Policymakers can derive the true cost of environmental goods by auctioning pollution allowances, with the number of allowances determined by the prices that are bid at auction. This approach can make pollution regulation more efficient and more effective.
If you ask almost any economist what first option you should consider when tackling an environmental problem, most would respond right away that we need to put a price on environmental commodities—whether it’s a price on pollution, payments for ecosystem services, or otherwise. Preferably, the price approximates the social value of the resource. This method can guide the economy away from the overuse and waste of valuable, but unpriced, environmental commodities.
But this realization that we should think about air, water, and other natural resources as goods that need an appropriate price has led to one of the longest-running debates among economists: Should we set the price directly, or should we choose a quantity and then facilitate voluntary exchange to discover the scarcity value or price of the resource? When economist Arthur Cecil Pigou first noted the “missing prices” for some goods in the early 1920s, he naturally suggested that we should think about setting these prices—although he cautioned that finding the right price would be devilishly difficult.
In the 1960s and 1970s, the possibility arose of letting the government fix the quantity of the environmental commodity and using markets to find a price for the commodity, first in the context of fisheries, and then as extended to pollution regulations. Various researchers showed that environmental problems could be solved not necessarily by setting a price, but rather by setting a limit on pollution and permitting the trade of pollution allowances; this way, the price could emerge through trading in those markets. In many ways, this approach seemed to match more closely the typical solutions that policymakers had been applying to pollution problems, but it kept the efficiency advantages of harnessing market incentives.
Since then, economists pretty much have divided themselves into two camps on this question: those who favor setting prices directly and letting market activity determine the quantity, and those who favor setting the quantity and using market activity to find the price. This topic has been the subject of countless papers, books, dissertations, and discussions, and has driven debates over the best way to address climate change.
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As it turns out, economists Marc Roberts and Michael Spence suggested a solution to this conundrum in a journal article they published in 1976. They suggested a radically different approach: that price and quantity for a pollutant could, theoretically, be set simultaneously—in the same way price and quantity are set in markets for regular goods when buyers and sellers meet. The scarcity of a good is determined both by the demand (i.e., the value that people place on it) and by the supply (i.e., the amount available at a given price). Rather than setting either the price or the supply of pollutants, Roberts and Spence pointed out that you can get closer to the optimal price and quantity if you use markets to determine the price and the quantity at the same time. To do this, you can set up a market for the environmental commodity (e.g., allowances for carbon dioxide emissions) but let the available quantity (as determined by the regulator) adjust to the demand that arises in the market. Note that this adjustment of supply to the market demand is the outcome one observes in other commodity markets in general: when demand goes up, more supply enters the market. The supply schedule of pollution allowances is determined by the policymaker’s best estimate of the damages expected from increased amounts of the pollutant, and the supply schedule is implemented by setting up many separate and very small markets for allowances with gradually increasing values. Unfortunately, as Roberts and Spence noted, such a sequence of markets would not satisfy the requirement that healthy markets have many traders, given that, for many allowance values, few traders may be interested in bidding for allowances in that particular price range. So, the economists’ idea has lain dormant for nearly 50 years.
In our recent journal article, Resources for the Future scholars Dallas Burtraw and Karen Palmer, our colleague Charles Holt, and I reexamine these ideas by taking advantage of recent innovations in emissions markets, wherein emissions allowances are auctioned rather than granted freely to emitters. We implement a price-responsive supply of allowances by making the number of allowances sold at auction responsive to the value of bids received—a feasible means of achieving the infinite sequence of markets that Roberts and Spence proposed. We show that, if the auction is competitive and has many buyers (such that buyers have an incentive to bid true values in the auction) then a price-responsive supply of pollution allowances finds the true value of the allowances better than policies that set either the price or the quantity of allowances. Hence, the solution is no longer an issue of price versus quantity, but rather price and quantity determined together.
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By using theory, experiments, and simulations, we show that price-responsive supply more accurately articulates the actual cost of environmental cleanup, even when the policymaker doesn’t know the true cost of pollution abatement—a factor that otherwise can tip the choice of policy design between setting the price or setting the quantity. The benefits of using price-responsive supply arise from the ability of competitive markets to reveal to policymakers the costs of firms complying with pollution regulations. This information, which is essential for policymakers who aim to set appropriate pollution regulations, is “revealed” by the bids that buyers make at auction, and the auction results respond instantaneously to new information contained in the bids.
Overall, we show that price-responsive supply can substantially improve the performance of environmental regulations. The simultaneous articulation of both the price and quantity of environmental commodities provides quicker and more accurate information to policymakers, and hence a more predictable regulatory environment for firms that need to decide how to invest in future pollution controls. Instead of being subject to delay and regulatory uncertainty, new information about compliance costs gets incorporated immediately and automatically in the market. The new approach thus helps solve a key problem for policymakers by explicitly addressing the supply side of the pollution market and making pollution regulation more efficient.
In our article, we specifically address the case of regulating greenhouse gas emissions. Global communities face lots of uncertainty about how quickly we can eliminate emissions at a reasonable cost. The keen debate among economists that pits carbon taxes against carbon cap-and-trade programs as potential solutions can be resolved by applying this strategy of price-responsive supply. By observing the prices that emerge from auctions of emissions allowances, we can automatically adjust our projected emissions reductions based on the most current information about costs.
We’ve demonstrated that this strategy can work in practice. With the assistance of our research team, an early version of price-responsive supply already has been implemented in the Regional Greenhouse Gas Initiative, a cooperative cap-and-trade program involving northeastern states from Virginia to Maine. The program has set up an “emissions containment reserve,” which is a practical implementation of just the sort of idea suggested by Roberts and Spence. The emissions containment reserve is, in a nutshell, price-responsive supply as laid out in our article.
This innovation is applicable to many of our most pressing environmental problems. The problem of price versus quantity arises in a wide range of environmental concerns, including the regulation of air pollution, water pollution, and fisheries harvests. The idea of price-responsive supply in environmental markets has great potential to improve both environmental and economic outcomes.
