Tradable Emission Permit

Published Sep 8, 2024

Definition of Tradable Emission Permit

Tradable emission permits, also known as emissions trading or cap-and-trade systems, are part of market-based approaches used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants. These systems set a cap on the total level of greenhouse gases that can be emitted by certain industries or economic sectors and allow entities to buy and sell permits that grant the holder the right to emit a specified amount. Through trading, companies that can reduce emissions at lower costs can sell their excess permits to companies for which emission reductions are more expensive.

• Cap-and-trade system
• Market-based approach
• Economic incentives

Example

To understand the concept of tradable emission permits, consider a simplified carbon market involving two factories, Factory A and Factory B. Both factories are within an industrial zone regulated by a cap-and-trade program aimed at reducing carbon dioxide emissions. The government has set an overall cap of 100 tons of emissions for this zone and distributed permits totaling this amount to the factories.

• Factory A: 60 permits
• Factory B: 40 permits

Factory A has modernized its production processes, achieving significant emission reductions. It now only emits 50 tons of carbon dioxide, leaving it with 10 excess permits. Meanwhile, Factory B has older, less efficient technology and is struggling to stay within its limit, needing an additional 10 permits to comply.

Under the tradable emission permits system, Factory A can sell its 10 unused permits to Factory B. Both factories benefit: Factory A monetizes its excess permits, and Factory B meets its compliance requirement without incurring the massive costs of overhauling its technology. The environmental goal is also achieved because total emissions do not exceed the set cap of 100 tons.

• Factory A: Sells permits (financial benefit)
• Factory B: Buys permits (compliance)

Why Tradable Emission Permits Matter

Tradable emission permits are crucial for several reasons:

1. Cost-Effectiveness: By allowing the market to determine the price of emission permits, companies that can reduce emissions efficiently sell their excess permits to companies for whom reduction is more costly. This market mechanism ensures that emission reductions are achieved at the lowest overall cost.
2. Incentives for Innovation: Firms are motivated to innovate and improve their technologies to reduce emissions cost-effectively. Those who succeed can profit from selling their extra permits, encouraging continuous improvements and advancements in green technology.
3. Flexibility: Tradable permits provide companies with the flexibility to meet their emission targets in a manner that suits their operational and financial situations best, without compromising the overall environmental objectives.
4. Environmental Integrity: The cap ensures that the environmental goals are met by limiting the total allowable emissions. The trading system enforces compliance, ensuring that all participating entities contribute to emission reductions.

Frequently Asked Questions (FAQ)

How does the tradable emission permits system differ from a carbon tax?

A carbon tax directly sets the price on carbon by levying a tax on each unit of greenhouse gas emissions, providing a consistent cost for emissions but does not guarantee a specific level of emissions reduction. In contrast, a tradable emission permits system sets a cap on emissions and allows the market to find the equilibrium price for permits through trading, ensuring a specific limit on emissions but with variable permit prices.

• Carbon tax: Price certainty, emissions uncertainty
• Tradable permits: Emissions certainty, price variability

What are the potential drawbacks or challenges of implementing a tradable emission permit system?

Several challenges can arise:

1. Market Volatility: Prices for permits can fluctuate widely based on market conditions, economic factors, and changes in regulations. This unpredictability can pose financial risks for companies.
2. Market Manipulation: If not properly regulated, the market for emission permits can be subject to manipulation by large players who might hoard permits to drive up prices artificially.
3. Initial Allocation: The method of initially distributing permits (auctioning vs. free allocation) can be controversial and impact the perceived fairness and effectiveness of the system.

Can tradable emission permits be applied globally, and are there successful examples?

Yes, tradable emission permits can be applied globally though it requires international cooperation and harmonization of standards. Successful examples include:

• European Union Emissions Trading System (EU ETS): The largest and most established emissions trading system, covering multiple countries and a wide range of industries.
• Regional Greenhouse Gas Initiative (RGGI): A collaboration among several U.S. states, focusing on capping and reducing carbon emissions from the power sector.