A Deeper Look at Tradeable Allowances

Since the passage of the Clean Air Act, SO2 emissions have decreased by 35%. Part of this is due to tradable allowances, which created a market solution to the external costs of SO2 emissions. In this video, we look at the lessons of tradable allowances for SO2 and see if a similar market-based solution could work to decrease other pollutants, such as CO2.

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- [Alex] Tradable permits are
a kind of combination

of costs and command and control.

We covered the essential idea
in the previous video.

In this video, I just want
to underline a few key points.

Let's get started.

The Clean Air Act
was very successful.

Under the act,
SO₂ emissions have fallen

over time, and at the same time,
electricity generation has continued to

increase. So the market has been able to
discover low cost ways of reducing

pollution. An important consequence of the
tradable allowance system is that firms

that generate electricity from clean
sources - they can make money by selling

allowances. On the other hand, firms that
generate electricity from dirty sources -

they have to buy allowances. The result
is that clean energy is subsidized, and

not by taxpayers. At the same time, dirty
energy is taxed. So a tradable allowance

system, implicitly within that system, is a
way of encouraging clean energy and

discouraging dirty energy. A very
interesting aspect of these markets is

that anyone can participate, not just
generators of electricity. So Tyler Cowen

and I, in fact, purchased the right to emit
30 pounds of sulfur dioxide into the

atmosphere. Now we didn't want to do
that. So what did we do? Well, we tore it

up. Why? Well, when we tore up that right
to emit 30 pounds of sulfur dioxide into

the atmosphere, we made the air cleaner.
Nobody else had that right. So by tearing

it up that's 30 fewer pounds of sulfur
dioxide which were allowed to be emitted

into the atmosphere. In fact, under the
tradable permits plan, environmental

groups are free to buy up permits, tear
them up, and reduce pollution in that way.

If they think that the government, for
example, set the pollution permits too

high, they're free to buy pollution
permits and tear them up. So it's a very

efficient way of reducing the amount of
pollution. Let's briefly compare tradable

allowances with Pigouvian taxes. They're
actually quite similar economically. If

the tax is set equal to the level of the
external cost, and the number of

allowances is equal to the efficient
quantity, then they're basically the same

economically. Politically however, they're
quite different. And the key question is,

who gets the initial allowances? Now some
people argue that pollution allowances are

the same as corrective or Pigouvian taxes
plus a little bit of corporate welfare.

You're giving away the right to pollute.
Now that's really not the best way to

look at the issue, however. First of all,
we don't have to give the allowances away.

They could be auctioned off generating
revenue for the government. In this case,

then politically and economically, the two
systems would be very similar. Most

importantly, however, is if the allowances
are given to the firms initially,

pollution control is more likely to be
accepted by the large energy firms. If you

just come at the large energy firms and
say, "We're going to tax you," of course

they're going to lobby against those
taxes. If on the other end you say,

"We're going to have a tradable allowance
system in which you guys are given some

right to pollute at, say, historical
levels," they're going to be much more

willing to accept the program politically.
In any case, that's the main difference -

politics. Tradable allowances have worked
very well for controlling sulfur dioxide.

Could a similar system be used to combat
global climate change and the problem of

carbon dioxide and carbon emissions more
generally? In theory, the answer is

definitely yes. All of the advantages of
tradable allowances for sulfur dioxide

would hold for carbon dioxide as well. The
main difference is, is that global climate

change is a global problem. The
externalities involved in sulfur dioxide,

the acidification of lakes, were primarily
national. So all we needed was a national

plan in order to control sulfur dioxide.
But to control carbon dioxide we need a

global plan, and it's going to be much more
difficult to get all the nations of the

world to agree to either a Pigouvian
tax system or a tradable allowance system

than it is just to get one country to
agree. The externalities are international

making the problem much more difficult to
solve. At the same time, economics is

going to be very important for solving
these problems, because what we've just

seen, is that both Pigouvian taxes and
tradable allowances give us the most bang

for our buck. They give us the most
pollution control at the lowest cost. And

if we can lower the cost of pollution
control or carbon dioxide emissions, we're

much more likely to get reductions in
carbon emissions. The lower the cost of

solving the problem, the more likely we
are to solve the problem - and that's one

reason why understanding economics and
the economics of Pigouvian taxes and

tradable allowances
is extremely important.

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