Although the temporary respite brought by the reduced energy demand and pandemic-related lockdowns paused the fast-paced increase of pollution for two years, an alarming milestone was reached in 2022 as the global carbon dioxide emissions from industrial processes rose to an unprecedented 36.8 gigatons. (IEA, 2023) To address the rising issue, many suggested that governments issue CO2 emission permits to companies – an approach that may seem highly ironic, but in reality, stands out as the most efficient in terms of both environment and cost.

However, prior to discussing the details of the pollution licences, it is imperative to address certain economic concepts for better understanding. The term ‘externality’ refers to indirect costs or benefits that affect parties not directly involved in the original economic activity; positive externalities involve indirect benefits to society like education, whereas negative externalities involve indirect costs to society such as pollution. Specifically focusing on pollution, it is a commonplace that negative externalities experience overproduction due to the disparity between the costs borne by the producer (of the negative externality) and those born by society at large. While the producers tend to recognise solely the marginal producers costs, society bears the burden of both marginal producers costs and marginal external costs. In other words, a factory owner would not necessarily factor in the pollution stemming from the factory’s operations. 

Various solutions exist to combat externalities with one of the most historical being the Pigouvian Tax, which internalises marginal external benefits and costs through subsidies and taxes respectively. Nevertheless, the focal point of this discussion revolves around the Cap and Trade program, a ‘government regulatory program designed to limit, or cap, the total level of emissions of certain chemicals, particularly carbon dioxide, as a result of industrial activity’. (Investopedia, 2020) 

As the term suggests, Cap and Trade involves governments issuing a fixed number of permits to companies, imposing a ceiling on allowable carbon dioxide emissions. But the term ‘pollution licence’ only encapsulates one half of the program as the key component is missing: trade of permits between companies. 

While companies that ‘overproduce’ pollution than the cap are taxed, the other companies can freely sell or trade unused credits (i.e. the pollution licence). Despite initial concerns of moral hazard in a sense that the program legally allows the companies to willingly pollute the environment, such a concern is readily dismissed when considering the permit-trades between companies as they encourage the companies with higher costs of pollution reduction to buy the permits from those with lower costs – resulting in a mutually beneficial scenario. For example, if company A possesses superior pollution reduction resources compared to company B, B’s purchase of A’s permits would be beneficial for both due to A’s comparative advantage. On a societal scale, the pollution is ultimately reduced at the lowest possible cost – achieving an efficient pollution reduction.

Another opposing viewpoint aside from the one previously mentioned suggests that the Cap and Trade program lacks incentives for companies to invest in cleaner alternatives, encouraging them to invest in ‘efficient pollution reduction’ rather than clean energy itself. However, this argument easily loses ground considering that the total pollution limit (i.e. the cap) declines every year – giving companies a definite incentive to find alternative energy sources.

Since its introduction by the European Union in 2005, the program has been adopted by California in 2013, and Mexico has been running a pilot program since 2020. Despite its merits of environmental efficacy and cost efficiency, the true effectiveness of real-world implementation of the Cap and Trade program remains under constant debate.

With the pressing global issue of climate change right in front of us, it is clear that well-designed policies accompanied by effective implementations are necessary for Earth’s survival. The Cap and Trade program has set in motion a train of policies that could guide us towards the right direction.

Tae Hyun (Terry) Kim

NLCS Hub Editor, Equilibrium Editor-in-Chief, Chair of Economics Society


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