Tradable Pollution Permits — Reducing the Cap

What this diagram shows

This diagram shows what happens in a permit market when the government reduces the cap. The supply of permits is set by the government, so it is a vertical line at the number of permits issued: S1 at the original cap, Q1. Demand for permits is a derived demand: firms want permits because they need them to keep producing and emitting, and how much they will pay for one reflects their marginal cost of abating (cutting) emissions instead. When the government cuts the cap from Q1 to Q2, the vertical supply line shifts left from S1 to S2. Demand has not changed, so permits are now scarcer and the equilibrium price rises from P1 to P2. The market sets this new price, given the new cap. A higher permit price raises the marginal cost of emitting, so cutting emissions becomes the cheaper option for more firms: they abate rather than buy permits, and total emissions fall to the new cap. In evaluation, the price rise may not last: over time, firms' investment in abatement reduces their demand for permits, so D shifts left and the price can fall back from P2. A cut that is too large also risks firms relocating to countries without a cap, so that emissions move abroad rather than falling (carbon leakage).

Key points

• The supply of permits is fixed by the government at the cap, so it is perfectly inelastic: a vertical line.
• Reducing the cap shifts the supply of permits to the left, from S1 to S2; it is not a movement along a supply curve.
• Demand for permits is a derived demand that reflects firms' marginal abatement costs, and it does not change when the cap is cut.
• The higher permit price strengthens the incentive for firms to invest in cleaner technology, which improves dynamic efficiency.
• Higher permit costs raise firms' costs of production, and these may be passed on to consumers as higher prices.