Chapter

13
Incentive-Based
Strategies: Market
Trading Systems
An effluent charge requires that some central public authority establish a charge
rate, monitor the performance of each polluter, and then collect the tax bills. It
is essentially an interaction between polluters and public authorities in which
we might expect the same type of adversarial relationship we get in any tax
system. In this chapter we take a look at a policy approach that, while incorpo-
rating economic incentives, is designed to work in a more decentralized fash-
ion. Rather than leaving everything to a centralized public agency, it works
through decentralized market interactions in which polluters may buy and sell
emission permits, and pollution is controlled by linking emissions with the
number of permits held.
These programs have proliferated in recent years. The most well known
in the United States is the sulfur dioxide (SO2) trading scheme introduced
as part of the Clean Air Act of 1990. A nitrous oxide (NOx) trading plan was
started among a group of eastern states in 1999. California has started several
programs within its own borders. The countries of the European Union have
recently inaugurated a multicountry trading plan to reduce carbon dioxide
(CO2) emissions.

General Principles
We can distinguish three types of trading systems for achieving more efficient
pollution control:
r
Offset trading
r
Emission rate trading
r
Cap-and-trade (CAP)

245

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 246 Section Four Environmental Policy Analysis

Offset trading initially came about to address a very practical problem: how
to limit environmental pollution but still be able to accommodate economic
growth. Under the original Clean Air Act of 1970, situations evolved (espe-
cially in Southern California) where all existing firms were subject to regula-
tory emission standards, but the air quality in the region was nevertheless still
below standard. How to allow the growth of new firms, but avoid making air
pollution worse? The answer was to allow new firms to pay existing firms to
reduce their emissions below standard so as to offset the added emissions of
the new firms. Trades of this type, since it involved transactions between two
firms subject to regulatory control, were sometimes called credit trading. But
offset-type trading can also occur between any two, or more, entities, whether
or not they are under regulatory control. For example, if the selling firm is not
under regulatory limits, they may be able to reduce their emissions below the
level that would exist if an agreement was not reached, and sell the resulting
offset to another entity that wishes to offset its emissions, either because it is re-
quired to, or it voluntarily choses to. One of the most well-known examples of
offset trading is the Clean Development Mechanism under the Kyoto Protocol
to reduce greenhouse gases. We will encounter this in Chapter 18.
Emission rate trading takes place in terms of the rate that a pollutant con-
stitutes in total output. For example, a greenhouse gas emission rate might be
defined in terms of tons of CO2 per 1,000 megawatt hours of power produc-
tion. After a base rate is set, either voluntarily or through regulation, trading
would take place between sources. Sources that are willing and able to reduce
their emission rate below the base would sell allowances to sources that want to
continue to operate at a rate higher than the base. We will discuss this in more
detail later in this chapter.
Cap-and-trade programs work a little differently. The first step in a CAP pro-
gram is to make a centralized decision (by a regulatory agency or some other
collective entity) on the aggregate quantity of emissions to be allowed. Permits
are then written in accordance with this quantity. These permits are then dis-
tributed among the sources responsible for the emissions. Some formula must
be used to determine how many permits each source will receive; we will come
back to this problem later. Assuming that the total number of permits is less
than current total emissions, some or all emitters will receive fewer permits
than their current emissions.

Cap-and-Trade
Suppose, for example, that a CAP program has been instituted to reduce the
amount of sulfur emitted by a group of power plants. Current total emissions
are, say, 150,000 tons of sulfur per year, and policymakers have decided that
this must be reduced to 100,000 tons per year. Let’s focus on the situation
of one of the power plants, which is depicted in Figure 13.1. We suppose
it is emitting 5,000 tons of sulfur currently. Under the program, the plant

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 Chapter 13 Incentive-Based Strategies: Market Trading Systems 247

FIGURE 13.1 Individual Firm Choices Under a Cap-and-Trade Program

$ MAC

60

40 Permit price

20

0 18 25 35 50
Emissions (100 tons)

is initially given 2,500 discharge permits. The plant manager now has three
choices:
1. Reduce the emissions to the level covered by the number of permits the plant
was initially awarded.
2. Buy additional permits and emit at levels higher than the original award
level (e.g., buy 1,000 permits to add to its 2,500 initial distribution, so its
emissions would now be 3,500 tons/year).
3. Reduce emissions below the level of the original award, then sell the permits it
doesn’t need (e.g., reduce emissions to 1,800 tons/year and sell 1,000 permits).
Note that whether the firm is a buyer or seller of permits depends on the
relationship of the price of permits and their marginal abatement costs at the
emission level corresponding to their initial permit holding.
1. If the original award is 1,800 permits, the firm’s marginal abatement costs
would be $60/ton; with a permit price of $40, it can improve its situation by
buying 700 permits and increasing its emissions to 2,500 tons.
2. If its original allocation is 3,500 permits, its marginal abatement costs
would be lower than the permit price; it can improve its situation by selling
1,000 permits and reducing its emission to 2,500 tons.
Now think of a situation involving an industry where there are a large num-
ber of firms and each one is emitting a pollutant we wish to control with a cap-
and-trade program. An overall level of aggregate emissions is set by the

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 248 Section Four Environmental Policy Analysis

authorities, and transferable permits are allocated to each firm according to some
formula. Marginal abatement costs can be expected to differ among firms, based
on different production and pollution-control technologies available to each.
Some sources will be potential buyers of permits (MAC > permit price), and some
firms will be potential sellers (MAC < permit price). There are gains from trade to
be had by the sources, by buying and selling permits, in effect rearranging the to-
tal number of permits (which has been fixed by the authorities) among the plants.
It is important to note, now, that each firm will be in a situation analogous
to the one depicted in Figure 13.1. By buying or selling permits, they move to
a situation where marginal abatement costs are equal to the price of permits.
Assuming there is a single overall market for permits, and therefore a single
market price for them, this means that the trading of permits among the firms
will result in a cost-effective reduction in total emission, because each firm will
end up equating its marginal abatement costs to the single permit price. Cost-
effectiveness in cap-and-trade programs requires that that there be a single
market for permits, where suppliers and demanders may interact openly and
where knowledge of transactions prices is publicly available to all participants.
The normal forces of competition would then bring about a single price for
permits. The permits would in general flow from sources with relatively low
marginal abatement costs to those with high marginal abatement costs.
A permit market is depicted in Figure 13.2. The demand for permits is simply
the aggregate marginal abatement cost functions of all the firms participating
in the market. The supply of permits is the quantity in the cap as initially estab-
lished by public authorities; the supply curve is vertical at that quantity.

FIGURE 13.2 The Market for Discharge Permits

Demand
$ for permits

Supply of permits
p2

p1

q2 q1
Quantity of permits

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 Chapter 13 Incentive-Based Strategies: Market Trading Systems 249

As in any competitive market, the price of permits is determined by the

interaction of supply and demand. If the cap is set at q1 in Figure 13.2, the price
of permits will settle at p1. A more restrictive cap, such as q2, would give a higher
permit price, the case at p2.
It’s important to understand that the permit price in a CAP program is what
provides the incentive for emission reductions by participating firms. In this
sense it is analogous to the emission tax as discussed in Chapter 12. But note
that the two approaches proceed differently. With a cap-and-trade program,
a quantity restriction (the cap) is set, and a permit price results as firms adjust
their emission levels. In an emission charge program, authorities first set the tax
level, and firms adjust their emission levels, leading to a change in the quantity
of aggregate emissions.
In recent years, the idea of transferable discharge permits has become quite
popular among some environmental policy advocates, as well as among poli-
cymakers themselves. Table 13.1 lists a few now in effect. Some of the largest
programs have to do with air pollution. On the water pollution-control side
there has been a proliferation of programs for particular water bodies.
Unlike effluent charge approaches, which basically make people pay for
something they were once getting for free, CAP programs begin by creating
and distributing a new type of right. These rights will have a market value as
long as the total number of permits created is limited. From a political stand-
point, it is perhaps easier for people to agree on a pollution-control policy that
begins by distributing valuable new rights than by notifying people they will
be subject to a new tax. Of course, like any pollution-control policy, CAP pro-
grams have their own set of problems that must be overcome if they are going
to work effectively. What looks in theory like a neat way of using market forces
to achieve efficient pollution reduction must be adapted to the complexities of
the real world.

The Initial Rights Allocation

The success of the CAP approach in controlling pollution depends critically on
limiting the number of rights in circulation; this is the “cap.” Because individual
polluters will no doubt want as many as they can get in the first distribution,
the very first step of the program is one of potentially great controversy: what
formula to use to make the original distribution of emission rights. Almost any
rule will appear to have some inequities. For example, they might be distrib-
uted equally among all existing sources of a particular effluent. But this would
encounter the problem that firms vary a lot in size. Some pulp mills are larger
than others, for example, and the average size of pulp mills, in terms of value of
output, may be different from the average size of, say, soda bottling plants. So
giving each polluter the same number of permits may not be fair.
Permits might be allocated in accordance with the existing emissions of a
source. For example, each source might get permits amounting to 50 percent
of its current emissions. This may sound equitable, but, in fact, it has built-in
incentive difficulties. A rule like this does not recognize the fact that some firms
already may have worked hard to reduce their emissions. One easily could

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 250 Section Four Environmental Policy Analysis

TABLE 13.1 Selected Trading Programs Existing in 2015

Program Item Traded

1990 Clean Air Act Tons of SO2 emissions from power

plants
Southern California Reclaim Tons of SO2 and NOX from large
industrial sources
California Trading Program Tons of greenhouse gases
New Zealand Trading Program Tons of greenhouse gases
Kyoto Protocol Clean Development Tons of greenhouse gases from projects
Mechanism in developing countries
European Trading Scheme Tons of greenhouse gases from large
power, industrial, and cement plants
Regional Greenhouse Gas Initiative Tons of greenhouse gases from large
plants in northeastern and mid-Atlantic
United States
Renewable Energy Certificates Certificates for each 1,000 kWh of
(in states where renewable energy renewable energy produced
portfolio standards exist)
Illinois Emission Reduction Tons of volatile organic compounds
Market System emitted from large sources in eight
Illinois counties
China Trading Program Tons of CO2 emissions
Long Island Sound Nitrogen Pounds of waterborne nitrogen emissions
Trading Program from wastewater treatment plants
Chesapeake Bay Agreement Pounds of waterborne nutrients
(nitrogen and phosphorus)
San Francisco Bay Offset Program Kilograms of waterborne mercury
emissions
Ohio Wetlands Mitigation Program Acres of restored, enhanced, or
preserved wetlands

argue that those firms that, out of a good conscience or for any reason, have
already invested in emission reduction should not now be penalized, in effect,
by receiving emission permits in proportion to these lower emission levels.1
This tends to reward firms that have dragged their feet in the past.2 It could go
even further. If polluters believe that permits will soon be allocated in this way,

1
When we study (in Chapter 15) the Clean Air Act of 1990, we will see that this was the source of
great conflict when the details of the SO2 trading program were being hammered out.
2
This is just another example of the perverse incentives built into any program that asks
everybody to cut their consumption by x percent from their current rate. It favors those who have
consumed at high rates in the past and hurts those who have tried hard to live frugally.

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 Chapter 13 Incentive-Based Strategies: Market Trading Systems 251

they may have the incentive to increase today’s emission rate because this would
give them a larger base for the initial allocation of permits.
Each allocation formula has its problems, and those setting the cap must find
some workable compromise if the approach is to be widely accepted. Closely re-
lated to this issue is the question of whether the rights should be given away or
perhaps sold or auctioned. In principle it doesn’t matter as long as the permits
get distributed fairly widely. Subsequent market transactions will redistribute
them in accordance with the relative marginal abatement costs of polluters,
whatever the original distribution may have been. But free distribution of per-
mits will confer windfall gains on the recipients, the amount of which would
depend on the market price of the permits. What a sale or auction would do is
transfer some of the original value of the rights into the hands of the auctioning
agency. This might be a good way for public agencies to raise funds for worthy
projects, but it has to be recognized that a plan like this would create political
objections. A hybrid system would be to distribute a certain number of permits
free and then auction some number of additional permits. Or a small surcharge
might be put on permits in the original distribution.

Establishing Trading Rules

For any market to work effectively, clear rules must exist governing who may
trade and the trading procedures that must be followed. Furthermore, the rules
should not be so burdensome that they make it impossible for market partici-
pants to gauge accurately the implications of buying or selling at specific prices.
This implies a hands-off stance by public agencies after the initial distribution
of the rights. Working against this is the normal tendency for environmental
agencies to want to monitor the market closely and perhaps try to influence
its performance. The supervising agency, for example, may want to have final
right of approval over all trades, so as to be able to stop any trades it considers
undesirable in some way. The problem with this is that it is likely to increase the
uncertainty among potential traders, increase the general level of transactions
costs in the market, and interfere with the efficient flow of permits. The general
rule for the public agency should be to set simple and clear rules and then allow
trading to proceed.
One basic rule that would have to be established is who may participate in
the market. Is this to be limited to polluters, or may anyone trade? For example,
may environmental advocacy groups buy permits and retire them as a way of
reducing total emissions?
As emission trading has grown (the global market for carbon emission per-
mits and offsets is currently almost $100 billion annually), 3 a substantial body
of law, both statutory and common, has developed to clarify the legal aspects of
the approach; for example, how it fits into standard laws regarding the defini-
tion and transfer of property rights, and what evidence is required in cases of
contested permit ownership.

3
David Freestone and Charlotte Streck, Legal Aspects of Carbon Trading: Kyoto, Copenhagen, and
Beyond, Oxford University Press, Oxford, U.K., 2009.

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 252 Section Four Environmental Policy Analysis

Reducing the Number of Permits

In most CAP programs, the total number of permits and their initial distribu-
tion are established by a public agency such as the Environmental protection
Agency (EPA). Then the sources are allowed to trade with one another, and
perhaps with other groups that are not polluters. One question that presents
itself is, how does the total number of permits get reduced over time? If the
efficient level of emissions is going down because of technological change, how
do authorities reduce the overall number of permits in circulation?
The most direct way is that in the initial distribution each permit is dated
according to the year in which it may be used. Then each participing emitter
would be issued a declining series of dated permits. In this way, the annual
total permit holdings would decline according to the formula adopted in the
overall program. Exhibit 13.1 depicts this for the California CAP for reducing
greenhouse gas emissions.
Another way the total cap may be reduced over time is for organizations, or
individuals, to enter the market, buy allowances, and retire them. The Adiron-
dack Council, a private conservation group in New York, has purchased CO2
emission permits in the Regional Greenhouse Gas Initiative of the Northeastern

The Carbon Market

of California EXHIBIT 13.1
In the absence of action on the federal Board. Fuel suppliers added to the pro-
level to combat climate change, some gram in 2015 were required to purchase
states have taken the initiative. One of allowances covering the greenhouse gas
these is the carbon cap-and-trade pro- content of the fuels they delivered. In
gram initiated in 2012 in California. It early 2014, this allowance market was
has the overall objective of reducing linked to a similar cap-and-trade market
California greenhouse gas emissions to in Quebec, Canada. The emission allow-
1990 levels by 2020. In the first phase, it ances of the California program can be
applied to power plants and large indus- exchanged one for one with allowances
trial plants; as of 2015 it was extended to in the Quebec program. Prices of allow-
suppliers of fuel, such as gasoline, natural ances fluctuated greatly during the first
gas, diesel, and propane. Covered emis- year of the program, and then settled
sions included CO2, plus other green- down to around $13 to $14 per ton of
house gases such as methane, NOx, and CO2 equivalent in 2013; during 2014
hydrofluorocarbons, recorded in terms of they stabilized at $10 to $12 per ton.
their CO2 equivalent values. The state-
wide emissions cap will decline by about For added information, see www.arb.ca.gov
/cc/capandtrade/capandtrade.htm
3 percent per year, so that by 2020 to-
tal emissions will reach the target level. See also: Katherine Hsia-Kiung and Erica
Emission allowances were distributed Morehouse, Carbon Market California, A
Comprehensive Analysis of the Golden States
free to initial participants; additional al- Cap-and-Trade Program, Year Two, 2014,
lowances were auctioned by the manag- Environmental Defense Fund, Washington,
ing agency, the California Air Resources D.C., 2015.

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 Chapter 13 Incentive-Based Strategies: Market Trading Systems 253

FIGURE 13.3 Nonuniform Emissions and CAP Programs

C
A B
D

prevailing
wind

Key: Locations of each emission point

Highest population density

Zones for permit trading

and Middle Atlantic States. The “Compensators” is a private group in Europe

that purchases allowances on the European Trading program. For a number of
years, the Clean Air Conservancy, a private group in the United States, bought
SO2, CO2, and NOx allowances in the programs of this country.

Nonuniform Emissions
Suppose we are trying to design a CAP program to control total airborne SO2
emissions in a region where there are numerous different sources—power plants,
industrial plants, and so on—scattered rather widely around the area. A sche-
matic of this situation is depicted in Figure 13.3. All of the emission points are not
equally situated relative to the prevailing wind or to the area of highest popula-
tion density. Some sources are upwind, others are downwind, of the populated
area. We assume they are not all equal in terms of marginal abatement costs, but
neither are they equal in terms of the impact of their emissions on ambient SO2
levels over the populated area. In technical terms, they have different transfer
coefficients linking their own emissions with damages in the urban area.
Having distributed discharge permits, we now allow them to be traded.
As long as the number of permits in circulation is held constant, we have
effectively controlled total SO2 emissions. But if we allow straight trading, unit
for unit, of permits among all sources, the damage caused by that total could
change. For example, if a downwind firm sold permits to an upwind firm, the
total number of permits would remain the same but there would now be more
emissions upwind of the population, and therefore more damage.4
The problem is similar to the one encountered under the effluent charge pol-
icy; in effect each firm is differently situated relative to the damage area, so the
4
This is sometimes called the “hotspot” problem.

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 254 Section Four Environmental Policy Analysis

emissions of each will have a different impact on ambient quality in that area.
If the program were simply to allow trading of permits among all sources on a
one-for-one basis, it could easily come to pass that a firm or group of firms with
higher transfer coefficients, whose emissions therefore have a greater impact on
ambient quality, could accumulate larger numbers of permits.
One way to get around this might be to adjust the trading rules to take
into account the impacts of individual sources. Suppose the emissions from
Source A were twice as damaging as the emissions of Source B simply because
of the location of the two sources. Then the administrators of the program
might set a rule that if Source A is buying permits from Source B, it must buy
two permits to get one. If this principle is extended to a situation with many
sources, things can quickly get very complicated. Authorities would have to
determine, for each source, how many permits would have to be purchased
from each other source in order for the purchasing source to be credited with
one new permit. If there were five sources, the agency would have to figure
out only 10 such trading ratios, but if there were 20 different sources, it would
have to estimate 190 of these ratios.5 One way around this would be to use a
zoned system, analogous to the zoned effluent charge we talked about earlier.
Authorities would designate a series of zones, each of which would contain
sources that were relatively similar in terms of their location and the impact of
their emissions on ambient quality. Four such zones are shown in Figure 13.3.
Authorities then could do one of two things: (1) allow trading by firms only
with other firms in the same zone or (2) make adjustments for all trades across
zone boundaries similar to the technique discussed previously. Thus, for ex-
ample, if sources in Zone A were judged to have transfer coefficients twice the
size, on average, as sources in Zone B, any trade between sources in these two
zones would be adjusted by that same factor of two: Any firm in Zone A buy-
ing permits from any firm in Zone B would have to buy two permits in order
to get credit for one new one; any source in Zone B would have to buy only
half a permit from a firm in Zone A to get credit for one new permit.

CAPs and Problems of Competition

The question of allowing trading across zone boundaries or, on the contrary,
restricting it to within zones has a much wider importance than might first ap-
pear. CAP programs work through a trading process in which buyers and sellers
interact to transfer title to valuable rights. Markets work best when there is sub-
stantial competition among buyers and among sellers; they work significantly
less well if there are so few buyers or sellers that competitive pressures are weak
or absent. In cases where there are few traders, one of them, or perhaps a small
group, may be able to exercise control over the market, colluding on prices, per-
haps charging different prices to different people, using the control of discharge
permits to gain economic control in its industry, and so on. From the standpoint
of fostering competition, therefore, we would like to set our trading zones as
widely as possible, to include large numbers of potential buyers and sellers.

5
In general, if there were n sources, there would have to be [n(n − 1)]/2 trading ratios established.

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 Chapter 13 Incentive-Based Strategies: Market Trading Systems 255

But this may work against the ecological facts. In many cases there may be
meteorological or hydrological reasons for limiting the trading area to a rela-
tively narrow geographical area. If the objective was to control airborne emis-
sions affecting a particular city, for example, we would probably not want
to allow firms located there to trade permits with firms in another city. Or if
our concern is controlling emissions into a particular lake or river, we could
not allow sources located there to trade permits with sources located on some
entirely different body of water. Thus, for environmental reasons, it may well
be desirable to have trading areas restricted, whereas for economic reasons we
would want to have trading areas defined broadly. There is no magic rule to
tell exactly how these two factors should be balanced in all cases. Authorities
can only look at specific cases as they arise and weigh the particularities of the
environmental features with the subtleties of the competitive conditions in the
industries where trading will occur.

CAPs and Enforcement

The directly controlling aspect of a CAP program is that sources are constrained
to keep their emissions at a level no greater than the total number of discharge
permits in their possession. Thus, an administering agency would essentially
have to keep track of two things: (1) the number of permits in the possession
of each source and (2) the quantity of emissions from each source. Because the
initial permit distribution will be well known, the agency must have some way
of keeping track of permit transactions among market participants. Trades, in
fact, could become complicated with multiple buyers and sellers and with dif-
ferent types of transactions, such as temporary rentals and long-term leases
in addition to permanent transfers. Because permit buyers (or renters) would
have a strong incentive to have their purchases revealed to the agency and
because all purchases imply sellers, a system of self-reporting, coupled with
modern means of information transfer, may be sufficient to provide reliable
information on which sources have the permits.
As regards monitoring, the administrative agency must be able to monitor
polluters to see whether emissions at each source exceed the number of per-
mits it holds. If permits are expressed in terms of total emissions over some
period of time, a means has to be available to measure cumulative emissions at
each source. This is the same requirement as with an effluent charge. If there
were reasonable certainty that emissions were fairly even throughout the year,
authorities could get a check on cumulative emissions by making spot checks
of instantaneous rates. For most industrial sources of pollution, however, there
are considerable daily, weekly, or seasonal variations in emissions; therefore,
more sophisticated monitoring would be required.

CAPs and the Incentive for R&D

One of our main criteria for judging an environmental policy is whether or not
it creates strong incentives for firms to seek better ways of reducing emissions.
Emission standards were weak in this regard, whereas emission charges were
much stronger. CAP programs in this respect are identical to emissions charges,

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 256 Section Four Environmental Policy Analysis

FIGURE 13.4 TDP and Technological Change

MAC1

MAC2
$

p Price of permits
c
e a
d
b
0
e2 e1
Emissions (tons/year)

at least in theory. Consider the firm in Figure 13.4. Suppose that at present the
firm’s marginal abatement cost function is MAC1. Emission permits sell for p
each, and let us assume that this price is not expected to change. The firm has
adjusted its holdings so that it currently owns e1 permits.6 Its emissions are
therefore e1 and its total abatement costs are (a + b). The incentive to do research
and development (R&D) is to find a less costly way of controlling emissions, so
the firm can cut emissions and sell the surplus permits. How much would it be
worth to get marginal abatement costs shifted to MAC2? With MAC2, the firm
would shift to an emissions level of e2. Its total abatement costs here would be
(b + d), but it would be able to sell (e1 − e2) permits for a revenue of p(e1 − e2) =
(c + d). The change in its position would thus be:
Total abatement costs Total abatement costs Receipts from
− − CAP sale
with MAC1 with MAC2

or (a + b) − (d + b) + (c + d), which equals (a + c). Check this with the savings un-
der an effluent charge (see Chapter 12). It is exactly the same. The market price
of the permit has the same incentive as a pollution charge; by not reducing their
emissions, firms are forgoing the increased revenues they could have obtained
by selling some of their permits.

6
These marginal abatement cost functions apply to a year; that is, they are the costs per year of
changing emissions. The price p is therefore a one-year purchase (or sale) price—what it would
cost to buy or sell a permit for just one year.

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 Chapter 13 Incentive-Based Strategies: Market Trading Systems 257

CAPs and Uncertainty

In the last chapter we discussed the use of emission charges to reduce pollu-
tion; you can think of that as a price-based system, because it starts with an
emission charge, which leads to a reduction in the quantity of emissions. A
CAP program can be thought of as a quantity-based system, because it starts
with the setting of a quantitative limit on total emissions, which then pro-
duces a certain price for emission permits. We discussed how, when marginal
abatement costs are certain, we couldn’t be sure about how much of a reduc-
tion of emissions we would get from a given emission charge. With a CAP
program the situation is the opposite: If emission control costs are uncertain,
we can’t be certain what price permits will trade for when the quantity of the
cap is set at some particular level. If the cap is set too high, permit prices will
be too low, weakening their incentive effect.7 If the cap is set too low, permit
prices could be very high, leading to economic disruption and volatile permit
markets.8
This has led recently to the idea of a safety valve in CAP programs. This is an
upper limit price that, if it is reached, would trigger an increase in the supply
of permits. If permit prices reach this limit, firms would be able to buy addi-
tional permits from the governmental authorities operating the program. This
effectively puts an upper limit on permit prices during periods when demand
exceeds available supply in the permit market.

Offset Trading
Most emissions trading carried out in the absence of an authoritative cap comes un-
der the heading of offset trading. Purchasers of offsets are entities who wish to com-
pensate for their increase in emissions; sellers of offsets are entities who will reduce
emissions in a quantity sufficient to compensate for the emissions of the buyers.
Offset demand may result from firms subject to legal limits on their activities.
Many states now have statutory requirements that power companies generate
some portion of their output from renewable sources (often called renewable
portfolio requirements). It is acceptable, in most cases, that they are allowed to
meet this requirement in part by buying renewable power offsets, usually from
firms who build and operate new renewable power plants.
Offset markets may also be formed as a result of voluntarily accepted limits
on emissions. For a number of years, the Chicago Climate Exchange provided
this type of institution. Each voluntary participant agreed to a reduction in
emissions of greenhouse gases, for example, perhaps by 5 or 10 percent. Indi-
vidual participants who exceeded this reduction could sell the resulting cred-
its to participants who were unable or unwilling to reduce emissions by the
required amount. 9

7
This happened in the early stages of the European greenhouse gas program.
8
This happened in the California Reclaim market in the 1990s.
9
The Chicago Climate Exchange was merged into the Intercontinental Exchange in 2010.

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 258 Section Four Environmental Policy Analysis

Finally a substantial international market has developed in strictly volun-

tary offset trading. In these markets, emitters, looking to purchase offsets, seek
to find suppliers of offsets who are willing to sell. These sellers agree to then
reduce their own emissions. Another way to create emission offsets is to take
steps that will naturally expand the carbon absorption of the environment,
such as planting trees. In 2012, an estimated 101 million tons of carbon offsets
were traded globally. The majority of these were traded directly between buyer
and seller, the rest were transacted through a variety of exchanges. Almost
90 percent of these were bought by firms in the private sector, the rest chiefly
by non-governmental organizations (NGOs). 10
Transactions in offsets are somewhat different from transactions in physical
goods. Offsets require emission reductions or altered technology by the offset
suppliers. This creates the problem of validating that the changes have actually
been made to supply the offset, that is, that a supplier has actually reduced their
emissions. Exhibit 13.2 discusses this problem.

Emission Rate Trading

An example of emission rate trading is the system used to phase out of leaded
gasoline in the United States.
In the 1950s, the practice of adding lead to fuel to augment its performance
became common among gasoline refiners. As leaded gas became popular, the
lead content of urban air began to show an alarming increase, and concern
mounted over the resulting health effects. In addition, lead in gasoline inter-
fered with catalytic converters, the technology of choice for reducing other
emissions. The federal response was to establish a timetable for the elimi-
nation of lead in gasoline. The program included a trading system to help
reduce the overall cost of a transition to lead-free gasoline. To decrease the
lead content of gas but maintain normal octane ratings, refineries had to in-
stall new equipment and institute new operating procedures. But conversion
costs differed among refineries, especially between large and small opera-
tions. Some could switch to lead-free gas quickly and at reasonably low cost,
whereas for others conversion would take longer and be more costly. A lead
trading program was introduced to allow more flexibility and lower costs in
the conversion process.
Refineries were given (by the EPA) annual base rates for the amount of lead
in the gas they produced. The rate declined over time, so all production of
leaded gas was ended by 1988. Suppose, for example, the base rate for a given
year was 1 g/gallon. If a refinery reduced its rate to, say, 0.5 g/gal for that year,
and produced 100,000 gallons of gas in that year, it would have 100,000 × 0.5 =
50,000 of allowances (sometimes called lead credits) to sell to refineries which
produced that year at a lead rate over the base level.

10
Molly Peters-Stanley and Gloria Gonzalez, Sharing the Stage, State of the Voluntary Carbon Markets
2014, Report by Forest Trends’ Ecosystem Marketplace, July 2014.

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 Chapter 13 Incentive-Based Strategies: Market Trading Systems 259

Carbon Offset Markets:

Real or Greenwashing? EXHIBIT 13.2
The market for carbon offsets has been offsets are actually reducing atmospheric
growing rapidly. In 2007 about $54 million carbon as part of the deal? Is there any
was spent on carbon offsets, which suppos- way of making sure that, at the end of the
edly went to tree planting, solar energy, line, somebody is reducing carbon as a re-
wind farms, and other means of reducing sult of your buying some offsets?
carbon dioxide emissions. This money was The Federal Trade Commission (FTC),
spent by people and corporations wanting charged with consumer protection, has
to offset the increase in atmospheric car- initiated steps to look into advertising
bon dioxide produced by their products claims made by suppliers of carbon off-
or activities: buying and using a computer, sets. It comes under the heading of green
taking a trip on an airplane, driving a new marketing, and is aimed at making sure
car, and so on. that suppliers of carbon offsets (and also
Dell offers customers a chance to renewable energy certificates) can sub-
purchase carbon offsets to offset the stantiate their claims that carbon is actu-
carbon emissions created in produc- ally reduced after people buy offsets. It
ing its computers. Volkswagon is telling would like to make sure that people are
buyers that it will offset the carbon im- not engaged in greenwashing, that is, sell-
plications of purchasing one of its cars. ing carbon offsets without being able to
General Electric and Bank of America will substantiate that the offsets have led to
convert credit card awards points into real carbon reductions, which could be
carbon offsets. Pacific Gas and Electric intentional, or simply mistaken because of
in California gives customers a chance lack of information.
to purchase offsets to offset the carbon The FTC has not accused anybody of
emissions stemming from their electricity actual wrongdoing, but recognizes that
consumption. it is a market that depends on accurate
In all of these cases, the offsets are be- information flowing through the long
ing produced not by these companies, line between producers and consumers.
but bought in a market that supposedly If I buy a car and it doesn’t work right, I
connects offset buyers with producers. can take it back. But if I buy some carbon
The market consists of a growing number offsets, it’s almost impossible to know if
of firms, brokers, and others who special- carbon has actually been reduced some-
ize in offset transactions. Firms, and some where. When Gaiam, a company that
nonprofits, such as Terra Pass, Carbon- makes equipment for yoga, began selling
fund, and the Chicago Climate Exchange, offsets that were supplied through the
are intermediaries between those who Conservation Fund, a nonprofit organiza-
are supposedly producing carbon reduc- tion, the general manager actually went
tions, either through reducing emissions to the tree-growing sites in Louisiana to
or increasing carbon sequestration, and verify that additional trees were in fact be-
corporations and individuals wanting to ing grown.
buy these reductions to offset their own
emissions.
Source: Based on Louise Story, “FTC Asks
But the question is, how are buyers of If Carbon-Offset Money Is Winding Up True
offsets to know whether the producers of Green,” New York Times, January 9, 2008.

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 260 Section Four Environmental Policy Analysis

The lead market, which was national in scope, was widely used in the transi-
tion to low-lead gas. The EPA estimates that it probably saved several hundreds
of millions of dollars in total transition costs. Its success has been chalked up to
two main points:
r
initial widespread agreement on the overall goal of phasing out leaded gas and
r
the ease of monitoring the amount of lead in gas.
Although the lead trading program was a success in easing the lead “phase-
down,” getting lead out of gas was not achieved without compensating envi-
ronmental costs. People wanted less lead, but they also still wanted high engine
performance. Thus, the octane ratings of gasoline were to some extent main-
tained by substituting other compounds for lead.

Summary
Programs of transferable discharge permits have become popular. One of
the first such programs was the SO2 control CAP in the 1990 Clean Air Act
Amendments. CAP programs for the control of greenhouse gas emissions have
been initiated in Europe and in California. The spirit behind this approach, the
transfer of emission rights from sources with low control costs to those with
high costs, is also behind some recent developments in the control of nonpoint-
source waterborne emissions; we will discuss these in the chapter on water
pollution (see Chapter 14). There is the expectation that this approach could
give us pollution control at a substantially lower cost than the current system
of technology-based effluent standards, and also a sense that, politically, these
programs would be more acceptable than emission charges.
But CAP programs come with their own set of problems. Most especially,
CAP programs take some of the burden of pollution control out of the hands
of engineers and place it under the operation of a market. How that market
operates is obviously critical to whether this type of policy will work. There is a
host of important factors: who gets the permits at the beginning, the strength of
their incentives to minimize costs, the degree of competition in the market, the
transaction rules set by the administering public agency, the ability to monitor
and enforce compliance, and so on. Besides CAP programs, several other trad-
ing systems are common. Offset markets, both voluntary and regulatory, are
widespread, particularly in efforts to reduce global greenhouse gas emissions.
Emission rate trading systems have also been used, for example, in phasing out
leaded gasoline.
Both transferable discharge systems and emission charge systems seek to take
the burden and responsibility of making technical pollution-control decisions out
of the hands of central administrators and put them into the hands of polluters
themselves. They are not, we should stress, aimed at putting pollution-control ob-
jectives themselves into the hands of the polluters. It is not the market that is going
to determine the most efficient level of pollution control for society. Rather, these
systems are the means of enlisting the incentives of the polluters themselves in
finding more effective ways of meeting the overall objective of reducing emissions.

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 Chapter 13 Incentive-Based Strategies: Market Trading Systems 261

Questions for Further Discussion

1. How might you design a transferable discharge permit system for solid
waste? For phasing out of use a certain type of plastic? For phasing in a pro-
gram for using recycled newsprint in newspapers?
2. Explain how a program of transferable discharge permits works to satisfy
the equimarginal principle.
3. Following are the marginal abatement costs of two sources. They currently
emit 10 tons each.
a. What would the total abatement costs be for an equiproportional cutback
to a total of 10 tons?
b. Suppose we print up 10 transferable discharge permits, each of which
entitles the holder to 1 ton of emissions. We distribute them equally to the
two sources. What will the final emissions be for each of the two sources,
and the total abatement costs after all adjustments have been made?
c. Show that if the permits are originally distributed in a different way (say
all to one source and none to the other), the final results will be the same
in terms of total and individual emissions, but the distribution of the gains
from trade will be different between the two sources.
Marginal Abatement Costs
Emissions (tons) Source A Source B
10 0 0
9 2 4
8 4 8
7 6 14
6 8 20
5 10 30
4 12 42
3 14 56
2 18 76
1 28 100
0 48 180

4. What are the pros and cons of letting anybody (banks, private citizens, envi-
ronmental groups, government agencies, etc.) buy and sell transferable dis-
charge permits, in addition to emission sources themselves?
5. Most of the carbon offsets traded globally are being bought by corporations,
many of which are not currently subject to emission restrictions. Why do you
think this is the case?
For additional readings and Web sites pertaining to the material in this chapter,
see www.mhhe.com/field7e.

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