Markets for Pollution Allowances : What Are the ( New ) Lessons ?

A bout 45 years ago a few economists offered the novel idea of trading pollution rights as a way of meeting environmental goals. Such trading was touted as a more cost-effective alternative to traditional forms of regulation, such as specifi c technology requirements or performance standards. The principal form of trading in pollution rights is a cap-and-trade system, a system whose essential elements are few and simple. First, the regulatory authority specifi es the cap —the total pollution allowed by all of the facilities covered by the regulatory program. Second, the regulatory authority needs to distribute the allowances, either by auction or through free provision. Third, the system provides for trading of allowances. The idea of cap and trade was implicit in the classic work of Ronald Coase (1960) on how well-defi ned property rights can assure effi cient outcomes despite the presence of externalities. It then took on shape in journal contributions by Crocker (1966), Dales (1968), and Montgomery (1972). The concept materialized into policy starting in 1974, when the US Environmental Protection Agency allowed companies to trade emissions reductions among sources within the fi rm so long as total, combined emissions did not exceed an aggregate limit (Tietenberg 1985; Hahn and Hester 1989; Foster and Hahn 1995). The EPA’s “offset” program, introduced in 1997, went further in allowing for trading across fi rms. These systems applied to various local pollutants, including volatile organic compounds, carbon monoxide, sulfur dioxide, and nitrogen oxides. Markets for Pollution Allowances: What Are the (New) Lessons?