Economic notes

1. Chapter 13
Transferable Emission
Permits (TEP)
© 2015 McGraw-Hill Ryerson Ltd.
Created by Dr. Charles Krusekopf
1

2. Learning Objectives
• LO1 Describe the general principles of a transferable
emission permit (TEP) and show graphically how it can
achieve a cost efficient equilibrium.
• LO2 Explain the pragmatic issues in setting up a TEP
system covering: initial rights allocation, trading rules,
non-uniformly mixed pollutants, non-competitive
markets, enforcement, and incentives for innovation.
• LO3 Describe the key features of the U.S. sulphur
dioxide TEP system and how it achieved target levels of
emissions cost effectively.
© 2015 McGraw-Hill Ryerson Ltd. 2

3. Transferrable Emission Permits (TEP)
• TEP create a form of property right (a product)
– The “right” to emit a certain amount of pollution
– Each permit entitles its holder to emit 1 unit (kilogram,
tonnes etc.) of the waste material as specified in the permit
– The total # of permits held by all sources puts an upper
limit on the total quantity of emissions
• Discharge permits are transferable
– Can be bought and sold
– Price agreed upon by the participants themselves
• Similar to a standard in that it caps the allowable
amount of pollution
– TEP begins with a centralized decision on total number of
discharge permits to be put into circulation by setting
MD=MAC
– But it places no set standard on any one firm
© 2015 McGraw-Hill Ryerson Ltd. 3
LO1

4. Transferrable Emission Permits
• Like a tax, transferable permits that are traded in a
competitive market are a cost-effective policy
• Regulators do not have to know each polluter’s MAC
curve to achieve cost-effectiveness
• Once the target level of pollution is set, the market will
reveal a polluter’s MAC curve
• Trading occurs if the MACs of polluters are sufficiently
different
– Some will become sellers of permits and the others, buyers
• The exchange of permits provides each trader with cost
savings
© 2015 McGraw-Hill Ryerson Ltd. 4
LO1

5. Transferrable Emission Permits
• Suppose a power plant emits 8000 tons of sulfur per year and
the government wants an overall reduction of 25% in SO2
emissions. The plant owner will initially be given 6000 discharge
permits.
• Consider three options for the polluter:
(a) reduce emissions to 6000 tons
(b) buy additional permits and emit at a higher level
(c) reduce emissions below 6000 and sell excess permits
• Polluter’s choice depends on our marginal abatement costs and
the price of a permit.
• Polluter will reduce emissions as long as MAC < permit price.
5
LO1

6. Transferrable Emission Permits
Figure 13-1 How Transferable Emissions Permits Work
•A TEP system is introduced to lower sulphur pollution from an initial
level of 120,000 to 80,000 tonnes per year. Polluters are given
emission permits in proportion to their initial level of emissions (30 to
firm A and 50 to firm B). Polluters will have an incentive to trade
permits as long as their MACs differ at each one’s emission levels.
Polluter A will have an incentive to sell permits to B because it can
reduce its emissions at lower marginal cost than can B. The cost-
effective equilibrium is reached where the MACs of the two polluters
are equal and their total emissions equal the target level. A total of 15
permits are traded. Firm A’s net gain is area c; firm B’s is area d.
© 2015 McGraw-Hill Ryerson Ltd.
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LO1

7. SUMMARY
*Initial emission by Firm A and Firm B=120,000 tonnes
*Target of emission control=80,000 tonnes
*Initial Permits allocation, 30 permits to firm A(cost efficient)
and 50 permits to Firm B.
*Cost Effective Solution—A sells 15 permits to Firm B. At this
exchange,
Firm A’s emission=15, Firm B’s emission =65
At these emission levels, MACs are equalized at $75. Firm A’s
net gain=area ‘c’, and Firm B’s net gain area ‘d’

8. DETAILS from the book
In the preceding diag, assume the following:
MACa=120-3Ea & MACb=400-5Eb
Total emissions of sulphur is found by setting Ea and Eb=0
Total E=Ea+Eb=120,000 tonnes of sulphur emission annually
Target Level(of emission control) of the govt.= 80,000 tonnes per
year
Emission Based TDP system:-
The regulator creates 80 units of TDP, each one entitles its possessor
to emit 1,000 tonnes/year
Permit Allocation Rule - each firm is allocated permits roughly in
proportion of its current emission rate (roughly in the ratio of 3/5)
Firm A receives 30 permits and firm B gets 50 permits in the original
allocation.
At this original allocation, firm A ‘s cost is $30 and B’s cost
is $150-which means firm A’s MAC is substantially lower than firm’s B.

9. Firm A’s gain by trading
Suppose Firm A reduces its emission from
30,000 to 15,000 tonnes
MACa=120 - 3(15)=$75
Change in total abatement cost if emission is reduced
from 30,000 to 15,000=(area a+b)=$787.50
If the firm A sells its 15 surplus permits to B for $75 per permit,
it will receive area (a+b+c)=$1125
Firm’s cost savings-=(a+b+c)-(a+b)=area c= $337.5
Firm B’s gain by trading
B’s TACs fall because B increases pollution
Reduction in B’s TAC=(d+e)=$1687.5
B’s cost of buying permits=$1125
B’s Gain=area d=$562.5=$1687.5-$1125
Total cost savings of both parties=(c+d)=$900

10. Gains from trade
•With different MACs, TEPs will continue to be traded
until MACs are equalized;
•TEP operates like a hybrid between imposing STDs and
using taxes to reach a target:
•Target:=fixed # of permits:=STDs;
•TDP price is like a tax.

11. •Advantages:
•Regulator does not have to know the polluter’s MAC curves;
•Hence, TDPs are less informational demanding than STDs &
taxes;
•The market achieves socially optimal price on its own.
•Disadvantages:
•Bargaining process can be tedious & complicated with a
large # of firms involved;
•A single overall market for permits is required for the system
to work properly;
•Markets must be perfectly competitive.

12. How TEP permits are allocated
• A central authority sets the total number of
permits (maximum level of emissions)
• The authority allocates the permits
– Methods of allocation include:
• Based on past pollution
• Based on past production
• Based on past efforts to reduce pollution
• Equal amount to everyone
• Auction (Tax revenue to government – same as with an
emissions tax)
© 2015 McGraw-Hill Ryerson Ltd. 12
LO2
© 2015 McGraw-Hill Ryerson Ltd.

13. The initial rights allocation
•The success of the TDP depends critically on limiting the # of rights
in circulation;
•What formula should be applied to share rights initially?
•Almost any rule will appear to have inequities:
•Equal allocation to all existing sources of a particular effluent?
•Or, in accordance with the existing emissions of source? Example:
50% of current emission;
•Should the permits be given out or auctioned off?
•Approach: Find some workable compromise that is widely
acceptable to those concerned.

14. Establish Trading Rules
• Intervention by supervising parties can be counterproductive
– 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
– General rule for public agency: set simple and clear rules
and then allow trading to proceed
• Can everyone participate, or only firms in the business? (Can
environmental groups buy permits and “retire” them?)
• How long are permits valid for? Is permit “banking” allowed?
What level of emissions will be allowed in the future?
© 2015 McGraw-Hill Ryerson Ltd. 14
LO2

15. TEP Market Opens…
• Firms can buy or sell based on the price in the market
and MAC
• If firms reduce emissions, they are rewarded by getting
the chance to sell permits
• If firms have very high costs of emission reductions –
they are better off than under a standard because the
permits cost less than the MAC
• The market price will be just above the value of the
MAC of the last unit reduced (same as the efficient
emissions tax level)
© 2015 McGraw-Hill Ryerson Ltd. 15
LO2

16. Non-uniformly Mixed Pollutants
• Non-uniform emissions – the “Hot Spot” problem
– E.g., TEP program to control total airborne SO2 emissions in
a region with numerous sources
– Emission points not equal in terms of:
• Location relative to the prevailing wind or to the area of
highest population density,
• MAC, nor
• Impact of their emissions on ambient SO2 levels over
the populated area
– If straight trading of permits among all sources, the
damage caused by total SO2 could change
• If a downwind firm sold permits to an upwind firm,
there would now be more emissions upwind of the
population and, therefore, more damage
© 2015 McGraw-Hill Ryerson Ltd. 16
LO2

17. Non-uniformly Mixed Pollutants
• Ambient-based TEP system overcomes “Hot Spot” issue
– E.g., emissions from Source B are twice as damaging as
emissions from Source A
• May set a rule that if Source B buys permits from
Source A, it must buy two permits to get 1
• When pollutants are non-uniformly mixed, the ambient
system is necessary to achieve a cost-efficient equilibrium
• However, very complex market system to operate
– Many sources of different MDs to determine
– Have to determine for each source how many permits
should be purchased in order to be credited with one
new permit
© 2015 McGraw-Hill Ryerson Ltd. 17
LO2

19. Non-uniformly Mixed Pollutants
• Simpler method: a zoned system
– Each zone designated based on sources that were
relatively similar in terms of location and impact
of their emissions on ambient quality
– Regulators could do one of two things:
• Allow trading by firms only with other firms in the same
zone, or
• Make adjustments for all trades across zone boundaries
using an ambient-based system
© 2015 McGraw-Hill Ryerson Ltd. 19
LO2

20. Non-Competitive Markets
• TEP programs work through a trading process,
where buyers and sellers interact to transfer title
to valuable property rights
• Problem with restricting trade across zone
borders:
– Markets work best when there is substantial
competition
– They work much less well if there are so few buyers
or sellers that competitive pressures are weak or
absent
– Large markets are therefore essential for the proper
workings of the TDP system.
© 2015 McGraw-Hill Ryerson Ltd. 20
LO2

21. Non-Competitive Markets
• To foster competition, regulators would like to set
trading zones as widely as possible, to include large
numbers of potential buyers and sellers
– This may work against the ecological facts
– May be meteorological or hydrological reasons for
limiting the trading area
• For environmental reasons regulators may want to have
trading areas restricted
– However, for economic reasons they would want to
have trading areas defined broadly
© 2015 McGraw-Hill Ryerson Ltd. 21
LO2

22. Enforcement
• Administering agency would essentially have to keep
track of two things:
– The number of permits in the possession of each
source and
– The quantity of emissions from each source
• Trades could, in fact, become complicated with multiple
buyers and sellers, and with different types of
transactions
• should create an incentive system for sources to monitor
each other
• Some encouragement of inter-firm monitoring
– If another firm cheats, that means they are not buying
a permit from you
© 2015 McGraw-Hill Ryerson Ltd. 22
LO2

23. Incentives to Improve Abatement
Technology
• TDPs and taxes create a strong incentive to
innovate than STDs.
• Incentive to find a less costly way of
controlling emissions
– Very strong because you can either sell additional
permits or buy fewer
• Over time, as technology improves, the price
of permits in the market should drop
© 2015 McGraw-Hill Ryerson Ltd. 23
LO2

24. Initially polluter owns E1 permits at
price p
Polluter reduces emission to E2 (by
using better technology.
Gain=area ‘c’ and area ‘a’

25. d
e
75
Incentives for Innovation: Numerical Example
Cost savings as good as emission taxes
MAC1
MAC2
MAC1 = 200 - 2E1
MAC2 = 100 – E2
100
50
Permit price = $50
$50
TAC with MAC1 = d + e = $625
TAC with MAC2 = b + e = $1250
Revenue from TDP = b + c = $1250
Cost Savings =
c
b
a
(d+e) – (b+e) + (b+c) = d + c = $625
$
$200
$100
emissions

26. U.S. 1990 Clean Air Act Amendments
• U.S. EPA created an innovative permit-trading
scheme for the control of airborne SO2
emissions in the 1990 Clean Air Act
Amendments
• The EPA issues a quantity of emission permits
to designated power plants
– Each permit will allow the release of 1 ton of
sulphur dioxide from that plant
© 2015 McGraw-Hill Ryerson Ltd. 26
LO3

27. U.S. 1990 Clean Air Act Amendments
• The permits may be traded at prices agreed
upon between buyer and seller.
• The purpose of a TEP program like this is to
achieve a reduction in total SO2 emissions in a
cost-effective way
– More so than if all plants were required to meet
the same proportionate reductions or if all firms
were held to the same TEPs
© 2015 McGraw-Hill Ryerson Ltd. 27
LO3

28. Initial Allocation of Permits
• Phase I limited to 110 plants in 21 Eastern and
Midwestern states
– Each plant was allocated a prescribed number of permits
– More permits given to larger plants, as measured by the
average quantity of fuel used during the base period
1985–1987
• Phase II extended to cover an additional 1000
plants burning oil, natural gas, or coal
• The program has been a success in terms of
reductions in emissions
– Total U.S. emissions fell by more than 50% from 1995-
2010
© 2015 McGraw-Hill Ryerson Ltd. 28
LO3

29. Was the SO2 TEP System Cost Effective?
• The program was cost-effective for the following
reasons:
1. TEP markets work best if firms are allowed to use
whatever means they find the cheapest way to
reduce emissions
2. Prior to 2010, the EPA did not dictate technology
choices made by utilities to reduce their SO2
emissions
3. The move to greater competition in supplying
electricity to consumers probably aided the
efficiency of the market by increasing the number of
buyers and sellers
© 2015 McGraw-Hill Ryerson Ltd. 29
LO3

30. Was the SO2 TEP System Cost Effective?
• The program was cost-effective for the following
reasons:
• Provisions for banking permits for future use
allow companies to hedge against future changes
in their emissions
• The increasing stringency of the regulations
signaled increasing permit scarcity
– As prices increase, producers have an R&D incentive
• No longer constrained to use a prescribed TEP.
© 2015 McGraw-Hill Ryerson Ltd. 30
LO3

31. Chapter
Overview
© 2015 McGraw-Hill Ryerson Ltd. 31
Transferable discharge permits are being used
more frequently
TEP programs come with
their own set of problems
How the TEP market
operates is critical to
whether this type of
policy will work
We examined the U.S. TEP program for SO 2
reduction among electric power producers
Both TEPs and emission tax systems give the
responsibility of making technical pollution-
control decisions into the hands of polluters
themselves rather than administrators
Chapter 14 will explain compliance costs,
uncertainty, and information associated with
policy.