Pricing Pollution

One of the first things that you learn in economics is what can and cannot be included in things like GDP. Almost always the question of externalities comes up. Externalities are parts of supply and demand that aren't directly influencing the buyer or the seller, but instead a third party that is not present at the transaction. The best example is one that most people in the Northeast are at least somewhat familiar with:

A coal power plant in West Virginia builds extremely tall smokestacks for its putrid filth that it pumps out. The smoke rises high above the residents of that particular portion of Appalacia and is carried by air currents up into the Northeast. The supplier (the power plant) gets low costs on its production and the consumers (the homes/businesses supplied by said power plant) get cheap energy without having to worry about all that nasty pollution caused by the removal of sulphur from the coal and the burning thereof. The locals don't have the pollution because the smokestacks are so high that it floats right on over them.

Now, the Yankees up there in the Northeast aren't getting cheap power or jobs at the power plant; they're just getting screwed by a supply/demand transaction hundreds of miles away. Pollution is considered the quintessential externality.

Until the Kyoto Protocol came around, anyway. The Kyoto Protocol allowed for the development of what is now considered the most effective way to tag a price on pollution: let the market do it. I've heard whispers about a "green GDP" that's being conceived of by some government ministers in China to take pollution into account as a drain on GDP, but I'm not going to buy into that until it's official policy. It's still in the developmental stage anyway.

Right now the best way that we have to price carbon dioxide, one of the worst greenhouse gases, doesn't even exist here: the Emissions Trading System (ETS). We actually already do have an ETS for sulphur dioxide, which was set up back in 1990 by the Clean Air Act. By 2010, emissions of sulphur dioxide should have been halved from their '90 levels. Cool peas.

"But Josh, how can you, a quasi-free-market-wannabe-economist support such a scheme? It's that darn gov't tellin' us little people what to do!!! Yer a sellout!"

Oh, hush. I'm not a sellout and if you think you're going to get back onto my blog with that mouth, you can forget it. Anyway, moving on.

The beauty of this "scheme" is that it couples a goal that helps the greater good - lower pollution emissions, less global warming, lower health care costs from things like skin cancer, fewer government payouts to those unfortunate enough to have those maladies, and ultimately a lower budget deficit - with a market mechanism.

Here's how it works: let's say that the U.S. emits 100 million tons of carbon dioxide a year. The government auctions off 100 "emissions credits," each worth 1 million tons of legal carbon dioxide emissions. If you buy one credit, you're allowed to pollute up to 1 million tons of carbon dioxide for that year. Anytime during then you can sell any unused credits to someone else who is interested in paying for the right to pollute. If a company doesn't pollute as much as it thinks it will, it can always get a little extra cash by selling their surplus credits to someone else. The credits are only good for a year and they can only be used once, so there's no possibility of "saving up" credits or hoarding them. If the price is too low, then polluters will as many credits as they need (or as many as they can get). If the price is too high, it makes sense to adopt cleaner-burning processes or pollution controls so that the number of credits that need to be bought remains as low as possible.

Here's the trick: the ETS works like a game of musical chairs. Every time you start a new round, you pull one chair out of the circle. Same thing with the ETS: every year, the government reduces the number of credits that is auctioned off to meet a target.

Let's go back to our 100 million ton of carbon dioxide country again. In year 1, there are 100 1-million-ton credits sold. The government wants to decrease carbon dioxide emissions by 10% over 10 years. In year 2, there are 99 1-million-ton credits sold. In year 3, there are 98 sold, and so on. As supply dwindles, the price of pollution should rise. If the government is transparent with letting companies know how many credits they will sell in the future, companies can plan ahead and begin adopting cleaner technologies earlier.

However, the government has to realize that there is a danger. Something like this happened in France a month or two ago. Pollution emissions came in lower than expected and suddenly there was a gap between the emission credits that France allowed and the actual amount of pollution it was belching out. If pollution emissions are cut below the cap set by the government, suddenly the supply of credits (albeit dwindling) is suddenly plentiful relative to the demand.

What happened in France? The price of pollution emissions crashed. If this keeps up, more companies will by the credits, pollute more, and France will bring itself right up against the cap again. Assuming, of course, that the price of the credits makes it economically viable to pollute instead of adopt cleaner technologies.

Put it this way: say that it's more profitable for companies to buy up the credits if the cost of each credit is $20. It costs them $25 per ton to use cleaner technology or pollution controls. If the price of the pollution credits is $30 a ton, it makes more sense to use the cleaner technology. If the price falls to $20, buying the credits is more cost-effective.

So there is a bit of a conundrum with these government-imposed caps: total pollution will fall, but only as slowly as the long-term goals that the government sets in the first place. Policy cannot risk becoming schizophrenic on the issue, lowering the cap just to keep the "slack" out of the market if total pollution falls below target levels due to innovation, conservation, or technology. Not only that, but a government that gets in the habit of lowering the total cap could just as easily be replaced by one that wants to raise the cap under the aegis of promoting business.

Guarded, incrememental, predictable, and steady reduction in total pollution allowed, distributed among polluters by a market mechanism, is the most effective way to reduce pollution in a cost-effective manner.