Tradable Pollution Permits, Regulation and Government Failure
A tradable pollution permit (cap-and-trade) scheme, such as the UK Emissions Trading Scheme, sets a regulatory cap on total emissions and issues tradable permits up to that cap, so firms can trade permits and the required reduction is achieved wherever it is cheapest across the economy.
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Method
- Explain the tradable permit chain step by step: government sets a cap on total emissions, issues permits up to that cap, firms trade permits, a market price for permits emerges, each firm compares this price to its own marginal abatement cost and chooses whichever is cheaper (cutting emissions or buying a permit), so total abatement cost across the economy is minimised for the given cap.
- Contrast this with direct regulation: a fixed legal limit or standard gives certainty over how much each individual firm must cut, but it does not equalise marginal abatement costs across firms, so the same total reduction can end up costing the economy more overall than under a permit scheme.
- Explain why tradable permits give a continuous incentive to innovate: a firm that develops a cheaper way to cut emissions can sell more spare permits at the going market price, so there is an ongoing financial reward for further abatement, unlike a fixed regulatory standard which gives no reward for cutting beyond the legal limit.
- Learn the specific causes of government failure and be ready to identify which applies in a given scenario: imperfect information (the cap or standard is set too high or too low), regulatory capture (the regulated industry lobbies successfully for a looser cap or standard), unintended consequences (e.g. 'carbon leakage', where firms relocate production to countries without the scheme rather than cutting emissions), and high administrative or enforcement costs.
- For an evaluation question, weigh the cost-effectiveness argument for tradable permits against the certainty argument for regulation, and weigh both against the specific government failure risks that could undermine each in practice.
- Support any evaluation with a real or plausible example, such as evidence of price volatility in an emissions trading scheme, which can weaken the incentive to invest in long-term abatement technology if firms are unsure what future permit prices will be.
Worked example
Firm A can abate one tonne of emissions for 10 pounds. Firm B can abate one tonne for 40 pounds. The market price of a tradable emissions permit is 20 pounds. Explain which firm should buy permits and which should sell permits, and show that this trade minimises the total cost of abatement compared with forcing both firms to cut emissions by equal amounts.
- Compare Firm A's abatement cost (10 pounds) to the permit price (20 pounds): since abating is cheaper than buying a permit, Firm A should abate more than its cap requires and sell its spare permits.
- Calculate Firm A's gain from selling: it earns 20 pounds per permit while it only cost 10 pounds to abate the tonne of emissions the permit represents, a profit of 20 - 10 = 10 pounds per tonne.
- Compare Firm B's abatement cost (40 pounds) to the permit price (20 pounds): since abating is more expensive than buying a permit, Firm B should buy permits instead of abating further.
- Calculate Firm B's saving from buying: it pays 20 pounds for a permit rather than 40 pounds to abate the tonne itself, a saving of 40 - 20 = 20 pounds per tonne.
- Conclude that total abatement across the two firms is cheapest when it happens at Firm A (10 pounds per tonne) rather than Firm B (40 pounds per tonne), so trading permits achieves the same total emissions cut at a lower total cost than requiring each firm to cut emissions by an identical, fixed amount.
Practice questions
Try each question, then tap to reveal the answer.
Q1Define a cap-and-trade tradable permit scheme in one sentence.Show answer
Answer: A scheme in which government sets a total limit (cap) on emissions and issues tradable permits up to that limit, allowing firms to buy and sell permits between themselves.
Q2Define government failure.Show answer
Answer: A misallocation of resources caused by government intervention itself, producing a net loss of economic welfare.
Q3Name a real UK tradable permit scheme and the year it launched.Show answer
Answer: The UK Emissions Trading Scheme, launched in January 2021.
Q4Give one cause of government failure.Show answer
Answer: Imperfect information (setting a cap, standard or tax at the wrong level), regulatory capture, unintended consequences, or high administrative and enforcement costs.
Q5Why do tradable permits give firms a continuous incentive to innovate, unlike a fixed regulatory standard?Show answer
Answer: Because a firm that cuts emissions below its cap can sell its spare permits for a profit at the market price, so there is an ongoing financial reward for further abatement, whereas a fixed legal standard gives no reward for cutting beyond the required limit.
Q6What is 'carbon leakage'?Show answer
Answer: An unintended consequence of environmental regulation in which firms relocate production to a country without similar environmental rules, rather than cutting their emissions, so global emissions are not necessarily reduced.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Explain one reason why regulation might achieve a given reduction in pollution at a higher cost to the economy than a tradable permit scheme.
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Assess the extent to which tradable pollution permits are more effective than direct regulation in reducing carbon emissions.
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See real A Level Economics past-paper questions, with official mark schemes →
Free printable worksheet
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