Fixing Environmental Externalities

I had a comment on my Externalities post asking about the Cap and Trade program being considered as a way to combat carbon emissions.  The cap and trade idea isn't new.  In fact, the United States has had a successful cap and trade plan in place for over ten years in an attempt to curb sulfur dioxide and nitrogen oxides in the atmosphere.  It is called the Acid Rain Program.

In the case of acid rain, an externality exists: coal-fired power plants (and other polluters) put sulfur dioxide and nitrogen oxides into the air, which then come back down and kill forests (among other bad things).  The residents and businesses that use those forests are harmed.  This is a negative externality.

Cap and trade programs aim to reduce these pollutants (and by extension the externality) by using the theory of free markets.  The government issues permits that allow the holder of the permit to pollute a certain amount per year.  The sum of the permits at the time of issuance will often be close to the current level of pollution.  The permits might be given to the current polluters for free or auctioned off, or some of both.  Then, these permits can be bought/sold at an exchange by anyone at prices that vary via market forces.  A new factory can choose between buying a pollution permit or investing in technology that pollutes less.  An environmental non-profit or the EPA can buy permits and then never use them to reduce overall pollution.

Cap and trade systems work; there isn't a substantive debate there.  The controversy around carbon emission cap and trade is that not everyone agrees that carbon emissions are a problem.  That is a debate for a different blog.