Market-based approach used to control pollution
Emissions trading is a market-oriented approach to controlling pollution by providing economic incentives for reducing the emissions of pollutants. The concept is also known as cap and trade (CAT) or emissions trading scheme (ETS). One prominent example is carbon emission trading for CO2 and other greenhouse gases which is a tool for climate change mitigation. Other schemes include sulfur dioxide and other pollutants.
In an emissions trading scheme, a central authority or governmental body allocates or sells a limited number (a "cap") of permits that allow a discharge of a specific quantity of a specific pollutant over a set time period. Polluters are required to hold permits in amount equal to their emissions. Polluters that want to increase their emissions must buy permits from others willing to sell them.
Emissions trading is a type of flexible environmental regulation that allows organizations and markets to decide how best to meet policy targets. This is in contrast to command-and-control environmental regulations such as best available technology (BAT) standards and government subsidies.
Introduction.
Pollution is a prime example of a market externality. An externality is an effect of some activity on an entity (such as a person) that is not party to a market transaction related to that activity. Emissions trading is a market-based approach to address pollution. The overall goal of an emissions trading plan is to minimize the cost of meeting a set emissions target.
In an emissions trading system, the government sets an overall limit on emissions, and defines permits (also called allowances), or limited authorizations to emit, up to the level of the overall limit. The government may sell the permits, but in many existing schemes, it gives permits to participants (regulated polluters) equal to each participant's baseline emissions. The baseline is determined by reference to the participant's historical emissions. To demonstrate compliance, a participant must hold permits at least equal to the quantity of pollution it actually emitted during the time period. If every participant complies, the total pollution emitted will be at most equal to the sum of individual limits. Because permits can be bought and sold, a participant can choose either to use its permits exactly (by reducing its own emissions); or to emit less than its permits, and perhaps sell the excess permits; or to emit more than its permits, and buy permits from other participants. In effect, the buyer pays a charge for polluting, while the seller gains a reward for having reduced emissions.
Emissions Trading results in the incorporation of economic costs into the costs of production which incentivizes corporations to consider investment returns and capital expenditure decisions with a model that includes the price of carbon and greenhouse gases (GHG).
In many schemes, organizations which do not pollute (and therefore have no obligations) may also trade permits and financial derivatives of permits.
In some schemes, participants can bank allowances to use in future periods. In some schemes, a proportion of all traded permits must be retired periodically, causing a net reduction in emissions over time. Thus, environmental groups may buy and retire permits, driving up the price of the remaining permits according to the law of demand. In most schemes, permit owners can donate permits to a nonprofit entity and receive a tax deductions. Usually, the government lowers the overall limit over time, with an aim towards a national emissions reduction target.
There are active trading programs in several air pollutants. An earlier application was the US national market to reduce acid rain. The United States now has several regional markets in nitrogen oxides.
History.
The efficiency of what later was to be called the "cap-and-trade" approach to air pollution abatement was first demonstrated in a series of micro-economic computer simulation studies between 1967 and 1970 for the National Air Pollution Control Administration (predecessor to the United States Environmental Protection Agency's Office of Air and Radiation) by Ellison Burton and William Sanjour. These studies used mathematical models of several cities and their emission sources in order to compare the cost and effectiveness of various control strategies. Each abatement strategy was compared with the "least-cost solution" produced by a computer optimization program to identify the least-costly combination of source reductions in order to achieve a given abatement goal. In each case it was found that the least-cost solution was dramatically less costly than the same amount of pollution reduction produced by any conventional abatement strategy. Burton and later Sanjour along with Edward H. Pechan continued improving and advancing these computer models at the newly created U.S. Environmental Protection Agency. The agency introduced the concept of computer modeling with least-cost abatement strategies (i.e., emissions trading) in its 1972 annual report to Congress on the cost of clean air. This led to the concept of "cap and trade" as a means of achieving the "least-cost solution" for a given level of abatement.
The development of emissions trading over the course of its history can be divided into four phases:
In the United States, the acid rain related emission trading system was principally conceived by C. Boyden Gray, a G.H.W. Bush administration attorney. Gray worked with the Environmental Defense Fund (EDF), who worked with the EPA to write the bill that became law as part of the Clean Air Act of 1990. The new emissions cap on NOx and gases took effect in 1995, and according to "Smithsonian" magazine, those acid rain emissions dropped 3 million tons that year.
Economics.
It is possible for a country to reduce emissions using a command-and-control approach, such as regulation, direct and indirect taxes. The cost of that approach differs between countries because the Marginal Abatement Cost Curve (MAC)—the cost of eliminating an additional unit of pollution—differs by country.
Coase model.
Coase (1960) argued that social costs could be accounted for by negotiating property rights according to a particular objective. Coase's model assumes perfectly operating markets and equal bargaining power among those arguing for property rights. 
In Coase's model, efficiency, i.e., achieving a given reduction in emissions at lowest cost, is promoted by the market system. This can also be looked at from the perspective of having the greatest flexibility to reduce emissions. Flexibility is desirable because the marginal costs, that is to say, the incremental costs of reducing emissions, varies among countries. Emissions trading allows emission reductions to be first made in locations where the marginal costs of abatement are lowest (Bashmakov "et al"., 2001). Over time, efficiency can also be promoted by allowing "banking" of permits (Goldemberg "et al"., 1996, p. 30). This allows polluters to reduce emissions at a time when it is most efficient to do so.
Equity.
One of the advantages of Coase's model is that it suggests that fairness (equity) can be addressed in the distribution of property rights, and that regardless of how these property rights are assigned, the market will produce the most efficient outcome. In reality, according to the held view, markets are not perfect, and it is therefore possible that a trade-off will occur between equity and efficiency (Halsnæs "et al"., 2007).
Trading.
In an emissions trading system, permits may be traded by emitters who are liable to hold a sufficient number of permits in system. Some analysts argue that allowing others to participate in trading, e.g., private brokerage firms, can allow for better management of risk in the system, e.g., to variations in permit prices (Bashmakov "et al.", 2001). It may also improve the efficiency of system. According to Bashmakov "et al". (2001), regulation of these other entities may be necessary, as is done in other financial markets, e.g., to prevent abuses of the system, such as insider trading.
Incentives and allocation.
Emissions trading gives polluters an incentive to reduce their emissions. However, there are possible perverse incentives that can exist in emissions trading. Allocating permits on the basis of past emissions ("grandfathering") can result in firms having an incentive to maintain emissions. For example, a firm that reduced its emissions would receive fewer permits in the future (IMF, 2008, pp. 25–26). There are costs that emitters do face, e.g., the costs of the fuel being used, but there are other costs that are not necessarily included in the price of a good or service. These other costs are called external costs (Halsnæs "et al.", 2007). This problem can also be criticized on ethical grounds, since the polluter is being paid to reduce emissions (Goldemberg "et al"., 1996, p. 38). On the other hand, a permit system where permits are auctioned rather than given away, provides the government with revenues. These revenues might be used to improve the efficiency of overall climate policy, e.g., by funding energy efficiency programs (ACEEE 2019) or reductions in distortionary taxes (Fisher "et al"., 1996, p. 417).
In Coase's model of social costs, either choice (grandfathering or auctioning) leads to efficiency. In reality, grandfathering subsidizes polluters, meaning that polluting industries may be kept in business longer than would otherwise occur. Grandfathering may also reduce the rate of technological improvement towards less polluting technologies (Fisher "et al.", 1996, p. 417).
William Nordhaus argues that allocations cost the economy as they cause the under utilisation an efficient form of taxation. Nordhaus argues that normal income, goods or service taxes distort efficient investment and consumption, so by using pollution taxes to generate revenue an emissions scheme can increase the efficiency of the economy.
Form of allocation
The economist Ross Garnaut states that permits allocated to existing emitters by 'grandfathering' are not 'free'. As the permits are scarce they have value and the benefit of that value is acquired in full by the emitter. The cost is imposed elsewhere in the economy, typically on consumers who cannot pass on the costs.
Market and least-cost.
Some economists have urged the use of market-based instruments such as emissions trading to address environmental problems instead of prescriptive "command-and-control" regulation. Command and control regulation is criticized for being insensitive to geographical and technological differences, and therefore inefficient; however, this is not always so, as shown by the WWII rationing program in the U.S. in which local and regional boards made adjustments for these differences.
After an emissions limit has been set by a government political process, individual companies are free to choose how or whether to reduce their emissions. Failure to report emissions and surrender emission permits is often punishable by a further government regulatory mechanism, such as a fine that increases costs of production. Firms will choose the least-cost way to comply with the pollution regulation, which will lead to reductions where the least expensive solutions exist, while allowing emissions that are more expensive to reduce.
Under an emissions trading system, each regulated polluter has flexibility to use the most cost-effective combination of buying or selling emission permits, reducing its emissions by installing cleaner technology, or reducing its emissions by reducing production. The most cost-effective strategy depends on the polluter's marginal abatement cost and the market price of permits. In theory, a polluter's decisions should lead to an economically efficient allocation of reductions among polluters, and lower compliance costs for individual firms and for the economy overall, compared to command-and-control mechanisms.
Measuring, reporting, verification and enforcement.
In some industrial processes, emissions can be physically measured by inserting sensors and flowmeters in chimneys and stacks, but many types of activity rely on theoretical calculations instead of measurement. Depending on local legislation, measurements may require additional checks and verification by government or third party auditors, prior or post submission to the local regulator.
Enforcement methods include fines and sanctions for polluters that have exceeded their allowances. Concerns include the cost of MRV and enforcement, and the risk that facilities may lie about actual emissions.
Pollution markets.
An emission license directly confers a right to emit pollutants up to a certain rate.
In contrast, a pollution license for a given location confers the right to emit pollutants at a rate which will cause no more than a specified increase at the pollution-level. For concreteness, consider the following model.
As an example, consider three countries along a river (as in the fair river sharing setting).
So the matrix formula_7 in this case is a triangular matrix of ones.
Each pollution-license for location formula_13 permits its holder to emit pollutants that will cause at most this level of pollution at location formula_13. Therefore, a polluter that affects water quality at a number of points has to hold a portfolio of licenses covering all relevant monitoring-points. In the above example, if country 2 wants to emit a unit of pollutant, it should purchase two permits: