ECON 100 Selling the Right to Pollute

St. Charles Community College
ECON 100    Survey Economics

Externalities commonly occur in any production process, and one such occurrence is the production of pollutants in the generation of electrical power.  Our society and our advanced standard of living depend upon the availability of relatively inexpensive electricity.  As we change and increase the technology levels in our day to day lives, each of us demands additional electrical power which causes the increase of the negative externality of industrial pollutants.  One of these pollutants is sulphur dioxide, commonly designated as SO2.   If you remember your high school chemistry, when sulphur dioxide mixes with the water in the air the two compounds form sulphuric acid which we call “acid rain”.  

Acid rain knows no boundaries.  The fact that acid rain produced in one part of the country can drift and cause damage in another part of the country makes the solution to the problem more important.

Because of the nature of the problem, and since clean air is a public good, government must get involved in the solution of the problem. And government has two general approaches that can be used: 

  • It can use the “command and control” technique of issuing ultimatums with potential penalties to the power companies.  This technique is commonly used in the nuclear power industry where trained technicians closely monitor all of the activities in the power plant to make sure strict procedures are closely followed.
  • It can issue regulations and let the market solve the problem with stiff penalties when firms opt out of the market solution.  In this case each participant works in its own best interest and the problem is solved.  The concept of issuing “rights to pollute” is an example of letting the market solve the problem, and that is the focus of this essay.   

It might be helpful to explain the terms here.  While your text refers to the “selling of the right to pollute”, the electrical power industry refers to these “rights” as “allocations”.  The idea here is that each power producer is assigned so many allocations for each year (For example, in the electrical power industry one allocation is equal to one ton of SO2 emissions).   If a power company, say AmerenUE, can not meet Federal guidelines for SO2 emissions each year, they can go into the market and purchase the necessary allocations from other power companies that do meet the Federal guidelines.  This raises their costs.  On the other hand, if AmerenUE can meet the Federal guidelines for the emission of SO2, they can sell their allocations to other power companies who need them.  This market activity increases the income to the seller and increases the production cost to the buyer.  The buyer can then be forced into a competitive disadvantage.

In order for such a system to work, certain conditions must be present:

  • There must be a recognizable problem that is measurable.
  • There must be recognizable and reachable goals in the program.
  • There must be a reliable system available for measuring the problem as well as the results.
  • There must be laws or regulations that force producers into the system.
  • There must be stiff penalties to producers for noncompliance.   The producers must realize that if they violate the law or fail to meet the regulations they will be hit very hard in the pocketbook.

The whole idea is to give value to the allocations related to production of undesirable emissions so that someone will want to buy, sell, trade, or hoard them.   Then a market must be made in which there is an open system where buyers and sellers can get together.  This market can be a public market or a private market.  If a firm, or agency, or individual wants to act as a broker in this case, so much the better.  If an individual or organization outside of the market wants to buy or sell in the market, that is even better yet.

Let’s look at a more specific example.  Let’s say that there are two companies in the electrical power generating business, and let’s say that they are both subject to the laws covering the production of smokestack emissions.  We’ll call one firm Company A and the other firm Company B.  Let’s assume that Company A has high stack emissions that are well above the established guidelines, and we’ll assume that Company A has been issued 100 pollution allocations.  Company A has a problem……they are facing potential fines and could be closed down because of their production of excess emissions.

Now let’s assume that Company B has low stack emissions and is operating at an emission level well below the established guidelines.  Company B does not have a problem and does not face punitive action.  Assume that Company B also has 100 pollution allocations.

The immediate problem for Company A is how they will solve their “dirty emissions” problem.  They have the following options:

  • One choice is that they can spend the money to alleviate their problem by installing new, cleaner burning equipment or by installing “scrubbers” which will remove the undesirable emissions prior to the gasses going out of the smokestack.  This can be a very large investment on the part of the firm.  
  • Another choice is that they can change the type of fuel that they are currently using to obtain cleaner stack emissions.  Usually, cleaner fuel is more expensive.
  • They can also avoid the potential penalties if they surrender some or all of their pollution allocations.  
  • Finally, if  they do not have sufficient allocations to avoid penalties in a given year they can buy pollution allocations from Company B if Company B is willing to sell them.  Sooner or later Company A is going to have to spend capital funds to modernize their plant, but the pollution allocations can buy them some time before they have to make the major capital purchases.  Also, once allocations are surrendered, they are gone forever.  

And here is a crucial point in the process……the government will not tell either company  what to do.  Company A chooses the course of action that is the most economically feasible to them.  If Company A elects to avoid the problem by purchasing pollution allocations from Company B, no one tells Company B what price to charge Company A for the pollution rights.  Further, Company B is under no obligation to sell its allocations.  It may want to “bank” them to cover a future problem or its own, or it may get a higher price from Company C who also has a pollution emissions problem of its own.  This means that the prices of the allocations are negotiable and subject to the rules of supply and demand according to the needs of the market participants.

Remember, most power companies have stockholders who expect a profit and a dividend check form the company.  Also, excess power is sold into a power grid where power is bought by others from the cheapest source.  Firms with high average total costs are at a disadvantage when selling into the power grids.  Money from the sale of any pollution allocations is income to the company.  Costs involved in buying allocations are costs to the business and will lower company profits.
Now we can complicate the situation by having outsiders enter the market for “social purposes” or for speculation.  Conservation groups interested in clean air can buy up allocations in order to take them off the market and put additional pressure on the power companies to clean up their act.  (Allocations not used in a given year will expire, although they can be used in future years.)   Also, speculators who want to gamble on the probability that pollution allocations might become more valuable in the future may buy them and hold them for future speculative sales.

At this point each firm takes action in its own best interest.  Since the demand for power will continue to grow in our society, more power plants will be built.  As power plants age, they become more inefficient and more prone to produce undesirable emissions.   Producers must factor aging equipment into the equation.  Even if power companies expect to obtain additional allocations each year in the future, they may look into the future and see major problems with growing negative externalities.   The financial analysis on the part of each firm is extremely complicated, but, under this system, the society gets what it wants (clean air) and the power companies get what they want (the right to control their own investment and marketing decisions).

If you read the business sections of current newspapers you will see that this same concept may soon be tried in ground water pollution problems, farm waste problems, solid waste problems, and greenhouse gas problems.  As long as the five conditions are met, the solution can work even though the name (the right to pollute) sounds a bit off key.