Tradable Permits

Clarification of concepts
Implementation issues
International Issues
Case studies


Tradable permits are a cost-efficient, market-driven approach to reducing greenhouse gas emissions. A government must start by deciding how many tons of a particular gas may be emitted each year. It then divides this quantity up into a number of tradable emissions entitlements - measured, perhaps, in CO2-equivalent tons - and allocates them to individual firms. This gives each firm a quota of greenhouse gases that it can emit over a specified interval of time. Then the market takes over. Those polluters that can reduce their emissions relatively cheaply may find it profitable to do so and to sell their emissions permits to other firms. Those that find it expensive to cut emissions may find it attractive to buy extra permits. Trading would continue until all profitable trading opportunities had been exhausted.

  Permits would ensure that emissions do not exceed a given level. They are not as good as carbon taxes, however, at guaranteeing that the costs of abatement will be neither too large nor too small. So, in choosing between the two main market-oriented approaches of tradable entitlements and carbon taxes, a government must decide whether it is more important to be certain of the quantity of reduced emissions or of the costs involved. 

  Tradable permits are already being used to address several other environmental problems. For example, the US regulates chlorofluorocarbons (CFCs) with tradable emissions entitlements, and it is introducing a similar system to limit emissions of pollutants that cause acid rain. The 1987 Montreal Protocol on Substances that Deplete the Ozone Layer also includes provisions for the international trading of emissions permits, although no such trades have yet taken place. To be successful, a permit scheme would have to be carefully designed. If the rules governing trading are complex, or if the market for permits consists of only a few players, trading may not be efficient. This will also be true if trading involves substantial transaction costs. On the other hand, even an inefficient permits system may be a more cost-efficient way to reduce emissions than using most forms of regulatory control.  If implemented internationally, tradable permits could lead to resource transfers from rich countries to poor ones.  International trading could take place between governments as well as between firms. But before trading could begin, governments would have to agree on how to make the initial allocation of permits. One proposal calls for allocating entitlements on an equal per-capita basis. Such an allocation would guarantee resource transfers from the North to the South because, having fewer greenhouse gas emissions per capita than do industrialized ones, developing countries would be net sellers of permits, while rich countries would be net buyers. However, it is highly unlikely that such an allocation would be acceptable to the rich countries. They would probably prefer to have no agreement at all than to make such large transfers. 

 To win broad acceptance, an international scheme for tradable permits could not allocate quotas on a simple per-capita basis. The problem is that developed countries have high per-capita emissions, the developing countries have low per-capita emissions, and the former Communist countries are somewhere in between. An allocation based on population would be attractive to developing countries, but probably unacceptable to industrial countries because it would require them to make huge transfers to poor countries (assuming that the agreed goal was to reduce global emissions on a large scale). Allocating entitlements according to a slightly more complex formula could reduce these transfers and ensure that every party to the agreement is better off than it would be without the agreement. Agreement would be far more likely if the entitlements were initially allocated according to a formula that reflected the different circumstances of these country groups. For example, the developed countries could receive somewhat fewer permits than would be required for current emissions levels, and the poor countries a slight surplus, with the total quantity of entitlements being somewhat below current global emission levels. One study estimates that such an allocation would lower resource transfers to a fraction of current overseas development assistance. 


International tradable permits could be effective even if implemented on a small scale. Economists analyses schemes for emissions permits have usually focused on international agreements for making large-scale reductions in global greenhouse gas emissions. But trading may also be effective in more limited circumstances. For example, a country facing high abatement costs may meet its own national target for emissions reduction by providing incentives for other countries with low abatement costs to undertake abatement on its behalf. Such bilateral agreements (known as "offsets") may involve relatively high transactions costs, but their small scale may make them easier to negotiate and implement, at least in the short run. 


From a narrow economic perspective, individual countries do not have a strong incentive to reduce their net greenhouse gas emissions unilaterally. Few countries emit more than 1-2% of mankind's current fossil fuel emissions of carbon dioxide (CO2). So if a country reduced its emissions, it would receive some benefit in the form of a small reduction in global climate change, but that benefit would be only a tiny fraction of the world-wide benefit. As a result, individual countries have very little economic incentive for incurring the costs of abating emissions or of enhancing forests or other "carbon sinks". 


To be truly effective, climate policies will have to be international. The industrial countries account for about one-half of mankindís current CO2 emissions. However, even if all the developed countries work together to cut their emissions, they would have only a limited impact on future climate change because emissions are expected to increase rapidly in the developing countries. It must be remembered that, while the industrialized countries are largely responsible for the historical build-up of atmospheric concentrations, new policies can only impact current and future emissions. 

  Resource transfers will be required to make an internationally coordinated policy attractive to developing countries. Developing countries may be relatively more vulnerable to climate change than are industrialized countries. However, the total benefit they would receive from policies to reduce climate change damages is likely to be smaller than the benefit realized by industrial countries, since the latter have larger economies (this analysis considers only market goods and services). Resources will therefore have to be transferred to developing countries to make it attractive for them to incur the costs of substantially reducing greenhouse gas emissions and enhancing carbon sinks. Precedents for such transfers exist. For example, under the amended Montreal Protocol industrialized countries compensate developing countries for the "incremental costs" of substituting new chemicals for CFCs. In the case of climate change, rich countries would find transfers economically attractive because the total cost of abatement can be reduced if the abatement burden is distributed widely. While the UN Convention on Climate Change calls for such transfers, agreeing on their magnitude and distribution will not be easy. Free rider incentives will be hard to overcome. The problem is that any country that decides not to participate in the global effort to reduce emissions saves substantially on abatement costs. At the same time, because this countryís emissions are small relative to the total, it would suffer only a minute loss in benefit as a consequence of its own decision not to participate. So this country would be better off economically if it did not participate. 

 It will be harder to reduce emissions of carbon dioxide than it has been to reduce emissions of gases that destroy the ozone layer. While it is true that the Montreal Protocol successfully harnessed international cooperation to phase out CFCs, climate change is a very different environmental problem. Reducing CFCs will be relatively cheap, and the economically measurable benefits quite high - largely because ozone depletion causes cancer, which people are willing to pay a lot to avoid. This gave countries strong unilateral incentives to agree to phasing out CFCs. Such is not the case with climate change.  To be cost-effective, international climate change policies should include more than just emissions targets. Many other actions can be taken to reduce atmospheric concentrations of greenhouse gases at a low cost. The destruction of rain forests, for example, has been hastened by domestic tax policies that provide incentives for excessive deforestation; removing these policies would not only reduce climate change, but would benefit national economic development. Eliminating subsidies on fossil fuels would also reduce CO2 emissions while improving economic performance. A different type of problem relates to large-scale leaks of methane from the former USSRís natural gas pipelines. These leaks occur largely because the Soviet incentive system did not reward efficiency. Economic reforms in Eastern Europe and the former USSR are almost certain to lead to more efficient energy use and thus fewer emissions per unit of GNP. International cooperation on these various issues would help to speed the adjustment to more efficient economies. 




School of Public and Environmental Affairs at Indiana University: V550 Climate Change Policy

Last changed: August 19, 2005