Permit market blues

 Does the pollution market pollute?

A few days ago, the European Parliament refused to pull many pollution permits off the market.  This sparked accusations that the permit market somehow worsens pollution – a mindset akin to that of the Incan emperor who throttled the bearer of bad tidings.

I’ll explain why.  But first, some background:  Most power plants burn coal or oil to generate electricity.  The combustion produces steam that turns a giant wheel, creating mechanical energy that is transformed into electrical energy.  A by-product of the burning is carbon gas, which the plant releases into the air.  The carbon accumulates in the stratosphere, sealing in heat.  This “greenhouse effect” threatens to reshape weather patterns and to melt polar ice, creating floods.

To restrict carbon emissions, the European Union prints a limited number of pollution permits.  Plants (and others) can buy and sell these permits among themselves.  The reason for this policy is to reduce pollution as cheaply as possible.  Plants that can decrease carbon emissions cheaply – say, by shifting to a cleaner fuel, like nuclear energy – sell their permits to plants that can’t control emissions easily.  As a result, most of the cleanup is by plants that clean up cheaply.

For example, suppose that Plant A can reduce carbon emissions by a ton for 50 euros.  This would cost Plant B 100 euros.  Then A can sell its permit to B for 75 euros.  This reduces the real cost of cleaning up the ton by 50 euros (100 minus 50).  The savings can preserve jobs and hold down electrical bills.

Is a monopoly in the making?

Moreover, the permit market gives us vital information.  The permit price reflects the cost to the polluter of reducing emissions by a ton, since he will buy a permit only if its price is below the cleanup cost.  If cleanup is cheap for most firms, then they will refuse to buy a permit until its price falls.  That’s the situation today.  Economic anemia in Europe, stemming from the difficulty of governments in paying their bills, has slowed production, so the European economy is using less electricity than it otherwise would.  The demand for permits has fallen sharply, and their price approaches zero. 

This is not the fault of the market.  It simply is telling us that Europeans don’t value more cleanup because economic stagnation has already reduced pollution.  If some Europeans want more cleanup anyway, then they can buy lots of permits and donate them to a bonfire.  This, more or less, was the proposal from the European Commission – to yank permits off the market and possibly reissue them later.  The Parliament voted it down. 

In fact, we might get too much cleanup in the years to come.  Since permits are cheap now, an agent could corner the market by buying them up and then releasing only a few later, at a price that is high because of their artificial scarcity.  Without permits, many power plants won’t be able to produce, so we may get too little electricity.

Central Asia is not a player in the permit market.  But it should follow its performance in order to learn about the European energy market.  Compared to coal, oil is a costly but cleaner fuel (though not as clean as natural gas).  A fall in the permit price indicates that the demand for oil – as a substitute for coal – is falling because additional cleanup of carbon emissions is not valued as highly as before.  

Moral of this story: Beware of Incan emperors.   –Leon Taylor, tayloralmaty@gmail.com

Good reading

Robert N. Stavins, editor.  Economics of the environment: Selected readings.  Fifth edition.  W. W. Norton.  2005.

References

Stanley Reed.  European lawmakers to vote on tougher carbon measure.  The New York Times.  April 15, 2013.

Stanley Reed.  Europe vote sets back carbon plan.  The New York Times.  April 16, 2013.