Trading in pollution

OECD Observer

One way to deal with pollution is to encourage polluters to buy and sell limited rights or permits to pollute. It is a market that works, though improvements are needed.

A 50% fall in emissions over 10 years: this might sound like fantasy but is exactly what the United States Environmental Protection Agency’s Sulphur Dioxide (SO2) Program (the “Acid Rain” programme) achieved in the 1990s when it set up an “air market” of tradeable permits.

The programme, which came into force in 1995 following the Clean Air Act Amendments five years earlier, introduced flexibility into pre-existing regulations mandating the use of flue-gas desulphurisation for electricity-generating plants. Instead, it gave firms the right to determine their own compliance strategy, including the right to purchase tradeable emission permits from other firms.

In short, a cap on total sulphur dioxide emissions was set, and the total permits issued among firms generating sulphur dioxide was equal to this cap. Firms could then trade these permits among themselves: those firms generating more emissions than their initial allocation would buy permits from firms that generated fewer. The total number of permits would remain stable, but the distribution of permits among firms would change with the market.

This made the programme environmentally effective, as well as reassuring regulators and the public (including environmental NGOs), that total emissions would not exceed a certain limit. The system was also economically efficient, because high-cost abaters bought permits from those who could abate at lower

cost. And it encouraged managerial and technological innovation as emitting firms and others sought out the best ways to meet the regulatory requirements. Meanwhile, the installation of continuous monitoring devices by the firms themselves reduced the government’s administration and enforcement costs.

The test was in the results, of course. From emission levels of 10 million tonnes for affected units of SO2 in 1990, emissions fell to less than five million by the end of the decade. Moreover, this was achieved at much lower costs than had been anticipated: original estimates of permit prices in the first phase of the programme had ranged between US$181 and US$981, but actual prices have hovered around US$150 and have rarely been in excess of the lower band of estimates.

The Acid Rain programme is not an isolated case. Other successful efforts to introduce tradeable permits reduced lead in gasoline, cut ozone-depleting substances, and other pollutants, like oxides of nitrogen. Now, other countries are following the US example, with notable programmes for a variety of pollutants starting or in existence in Canada, Denmark, the Netherlands, the United Kingdom, and elsewhere.

Perhaps more importantly, the Kyoto Protocol has endorsed the use of tradeable permits on an international scale, as a means to address climate change. Indeed, it is paradoxical that the United States has refused to ratify a protocol which endorses an instrument that they have pioneered. Instead, the baton has been taken up by countries such as Denmark and the United Kingdom, who have developed tradeable permit programmes for carbon dioxide in anticipation of an EU-wide scheme.

However, not all tradeable permit systems have had similar success and many have resulted in few trades and precious few efficiency gains. This has been particularly true of the first American water pollution tradeable permit regimes. One reason for this is the fact that in some cases there were very few participants, since the scope of the market was determined by the affected river or lake. Moreover, those firms that were involved often had similar technological opportunities to reduce their effluent, so narrowing the scope to increase efficiency by trading permits. In addition, the first programmes often placed significant regulatory constraints on trading. Some have adopted fairly cumbersome systems, such as basing the creation of permits on emission reductions below an agreed baseline: The gap between the polluter’s improved performance and the baseline would become a permit, which they can then sell to others. Good in theory, but it demands paperwork, not least in trying to define the baseline.

The lessons are that tradeable permits markets should be broad to ensure competitiveness and enable efficiency gains. The rules should be easily understood to encourage participants to exploit the market as fully as possible. And while single undifferentiated markets appear to work for carbon dioxide emissions whose effects are widespread, markets for pollutants with different effects must take account of local “hot spots”.

Tradeable permits can work, but they are under-used by OECD country governments. This is part of the problem, since they need to be tried and tested more if they are to be improved. This is likely to happen in the years ahead. The EU carbon dioxide programme, which is expected to get under way in 2005, will be watched with interest.



• OECD (2002), Implementing Domestic Tradeable Permits: Recent Developments and Future Challenges, OECD, Paris.

• Ellerman, Denny et al (2000), Markets for Clean Air: The U.S. Acid Rain Program, Cambridge University Press, New York.

©OECD Observer No. 233, August 2002

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