02 May 2006
Tradable Permits
Pollution trading permits have been touted as a way of helping to reduce the levels of pollution. Let us take the example of carbon emissions. A carbon pollution trading permit works by giving firms maximum levels of carbon that they can emit during production. They acquire these permits by bidding for them at an auction. By so doing, the firms are balancing their current levels of technology, what they expect to do in the future and their production levels. If they do not reach the maximum level of pollution allowed by their permit, they are then able to sell off any surplus to other firms who may not have been able to keep within their limit.
As the process continues, the intention is that firms have an incentive to reduce pollution levels by generating new and more efficient technologies and thus reduce their need to have these permits. As they do so, pollution levels are reduced. Such schemes are being used in the EU - the EU Carbon Emissions Trading Scheme. Like all markets, however, we have to look at how they work and what the unexpected or unintended consequences of such schemes are on behaviour.
The government in the UK has various commitments to reduce pollution levels - the emission of carbon dioxide being one of these. These targets are for the industry as a whole. If the Government wants to reduce emissions by 20% by 2012 (one of its current targets), it will go some way towards trying to do this by putting the emphasis on firms who pollute to reduce their emissions. The total 'pot' of pollution is thus calculated and the permit levels allocated between the firms concerned. Each firm is able to plead its case to receive a better deal and the Government will have to decide on the merits of each case.
The first thing to note is that in the EU scheme, the permits are not auctioned - they have been given to firms. This has led to claims that the market in this case has a built-in weakness. It means that firms do not make the same sorts of decisions that would be the case if they had to bid a price for acquiring the right to pollute.
What is happening as a result of the scheme is that firms who have high levels of carbon emissions - for example, those who use coal in the production of electricity - have to buy extra permits. Given that there is a market for carbon permits, the price of these permits can rise quite significantly. Since buying such permits is a cost of production, it has a knock-on effect on the price of electricity. As the price of electricity rises, the revenues gained by firms who use nuclear fuel or gas to generate electricity also rise. These firms emit relatively low amounts of carbon and so have not had the cost of buying additional permits, but they do get the benefit from the increase in price.
Estimates of the extent of this unintended benefit is as much as £1 billion. Opposition MPs and environmental pressure groups are angry at this news. They blame the boost to some firms' profits on incompetence by the Government and point out that until the market is made to work more effectively by auctioning off the permits rather than allocating them, such distortions will continue to occur. They also argue that the permit levels set are too generous and that they should be much tougher. The firms themselves are lobbying for a relaxation in the levels, a view the Government seems to support.
The market for carbon permits is under some pressure, however. It seems that the over-allocation of permits to French firms has meant that the price of such permits is falling. Critics are arguing that the market is failing and that the intended outcome - the reduction in pollution levels - is not happening at the rate it should because of failures in the scheme.