The Pollution Solution

May 4, 2012

By far the most common response to providing air quality control has been command-and-control regulations where the government decides what actions shall be taken by individuals and organizations to meet the environmental objective and enforces them with its police powers, says Gary D. Libecap of the Hoover Institution.

There are several fundamental problems with this approach that limit its effectiveness and exacerbate its negative impacts.

  • Regulators do not have the information required to set a cap on the right amount of air pollution, and this lends itself to inefficient regulatory actions.
  • Furthermore, because regulators do not have the correct information, they typically mandate uniform technologies or performance standards for all parties that inhibit flexibility and retard market forces' adaptability.
  • Finally, because the ultimate decision usually lies with an agency expert, it is susceptible to manipulation by those with a vested interest and political inroads.

An alternative form of environmental regulation that maximizes flexibility for market participants is a cap-and-trade system that allows strong property rights on issued permits.

  • The way this works is that, in the case of air pollution, the total annual amount of allowable emissions is set by a regulator.
  • The regulator subsequently issues permits to firms in the market that they can trade in to allow a given amount of emissions.
  • This is the limit of the agency's participation in the regulation -- the market will then adapt as firms seek to reduce their emissions levels.
  • The total number of allowable emission shares can be reduced each year until the desired cap or pollution objective is met.
  • Crucially, firms can trade permits, allowing those with high pollution control costs to buy shares from others that have lower control costs.
  • By placing the ball in the court of the firms and providing them ample flexibility in meeting emissions standards, the incentive to protect the environment is internalized into the firm's decision making.

Regulation through this mechanism captures the inherent creativity and innovativeness of the market to meet emissions goals: firms that can create new, emissions-reducing technologies will be rewarded, while those with little interest in that endeavor can simply pay for additional permits.

Source: Gary D. Libecap, "The Pollution Solution," Hoover Institution, April 23, 2012.

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