Marketable Permits Essays

“Don’t it always seem to go
That you don’t know what you’ve got till it’s gone”

—Joni Mitchell, “Big Yellow Taxi”

For many environmentalists, protecting the environment is a matter of ethics, morality, and stewardship. For others, the environment is just one of many daily concerns. And, while many people might prefer a cleaner environment, nearly all economic activity results in some pollution. So, if society wants goods and services, it must accept some pollution. Less pollution will likely require less production (and consumption) of goods and services, higher costs for firms (and higher prices for consumers), or some combination of the two (see the graph). This highlights the underlying trade-off: A clean environment imposes costs.

NOTE: Motor vehicle exhaust is a source of pollution. The number of miles driven in the United States peaked in November 2007 at 3.04 trillion. More recently, the data released in February 2014 show 2.97 trillion miles driven (12-month moving average). The gray bars indicate recessions as determined by the National Bureau of Economic Research.

SOURCE: Federal Reserve Bank of St. Louis FRED; http://research.stlouisfed.org/fred2/series/M12MTVUSM227NFWA.

Government regulation is one approach to protecting the environment. The government may mandate certain technologies (e.g., catalytic converters for cars or smokestack scrubbers for factories), ban certain goods (e.g., most traditional incandescent light bulbs), or stipulate a target level of efficiency and then let firms determine how they will meet the requirements.1 Such government regulations achieve environmental goals, but in many cases they may not be the most cost-effective or efficient methods of doing so.

Property Rights and Externalities

From an economic perspective, firms that dump large amounts of waste into the air or water are shifting some of their production costs to society. The firms that pollute benefit from paying lower production costs (compared with using cleaner technology or fuels or installing pollution-control equipment). Society bears the costs of pollution through diminished opportunities to enjoy outdoor activities, potential long-term damage to ecosystems, as well as pollution-related health issues and their associated medical costs. Economists refer to this shifting of costs to third parties as a negative externality.

Economists generally attribute the existence of negative externalities to the lack of clear property rights.2 When people own property, they have an incentive to protect it, care for it, and ensure that it lasts. For example, if you owned the air that you breathe, you would likely take action to stop others from polluting it or require compensation for the use of your property. But when property is not owned—such as air or water in a river— no one has a vested interest to be responsible for its welfare.

The Environment as the “Commons”

William Forster Lloyd wrote about the connection between property rights and externalities in 1832. In the England of his day, herders could graze their animals on lands owned “in common,” or essentially by everyone. Lloyd noticed that these areas were overgrazed by animals to the point of barrenness. In economic terms, individual herders benefited from grazing their animals on the common, but the cost to each individual herder was near zero because the common grazing area was shared by all. As a result, the herders kept adding more animals to the common that became overgrazed and unproductive, which was harmful to the entire group. Lloyd’s story is known to economists as the tragedy of the commons. In essence, the herders using the commons were gaining the benefits of their animals’ growth, but by grazing their animals on the common, they were shifting much of their production costs to their neighbors collectively. In other words, there was a negative externality.

Economists understand the lesson from the tragedy of the commons: When resources are not owned or the property rights are poorly defined, individuals have little incentive to monitor its use or overuse. In such cases, economists suggest property rights can be granted to ensure custodianship of the resource. However, granting property rights over some resources (e.g., the environment) can be difficult or unpopular. When granting property rights is not feasible or acceptable, the government can act as the custodian.

Economic Solutions to Pollution

According to economic models, firms that produce negative externalities by shifting some of their production costs will produce a greater quantity of the pollution-producing good or service than the socially optimal quantity, which (in this context) is the quantity of goods produced that takes both the private and social (or external) costs into account. In short, in the case of the environment, this means that the free market, left alone, will overproduce pollution. How is this dilemma resolved?

Economist Arthur Pigou was an early advocate of using taxes to correct for negative externalities. He suggested negative externalities could be reduced by imposing a cost that reflects the extra cost shifted to society on the producer of the externality. To accomplish this, the government (acting as custodian) could impose a corrective Pigovian tax (named after Pigou) on the firm. For example, if a firm’s production of widgets shifted $10 of the production cost per widget to society in the form of pollution, the government (representing society) could impose a $10 per widget tax on the firm. This action would force the firm to make its production decisions based on a cost that accounts for the negative externality, which is called internalizing the externality. Given the higher cost of production, the firm would probably reduce its production of widgets—and the amount of pollution created. Alternatively, the government could directly tax each unit of pollution emitted instead of each widget produced, thereby setting a fixed price for polluting and creating a direct incentive for firms to reduce the amount of pollution emitted. For example, firms might adopt technology that produces less pollution.

Economists view these types of policies as effective and efficient methods of reducing pollution because they use market forces and economic incentives to correct for negative externalities.3 They also give firms the freedom to choose the least-costly method of pollution reduction. In economic terms, this allows firms to “pick the low-hanging fruit” by pursuing the options with the lowest opportunity cost first. Economists also note that such tax policies create government revenue, which can be used to reduce other taxes, pay debt, or fund infrastructure, education, or social programs.4 This is the underlying concept for many carbon tax policy proposals.

Because taxes require direct payment by firms (and therefore indirect payment by their customers), some economists consider using tradable pollution permits a more acceptable alternative.5 In this scenario, the government can issue a specific (total) number of permits, which are allocated to firms based on a sustainable use of the resource (in this case, the atmosphere). Firms can emit only as much pollution as their permits allow. Because the government determines the number of permits, it can set a cap on the total amount of pollution emitted. Firms can buy and sell the permits in an established market at a price determined in the market. Firms that emit a great deal of pollution must buy permits, and firms that emit less can sell their permits in excess of those needed to cover their emissions. This provides an economic incentive for firms to reduce pollution in cost-effective ways. In practical terms, this serves as a subsidy to firms that use clean energy and production methods and a tax on those that pollute excessively.6

The total number of permits issued by the government can be reduced over time, thereby reducing the total amount of pollution emitted. Further, individuals or groups that wish to reduce pollution can have a direct impact by buying the permits and taking them off the market. The Clean Air Act Amendments of 1990 used tradable pollution permits to cost-effectively reduce sulfur dioxide pollution, which was causing acid rain. At the time, the concept of the government issuing a permit to pollute did not sit well with some environmentalist groups; many criticized them as “licenses to pollute.” The permits were given to firms, and they were allowed to trade them. This technique, known popularly as “cap and trade,” is still controversial, but the successful use of pollution permits in reducing sulfur dioxide pollution and acid rain has made them more acceptable.

Conclusion

Economists generally do not regard environmental cleanliness as an absolute good. Instead, they consider environmental quality as an economic decision with trade-offs. Individuals or firms that pollute are shifting some of their costs to society. And, because some costs are shifted, the market, left alone, will produce too much pollution. In these cases, the government can use regulations, taxes, or tradable permits to protect environmental resources from overuse. While each of these methods can be effective in achieving environmental goals, economists generally favor methods such as pollution taxes or tradable pollution permits over government mandates because these two methods create incentives for firms to reduce pollution in the most efficient, cost-effective way.7

Notes

1 For example, auto manufacturers must meet Corporate Average Fuel Economy (CAFE) and emission standards, which may become more stringent and require further engineering and technology changes over time.

2 Stavins, Robert N. “The Problem of the Commons: Still Unsettled after 100 Years.” American Economic Review, February 2011, 101(1), pp. 81-108.

3 Milliman, Scott R. and Prince, Raymond. “Firm Incentives to Promote Technological Change in Pollution Control.” Journal of Environmental Economics and Management, November 1989, 17(3), pp. 247-65.

4 Goulder, Lawrence H. “Environmental Taxation and the Double Dividend: A Reader’s Guide.” International Tax and Public Finance, August 1995, 2(2), pp. 157-83.

5 Stavins, Robert N. “What Can We Learn from the Grand Policy Experiment? Lessons from SO2 Allowance Trading.” Journal of Economic Perspectives, Summer 1998, 12(3), pp. 69-88.

6 Cowen, Tyler and Tabarrok, Alex. Modern Principles of Economics. Second Edition. New York: Worth Publishers, 2012.

7 A 2011 survey of American Economic Association members asked respondents to reply to the following statement: “Pollution taxes or marketable pollution permits are a more efficient approach to pollution control than emission standards.” Of the 568 respondents, 58.5 percent agreed, another 29.1 percent agreed with conditions, and only 10.9 percent disagreed. See Fuller, Dan and Geide-Stevenson, Doris. “Consensus Among Economists—An Update.” Journal of Economic Education, 2014, 45(2), pp. 131-46.

Glossary

Absolute good: A value that cannot be traded off against other things that are highly valued by individuals. Many moral or ethical laws are considered to be absolute goods by the supporters (or advocates) of such laws.

Internalizing the externality: Altering the incentives so that individuals and firms incorporate the costs and benefits that have been shifted to third parties into their decisionmaking.

Negative externality: A negative side effect that occurs when the production or consumption of a good or service affects the welfare of individuals who are not the parties directly involved in a market exchange. A company that pollutes imposes a negative externality on those harmed by the pollution.

Opportunity cost: The value of the next-best alternative when a decision is made; it’s what is given up.

Pigovian tax: A tax used to correct for a negative externality.

Socially optimal quantity: The quantity of goods produced that takes private and social costs into account.

Tragedy of the commons: The overuse of a resource, such as water, land, or air, due to poorly defined property rights.




Scott A. Wolla, "Economics and the Environment," Page One Economics, September 2014

ACUS provides marketable permit recommendations to harness efficiency and maintain policy objectives.

Although cap-and-trade programs for government permits to emit carbon dioxide occasionally makeheadlinenews, the average American may not realize that billions of dollars’ worth of government permits are auctioned or traded in a wide variety of industries, from broadcasting to construction to fishing.

Those industries all rely on “marketable permits”: government licenses issued for various activities that regulated parties can purchase from the government or buy from and sell to other private parties. The intended goals of making regulatory permits marketable include harnessing the efficiency of the market to lower compliance costs, encourage innovation, and ease administrative burdens, all—in theory—without compromising the policy objectives of the regulation.

The alienability of marketable permits makes it important for regulatory agencies to clearly define the privileges and requirements of ownership. Regulatory agencies must also oversee permit markets to ensure the permitting program achieves its regulatory objectives efficiently and without market manipulation.

Last December, the Administrative Conference of the United States (ACUS) adopted recommendations to provide guidance on such issues to federal agencies, articulating the best practices to follow in designing and overseeing marketable permit programs.

Marketable permits have a long history of bipartisan support in a variety of contexts, starting with air pollution markets in the 1970s and 1980s and exemplified by the 1990 Clean Air Act’s creation of the acid rain market. Since then, marketable permits have spread to other environmental and natural resource regulations, including water quality trading, tradable fish catch shares, and offset credits that land developers can purchase from third parties to mitigate their development projects’ impacts on endangered species or wetlands.

These programs are quite popular with regulated entities. For example, there are 1,500 wetland mitigation banks, and over 50 percent of development projects purchase credits from those banks for their required wetland mitigation. Some 15,000 hectares are traded annually, with cumulative transactions worth over $3 billion.

Marketable permits are not limited to the environmental context. A presidential Executive Order instructs agencies broadly to consider the possible advantages of regulating through marketable permits across all policy contexts. There are marketable permit programs for motor vehicle efficiency standards, renewable energy credits, auctions for electromagnetic spectrum licenses, and secondary trading of airport landing slots. And that is just at the federal level; at the state and local level, marketable permit programs thrive for transferrable property development rights, liquor licenses, and taxi medallions. Possible future applications, discussed by agencies and academics, include helping to manage satellite congestion or even to curtail the over-prescription of antibiotics.

Active interest in marketable permits remains strong among federal agencies. Most recently, at the end of November 2017, the U.S. Department of Energypublished a request for information on a proposed rule to consider allowing credit trading for its appliance and equipment efficiency standards. At the same time as this ongoing interest in applying marketable permits in new regulatory areas, there continue to be open questions and inconsistent practices on how best to manage existing permit markets. For example, in recent years, there have been accusations and congressional calls for investigations into possible fraud and extreme price volatility in the renewable fuels credit market.

Similarly, the Inspector General of the National Oceanic and Atmospheric Administration has found that information collected by the agency on fish catch share ownership and transaction prices was especially spotty in some regional catch share programs, preventing interested parties from making informed, efficient decisions in the market. There are even questions about the legal status of some programs. Some participants at a recent interagency workshop on water quality markets expressed concern that the lack of codified regulations establishing the water quality trading program may create uncertainty about the longevity and privileges of permits.

On such management issues, as well as in creating future marketable permit programs, the recommendations from ACUS can help guide agencies on how to use marketable permits to harness the efficient decision-making powers of the market without undermining policy goals.

ACUS recommends that agencies consider which type of permit trading system—if any—will best promote the prescribed policy objectives. Agencies are encouraged to issue clear guidelines to clarify issues like permit longevity; ideally, agencies should do so through notice-and-comment rulemaking to ensure public input and transparency. Agencies are also advised to promote market liquidity, but simultaneously are cautioned that some market design choices could increase opportunities for manipulation. ACUS calls on agencies to work together to share expertise and responsibility for preventing manipulation and enforcing compliance in permit markets.

On overseeing marketable permit programs in general, ACUS reminds agencies that compliance is key, and noncompliant parties should develop plans to come into compliance. Agencies must carefully track permit ownership, transactions, and the regulated activity levels. Offset credits must be “real,” and credit verification procedures should have standards, like preventing conflicts of interest in third-party credit verifiers. Extreme price volatility should be addressed through appropriate tools, such as price ceilings and floors. A reserve pool of credits can help facilitate new entrants into the market.

Finally, the careful management of information is key to running an efficient permit market and keeping market actors on a level playing field. Agencies should collect data to assess the market’s efficiency and its effectiveness at achieving the intended policy objectives. Mindful of confidentiality issues and other legal limitations, agencies should release data needed for the public and market participants to monitor permit transactions and prices. When it comes to the agency releasing its own information about potential policy changes or enforcement actions that could influence the market, clear communication policies, such as pre-scheduling announcements, can help minimize information asymmetries among market actors.

By following ACUS’s recommendations, agencies will be able to use the efficiency of the market to lessen compliance costs, encourage innovation, and ease administrative burdens, all without sacrificing policy objectives.

This essay is part of a five-part series, entitled Five Recommendations for Improving Administrative Government.

Tagged: ACUS, Guidance, Marketable Permits

Jason A. Schwartz is an adjunct professor at New York University School of Law and was the consultant to ACUS on the marketable permit project.

H. Russell Frisby, Jr. is a partner at Stinson Leonard Street LLP and chaired the ACUS Committee on Regulation meetings on the project.

E. Donald Elliott is senior of counsel at Covington & Burling LLP and chaired the ACUS Committee of the Whole meetings on the project.

0 thoughts on “Marketable Permits Essays

Leave a Reply

Your email address will not be published. Required fields are marked *