titenberg (1991), on the other hand, pointed out that actual savings from trading
programs might be lower than expected due to a sequential and bilateral trading
process and non-uniformly mixed pollutants. Burtraw, Harrison and Turner (1998)
argued that divergence between the cost-minimizing and the observed pattern of
permit trading may be due to the informal structure of many trading programs,
incomplete assignation of permits and uncertainty of the trading program length. One
added advantage of using tradable permits is that any initial misallocation of pollution
permits can be remedied through trading. In the case of perfect competition and full
information, initial allocation of permits has no role in the market equilibrium
formation and the same environmental goal can be achieved under any allocation as
long as the total number of permits issued remains the same (Montgomery 1972).

Beside the actual trading costs, preliminary works for establishing a trading
program may also increase the cost of permit trading. For example, a new program
requires agreement on (1) the universe of covered sources, (2) baseline emission
levels, (3) the emissions cap and planned rate of decline, (4) the allocation of emission
allowances and (5) standardize monitoring and measurement techniques for
determining each source’s emissions. These administration costs may be substantial
when the number of affected sources is large. Experience with the Regional Clean Air
Incentives Market (RECLAIM) and the Acid Rain program shows that obtaining the
agreement on these points can take several years.

Another factor that may also reduce the potential cost-saving of permit systems
is the indivisibility and irreversibility of investment on control equipment. This factor
is largely neglected in the permit trading literature. Usually, emissions can be reduced
by using less polluting inputs, cleaning up after emission is generated at the
end-of-the-pipe or installing better and cleaner technologies which lower emissions
during the production process. For some equipments, the amount of pollution
reduction depends only on the control capacity of that equipment and firms’ actual
pollution level. Once the equipment has been installed, it will always perform at a
constant removing rate without incurring extra operating costs as long as the emission
levels are within the capacity range. That is, firms’ actual emission reduction levels



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