Tradeable pollution permits

Overview

Permit market when the government tightens the cap, setting the cap require information the government may not have and if a government issues too many permits.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Draw and describe in words the market for tradeable pollution permits.

   Model answer

   Put the permit price in £ per tonne on the vertical axis and permits in millions of tonnes on the horizontal. The supply of permits is a vertical straight line at the cap, because the government issues a fixed total and will not issue more however high the price goes, so supply is perfectly inelastic. Demand for permits slopes downward, since it reflects firms' willingness to pay for the right to emit rather than abate: at a high price fewer firms prefer to buy. The equilibrium permit price is found where the downward-sloping demand curve crosses the vertical supply line at the cap.

2. 2

   Firm A can cut a tonne of emissions for £20 and Firm B can only do so for £60. Permits trade at £35 a tonne and Firm B must account for 1,000 tonnes. Calculate what B does and what it saves.

   Model answer

   B compares two ways of covering 1,000 tonnes. Abating itself costs £60 multiplied by 1,000, which is £60,000. Buying 1,000 permits costs £35 multiplied by 1,000, which is £35,000. Buying is cheaper, so B buys the permits and saves £60,000 minus £35,000, which is £25,000. B only abates itself if the permit price rises above its own abatement cost of £60 a tonne, so at £35 buying is clearly the rational choice.

3. 3

   Firm A can abate a tonne for £20 and permits trade at £35 a tonne. Calculate A's gain from abating an extra 1,000 tonnes and selling the permits it frees up.

   Model answer

   Abating 1,000 tonnes costs A £20 multiplied by 1,000, which is £20,000. Selling the 1,000 permits it no longer needs raises £35 multiplied by 1,000, which is £35,000. A's gain is £35,000 minus £20,000, which is £15,000. A therefore has a positive incentive to abate beyond what its own permits require, and will keep doing so as long as the permit price stays above its abatement cost of £20 a tonne.

4. 4

   Firm A abates at £20 a tonne and Firm B at £60 a tonne. Show that trading 1,000 permits between them delivers the same emissions at a lower cost to society, and quantify the saving.

   Model answer

   Without trade, B abates 1,000 tonnes itself at £60 a tonne, a real resource cost of £60,000. With trade, A abates the same 1,000 tonnes at £20 a tonne, a real cost of £20,000, and sells the permits to B. Total emissions are identical because the cap is unchanged, but the abatement bill is £20,000 instead of £60,000, so society saves £60,000 minus £20,000, which is £40,000. Note that B's saving of £25,000 plus A's gain of £15,000 also comes to £40,000, since the £35,000 payment is a transfer between them, not a cost to society.

5. 5

   Why does trading permits produce the same environmental result more cheaply than requiring every firm to cut by the same amount?

   Model answer

   Abatement costs differ enormously between firms because of their age, technology and process. A uniform rule forces high-cost firms to abate alongside low-cost ones. Under trading, the single permit price faces every firm with the same choice: abate if your own cost per tonne is below the price, buy a permit if it is above. Every firm whose cost is below the price abates and every firm above it buys, so the total cut is delivered by whoever can achieve it most cheaply. The cap fixes the environmental outcome; the trading fixes who bears the effort.

6. 6

   What happens in the permit market when the government tightens the cap, and why?

   Model answer

   The vertical supply line shifts to the left to the new, lower number of permits. Demand for permits is unchanged in the short run, so the new intersection lies further up the downward-sloping demand curve and the permit price rises. The higher price makes abatement worthwhile for firms whose costs previously exceeded the market price, so more real abatement takes place and emissions fall to the new cap. The rise in price is larger the more inelastic demand for permits is, which is the case when firms have few cheap abatement options available.

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