ChainWhat it assumes · how to break it
Start
The government caps total emissions from power generation and heavy industry and issues permits that firms can buy and sell, as in the EU Emissions Trading System and the UK Emissions Trading Scheme.
1
As a result, the government must set the cap and allocate permits without full information on firms' emissions and abatement costs.
information gaps
information gaps
Assumes: Firms know more about their emissions than the government.
But: Monitoring and reporting rules can give the regulator accurate emissions data over time.
2
This means industries can use their better information to lobby for generous free allocations, and the regulator may give away more permits than needed.
regulatory capture · free allocation
regulatory capture · free allocation
Best link to attack
Assumes: Permits are given away rather than sold.
Assumes: Permits are given away rather than sold.
But: Auctioning permits removes the incentive to lobby for a bigger free allocation.
3
Consequently, the permit price stays too low to change behaviour, while firms given free permits can still raise prices by the market value of the permits and earn windfall profits.
windfall profits
windfall profits
Assumes: Firms pass on the value of free permits.
But: In markets with strong foreign competition firms cannot pass on costs, so windfalls are smaller.
4
At the same time, production may move to countries with no carbon price, so global emissions fall by less than emissions at home.
carbon leakage
carbon leakage
Assumes: Firms can relocate easily.
But: Relocation is costly, and a carbon border charge on imports can remove the advantage of moving.
5
Therefore, consumers and firms bear costs while the externality is barely reduced, a net welfare loss: government failure.
government failure · net welfare loss
government failure · net welfare loss
Assumes: The scheme's costs exceed its benefits.
But: Once the cap is tightened, the scheme can cut emissions at lower cost than regulation would.
End
Over-allocation, windfall profits and carbon leakage can leave the externality in place at a cost, which is government failure.
Evaluation chain
- E1However, the risk of capture depends on how permits are allocated.
- E2When permits are auctioned, firms pay for every tonne they emit and gain nothing from lobbying for a bigger free allocation.
- E3As a result, windfall profits disappear and the government gains revenue it can use, for example to help households with higher energy prices.
- E4So government failure is most likely with free allocation, and moving to auctions, as the EU scheme did for power generation, reduces it.
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Questions this answers
- Explain how tradable pollution permits might lead to government failure.
- Assess the problems governments face in running emissions trading schemes.
- Evaluate the view that permits are more effective than regulation in reducing pollution.
Diagram
Permit market with a cap set to the right of the level needed: the permit price is low, so the MPC curve rises only a little towards MSC and much of the welfare loss triangle remains.
Reverse and related
Auctioning permits and tightening the cap → windfalls disappear, the price rises and the risk of government failure falls.