Tradable Pollution Permits: “Cap and
Trade”
The third general policy approach to pollution reduction is often referred
to as a system of “cap and trade.” This system comprises two fundamental
parts. First, the government mandates a limit (or “cap”) on the total
amount of pollution of some specific type. Second, the government
distributes permits to firms (either by granting or auctioning) allowing the
firms to emit a specified amount of pollution. These permits can be traded
among the firms at prices determined in a free market. For example, the
government might issue permits for a total of 10 000 megatonnes of
annual sulphur dioxide emissions and distribute to each of 20 firms a
permit for 500 megatonnes. In any given year, a firm is restricted to
emitting an amount of sulphur dioxide no greater than the amount
allowed by the permits it holds. Firms can then trade the permits freely
among themselves and a market-determined price will be established. For
obvious reasons, a cap-and-trade system is also referred to as a system of
tradable pollution permits.
Like emissions taxes, cap-and-trade systems can minimize the cost of a
given amount of pollution abatement. To see this, consider starting from
a situation similar to that with direct regulatory controls. In Figure 17-5
both firms are abating pollution by units. (The inefficiency of this
initial situation is reflected by the difference in marginal costs between
the two firms.) Now suppose the government issues permits for a total
Q∗