It is possible for a country to reduce emissions using a
command-and-control approach, such as regulation,
direct and
indirect taxes. The cost of that approach differs between countries because the
Marginal Abatement Cost Curve (MAC)—the cost of eliminating an additional unit of pollution—differs by country.
Coase model Coase (1960) argued that social costs could be accounted for by negotiating property rights according to a particular objective. Coase's model assumes perfectly operating
markets and equal
bargaining power among those arguing for property rights. In Coase's model, efficiency, i.e., achieving a given reduction in emissions at lowest cost, is promoted by the market system. This can also be looked at from the perspective of having the greatest flexibility to reduce emissions. Flexibility is desirable because the
marginal costs, that is to say, the incremental costs of reducing emissions, varies among countries. Emissions trading allows emission reductions to be first made in locations where the marginal costs of abatement are lowest (Bashmakov
et al., 2001). Over time, efficiency can also be promoted by allowing "banking" of permits (Goldemberg
et al., 1996, p. 30). This allows polluters to reduce emissions at a time when it is most efficient to do so.
Equity One of the advantages of Coase's model is that it suggests that fairness (equity) can be addressed in the distribution of property rights, and that regardless of how these property rights are assigned, the market will produce the most efficient outcome. In reality, according to the held view, markets are not perfect, and it is therefore possible that a trade-off will occur between equity and efficiency (Halsnæs
et al., 2007).
Trading In an emissions trading system, permits may be traded by emitters who are liable to hold a sufficient number of permits in system. Some analysts argue that allowing others to participate in trading, e.g., private
brokerage firms, can allow for better
management of risk in the system, e.g., to variations in permit prices (Bashmakov
et al., 2001). It may also improve the efficiency of system. According to Bashmakov
et al. (2001), regulation of these other entities may be necessary, as is done in other
financial markets, e.g., to prevent abuses of the system, such as
insider trading.
Incentives and allocation Emissions trading gives polluters an incentive to reduce their emissions. However, there are possible
perverse incentives that can exist in emissions trading. Allocating permits on the basis of past emissions ("grandfathering") can result in firms having an incentive to maintain emissions. For example, a firm that reduced its emissions would receive fewer permits in the future (IMF, 2008, pp. 25–26). There are costs that emitters do face, e.g., the costs of the fuel being used, but there are other costs that are not necessarily included in the price of a good or service. These other costs are called
external costs (Halsnæs
et al., 2007). This problem can also be criticized on ethical grounds, since the polluter is being paid to reduce emissions (Goldemberg
et al., 1996, p. 38). or reductions in
distortionary taxes (Fisher
et al., 1996, p. 417). In Coase's model of social costs, either choice (grandfathering or auctioning) leads to efficiency. In reality, grandfathering subsidizes polluters, meaning that polluting industries may be kept in business longer than would otherwise occur. Grandfathering may also reduce the rate of technological improvement towards less polluting technologies (Fisher
et al., 1996, p. 417). William Nordhaus argues that allocations cost the economy as they cause the under utilization an efficient form of taxation. Nordhaus argues that normal income, goods or service taxes distort efficient investment and consumption, so by using pollution taxes to generate revenue an emissions scheme can increase the efficiency of the economy.
Market and least-cost Some economists have urged the use of market-based instruments such as emissions trading to address environmental problems instead of prescriptive "command-and-control" regulation.
Command and control regulation is criticized for being insensitive to geographical and technological differences, and therefore inefficient; however, this is not always so, as shown by the WWII rationing program in the U.S. in which local and regional boards made adjustments for these differences. After an emissions limit has been set by a government political process, individual companies are free to choose how or whether to reduce their emissions. Failure to report emissions and surrender emission permits is often punishable by a further government regulatory mechanism, such as a fine that increases costs of production. Firms will choose the least-cost way to comply with the pollution regulation, which will lead to reductions where the least expensive solutions exist, while allowing emissions that are more expensive to reduce. Under an emissions trading system, each regulated polluter has flexibility to use the most cost-effective combination of buying or selling emission permits, reducing its emissions by installing cleaner technology, or reducing its emissions by reducing production. The most cost-effective strategy depends on the polluter's marginal abatement cost and the market price of permits. In theory, a polluter's decisions should lead to an economically efficient allocation of reductions among polluters, and lower compliance costs for individual firms and for the economy overall, compared to command-and-control mechanisms. The policy framework is different for regional pollutants (e.g.
SO2 and
NOx, and also
mercury) because the impact of these pollutants may differ by location. The same amount of a regional pollutant can exert a very high impact in some locations and a low impact in other locations, so it matters where the pollutant is released. This is known as the
Hot Spot problem. A
Lagrange framework is commonly used to determine the least cost of achieving an objective, in this case the total reduction in emissions required in a year. In some cases, it is possible to use the Lagrange optimization framework to determine the required reductions for each country (based on their MAC) so that the total cost of reduction is minimized. In such a scenario, the
Lagrange multiplier represents the market allowance price (P) of a pollutant, such as the current market price of emission permits in Europe and the US. Countries face the permit market price that exists in the market that day, so they are able to make individual decisions that would minimize their costs while at the same time achieving regulatory compliance. This is also another version of the
Equi-Marginal Principle, commonly used in economics to choose the most economically efficient decision.
Prices versus quantities, and the safety valve , 2008–2021. The price of carbon emission has increased as the number of allowances issued has decreased. There has been longstanding debate on the relative merits of
price versus
quantity instruments to achieve emission reductions. An emission cap and permit trading system is a
quantity instrument because it fixes the overall emission level (quantity) and allows the price to vary. Uncertainty in future supply and demand conditions (market
volatility) coupled with a fixed number of pollution permits creates an uncertainty in the future price of pollution permits, and the industry must accordingly bear the cost of adapting to these volatile market conditions. The burden of a volatile market thus lies with the industry rather than the controlling agency, which is generally more efficient. However, under volatile market conditions, the ability of the controlling agency to alter the caps will translate into an ability to pick "winners and losers" and thus presents an opportunity for corruption. In contrast, an
emission tax is a
price instrument because it fixes the price while the emission level is allowed to vary according to economic activity. A major drawback of an emission tax is that the environmental outcome (e.g. a limit on the amount of emissions) is not guaranteed. On one hand, a tax will remove capital from the industry, suppressing possibly useful economic activity, but conversely, the polluter will not need to hedge as much against future uncertainty since the amount of tax will track with profits. The burden of a volatile market will be borne by the controlling (taxing) agency rather than the industry itself, which is generally less efficient. An advantage is that, given a uniform tax rate and a volatile market, the taxing entity will not be in a position to pick "winners and losers" and the opportunity for corruption will be less. Assuming no corruption and assuming that the controlling agency and the industry are equally efficient at adapting to volatile market conditions, the best choice depends on the sensitivity of the costs of emission reduction, compared to the sensitivity of the benefits (i.e., climate damage avoided by a reduction) when the level of emission control is varied. A third option, known as a
safety valve, is a hybrid of the price and quantity instruments. The system is essentially an emission cap and permit trading system but the maximum (or minimum) permit price is capped. Emitters have the choice of either obtaining permits in the marketplace or buying them from the government at a specified trigger price (which could be adjusted over time). The system is sometimes recommended as a way of overcoming the fundamental disadvantages of both systems by giving governments the flexibility to adjust the system as new information comes to light. It can be shown that by setting the trigger price high enough, or the number of permits low enough, the safety valve can be used to mimic either a pure quantity or pure price mechanism. ==Comparison with other methods of emission reduction==