Can Markets Set Caps for Cap-and-trade Pollution Permits?

1. Can Markets Set Caps for Cap-and-trade Pollution Permits? Ted Bergstrom Economics Department University of California Santa Barbara

2. Alternate Title: Arrow, Coase, Missing Markets, and the Easter Bunny

3. 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?

4. 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

5. 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?

6. 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.

7. 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.

8. 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”

9. 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.

10. 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.

11. 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.

12. 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?

13. 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”

14. 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.

15. Does this mean that decentralized markets can optimize externalities ?

16. 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.

17. 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.

18. Is there a way around these problems?

19. 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.

20. 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.

21. 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.

22. 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?

23. 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?

24. 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.

25. 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.

26. 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.

27. 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.)

28. 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.

29. 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.

30. 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.

31. 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.

32. 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{Qj} units of pollution.

33. Lindahl equilibrium is not supported by a competitive equilibrium in pollution tickets

34. 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?

35. Hope springs eternal

36. Had enough?