Cap-and-Trade Applied to Water Pollution

Cap-and-Trade Applied to Water Pollution: Example

Two firms are located on the bank of the Kelley River. Firm A manufactures paper, a process that uses a lot of chemicals and water – polluting 110 units of chemicals into the water. Firm B is in the same paper industry, but they make cardboard – polluting 100 units of chemicals into the water. They each introduce more pollution into the river than the government desires, so a cap is set where both firms have to reduce emissions – 150 total pollution units allowed, 75 permits are given to each firm. Firm A has lower costs to cut their effluent emissions than Firm B – it costs Firm A $10/unit to abate their pollution. Firm B is an older plant using outdated production and pollution-control technology, so it has very high costs of abatement – $20/unit to abate the pollution. Without a trade, Firm A needs to abate 35 (110-75) units at $10/unit = $350; and Firm B needs to abate 25 (100-75) units at $20/unit = $500. This shows that Firm A will (in total) spend a lot less money on pollution reduction than Firm B with no trades taking place. So Firm B negotiates with Firm A in order to buy some of their allowances, which Firm A valued at a lower amount than firm B. A permit for one pollution unit is valued at $10 for Firm A and $20 for firm B. As long at firm B buys the permit for an amount less than the price it costs to actually abate the pollution, and Firm A sells the permit for more than the it costs to abate the pollution they produce, then they both benefit from the trade. In this scenario, a trade would be made if the price of the permit was anywhere between $10.01 and $19.99. This would make the trade beneficial for both parties since before the trade firm B would have to pay $20/unit to reduce all their pollution units until only 75 units remain. (Firm B would be saving money with a permit price at or below $19.99).  For Firm A, the cost to reduce pollution by one unit is $10. (Firm A would make a profit if the one-unit permit was sold for any amount at or above 10.01). This is an example of how a cap-and-trade policy works to reduce water pollution.