Pollution Permits: Efficiency by Design

Abstract

The annual adverse effects of pollution are on the order of 10% of world GDP. Many approaches are used or have been proposed to control the growing pollution problem, but none of them allows for efficient pollution control in settings in which the marginal cost of pollution is increasing and polluters are better informed than regulators about the costs of abatement. In particular, taxes, quantity restrictions, uniform-price auctions, and the usual implementations of discriminatory auctions (e.g., by the U.S. Environmental Protection Agency) in general lead to inefficient allocations. We propose a simple primary market mechanism, True-Cost Pay as Bid (TCPAB), that implements efficient pollution control and does not depend on how much information regulators have about firms' abatement costs. When polluters have symmetric information and the marginal cost of pollution is known, TCPAB implements an efficient primary market allocation. When the marginal cost of pollution is uncertain, TCPAB implements the most efficient allocation possible without further information on the true marginal cost. When polluters have asymmetric information about their opponents' costs of abatement, the inefficiency of TCPAB is small provided the informational asymmetry is not too large. TCPAB's favorable properties extend to dynamic environments provided limits are placed on the trading of permits across time. We also discuss how an adoption of TCPAB may facilitate international bargaining over emissions abatement.