ENVIRONMENTAL COMMODITIES MARKETS: ‘MESSY’ VERSUS ‘IDEAL’ WORLDS

I. INTRODUCTION Tradable or marketable permits, quotas, or licenses have become increasingly popular for addressing a wide range of policy problems. Economists have long theorized that allowing decentralized individual choice should achieve the same environmental quality level as centralized-planning at less cost due to savings in information acquisition costs and greater flexibility to exploit all beneficial opportunities. Current applications of tradable permit markets (TPMs) include taxicab medallions in New York City, fishery quotas in New Zealand, agricultural production quotas for dairy products and tobacco, water rights in the Western United States, and air and water pollution permits in the United States and Europe. With all of this enthusiasm for permit trading, both by economists and regulators, one yet might ask: "Why have these programs not been as successful as predicted in environmental regulation?" Perhaps the most important consideration in evaluating whether to "harness the marketplace" to solve environmental problems is that implementing these programs will occur in a world that is just as "messy" as the one in which the current regulatory regimes operate. Insufficient information available to firms and regulators lead to a degree of uncertainty; market participation or regulatory compliance have additional administration costs; and compliance and enforcement of permits is necessary. Nevertheless, many evaluations of permit markets compare an "ideal" market-based program to an implicitly "messy" existing command-and-control (CAC) or appropriative rights ("queuing") system. The result maybe to overestimate the benefits attributable to a market-based approach (Hahn and Stavins, 1992; Stavins, 1995). One can broadly delineate the traits that influence the workings of these markets into four areas of investigation. First, what are the physical and technological characteristics of the problem? How easily the commodity can be defined and segmented depends on these traits. Second, how will property rights be defined and enforced? While property rights - implicit and explicit - can and do exist without markets, markets require defined property rights to operate properly. A tension exists between defining immutable permit rights to assure tradability and achieving environmental quality or water supply reliability without regulators' completely understanding the influence of emissions or diversions. Third, how will transactions be consummated? The search, bargaining, and transfer process can affect the chosen regulatory instrument's efficiency, both through transaction costs and the resolution of trades. Fourth, how committed are policymakers to the chosen policy approach? Success of any government program, not only establishing a market, depends on the level of commitment and resulting surety that participants expect. Without such certainty, potential participants may discount the value of holding permits or be reluctant even to enter the market. This paper describes how "messy" environmental commodity markets can diverge from the "ideal" world that economists often use. To ground this discussion in real-world examples, the analysis here focuses on markets for air pollution emission permits and water rights. Only by accurately capturing how similar imperfections and tradeoffs affect markets as well as other regulatory approaches can one properly compare the ideal to the existing regulatory structure. However, one should keep in mind that many problems with environmental commodity markets identified here also occur in conventional regulatory approaches. II. PROVIDING AN ANALYTIC FRAMEWORK Economists tend to focus on a narrow set of issues surrounding economic activity, such as individual human behavior, technological aspects of the production process, and physical characteristics of resources traded and consumed. Yet the institutional details of how these resources are managed and exchanged intersect with the economic process at key points. …