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, total emissions from the firms covered cannot exceed the cap, whatever happens to their output.
cap and trade
cap and trade
Best link to attack
Assumes: The cap is tight enough to bind.
Assumes: The cap is tight enough to bind.
But: In the early years of the EU scheme too many permits were issued, the permit price collapsed and emissions were barely constrained.
2
This means firms that can cut emissions cheaply sell spare permits, while firms with high abatement costs buy them, so emissions are cut where it is cheapest.
abatement cost · market-based policy
abatement cost · market-based policy
Assumes: Firms' abatement costs differ.
But: Trading costs and uncertainty about future prices may deter trading, so some cheap cuts are not made.
3
Consequently, the permit price becomes a cost of polluting, so the external cost is internalised and firms have an incentive to invest in cleaner technology.
internalising the externality · dynamic efficiency
internalising the externality · dynamic efficiency
Assumes: The permit price is high and stable enough to justify investment.
But: A volatile permit price makes long-term investment in clean technology risky.
4
Therefore, output of polluting goods moves towards the social optimum and the welfare loss shrinks, at a lower total cost of cutting emissions than uniform regulation.
social optimum · welfare loss
social optimum · welfare loss
Assumes: The cap matches the socially optimal level of emissions.
But: The government cannot know the optimal level precisely, so the cap is a judgement.
End
Emissions are held to the cap at least cost, moving output towards the social optimum if the cap is set correctly.
Evaluation chain
- E1However, the cut in emissions depends on the government setting the cap at the right level.
- E2Because the government lacks precise information on firms' emissions and the external cost, and faces lobbying from industry,
- E3so the cap may be set too loosely, as in the early EU scheme, when over-allocation drove the permit price close to zero.
- E4So permits guarantee a level of emissions, but they move output to the social optimum only if the cap matches it; a loose cap leaves most of the welfare loss in place.
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Questions this answers
- Explain how tradable pollution permits can reduce a negative externality.
- Assess the effectiveness of emissions trading in reducing carbon emissions.
- Evaluate tradable pollution permits compared with a carbon tax.
Diagram
Permit market: a vertical supply of permits at the cap and a downward-sloping demand for permits from firms; the permit price is set where they meet. Tightening the cap shifts supply left and raises the price. Link to an MPC/MSC diagram: the permit price adds to MPC, shifting it towards MSC.
Reverse and related
Loosening the cap → permit price falls, firms pollute more and output moves back above the social optimum.