Tradable emissions permits are licenses to emit limited quantities of pollutants that can be bought and sold by polluters. Tradable emissions permits work in practice much like the tradable quotas discussed in a Chapter 5 Economics in Action in which regulators created a system of tradable licenses to fish for crabs. The tradable licenses resulted in an efficient way to allocate the right to fish as boat-owners with the safest and lowest cost of operation purchase the rights of owners with less safe, higher cost boats. Although tradable emissions permits involve trading a “bad” like pollution instead of a “good” like crab, both systems work to allocate an activity efficiently because the permits, like licenses, are tradable.

Here’s why this system works in the case of pollution. Firms that pollute typically have different costs of reducing pollution—for example, it will be more costly for plants using older technology to reduce pollution than plants using newer technology. Regulators begin the system by issuing polluters with permits to pollute based on some formula—say, for example, equal to 50% of a given firm’s historical level of emissions. Firms then have the right to trade permits among themselves. Under this system, a market in permits to pollute will emerge. Polluters who place a higher value on the right to pollute—those with older technology—will purchase permits from polluters who place a lower value on the right to pollute—those with newer technology. As a result, a polluter with a higher value for a unit of emissions will pollute more than a polluter with a lower value.

In the end, those with the lowest cost of reducing pollution will reduce their pollution the most, while those with the highest cost of reducing pollution will reduce their pollution the least. The total effect is to allocate pollution reduction efficiently—that is, in the least costly way.

Just like emissions taxes, tradable emissions permits provide polluters with an incentive to take the marginal social cost of pollution into account. To see why, suppose that the market price of a permit to emit one unit of pollution is $200. Every polluter now has an incentive to limit its emissions to the point where its marginal benefit of one unit of pollution is $200. Why?

If the marginal benefit of one more unit of pollution is greater than $200 then it is cheaper to pollute more than to pollute less. In that case the polluter will buy a permit and emit another unit. And if the marginal benefit of one more unit of pollution is less than $200, then it is cheaper to reduce pollution than to pollute more. In that scenario the polluter will reduce pollution rather than buy the $200 permit.

From this example we can see how an emissions permit leads to the same outcome as an emissions tax when they are the same amount: a polluter who pays $200 for the right to emit one unit faces the same incentives as a polluter who faces an emissions tax of $200 per unit. And it’s equally true for polluters that have received more permits from regulators than they plan to use: by not emitting one unit of pollution, a polluter frees up a permit that it can sell for $200. In other words, the opportunity cost of a unit of pollution to this firm is $200, regardless of whether it is used.

Recall that when using emissions taxes to arrive at the optimal level of pollution, the problem arises of finding the right amount of the tax: if the tax is too low, too much pollution is emitted; if the tax is too high, too little pollution is emitted (in other words, too many resources are spent reducing pollution). A similar problem with tradable emissions permits is getting the quantity of permits right, which is much like the flip-side of getting the level of the tax right.

Because it is difficult to determine the optimal quantity of pollution, regulators can find themselves either issuing too many permits, so that there is insufficient pollution reduction, or issuing too few, so that there is too much pollution reduction.

In the case of sulfur dioxide pollution, the U.S. government first relied on environmental standards, but then turned to a system of tradable emissions permits. Currently the largest emissions permit trading system is the European Union system for controlling emissions of carbon dioxide.