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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