Are green markets an alternative to pollution laws?

by Michael Rothchild
ith the threat of nuclear annihilation behind us, we might have hoped that humanity would get a decent breather before facing its next crisis. No such luck. Just as the ICBMs were being taken off launch status, the prospect of global environmental catastrophe took center stage. The threat of nuclear winter was superseded by global warming, the East/West confrontation turned into the North/South conflict, and the global summit relocated from Geneva to Rio de Janiero.
Far be it for me to question the thinking of the world's leaders and media big shots, but is it possible that the central issue of the environmental crisis, like the root cause of the Cold War, has been overlooked? In case you've forgotten, despite the incessant media focus on Pershing IIs, SS-20s and their deadly ilk, the East/West struggle never was about nuclear weapons. The threat of instant incineration was a symptom, not the cause. The conflict grew out of two radically different visions of "the good society."
The socialists held that complex social problems are best solved by central planning and strict command-and-control regulation. The capitalists argued that solutions to such problems cannot be planned, but must emerge spontaneously from the decentralized interactions of free market forces. We all know which view proved more accurate, but when it comes to solving our environmental problems, that lesson already seems to have been lost.
From Rio to Washington to every state capital and village council, environmental debates center on the specific details of proposed regulations. Are they tough enough? Are they broad enough? Do they demand compliance fast enough? Hardly anyone, including the business people involved, dares ask whether regulations are the best tools for solving our environmental problems.

Market failure

Why? In part because we've been taught that pollution is a prime example of "market failure." This is false. Except for a handful of recent experiments, pollution markets have not been tried. Something that doesn't exist cannot logically be said to have failed. Market absence is not market failure. Like stock markets and future markets, "green markets" will work, but certain systems must be put in place before trading can begin.
For example, Congress could set up a new environmental trust fund called the "EcoTrust." The EcoTrust would be authorized to auction off EcoTrust pollution permits. Ownership of a permit would grant its holder the legal right to emit a specific quantity of a certain pollutant. For instance, a one-ton sulfur-dioxide (SO2) permit would allow a company to discharge one ton of that chemical each year. If the Environmental Protection Agency caught the firm releasing an amount in excess of its permit quantity, it would be slapped with stiff penalties.
EcoTrust permits would be issued just once. Like deeds to real estate, the permits could be resold and subdivided an indefinite number of times, but no additional EcoTrust permits could be authorized after the initial offering. To determine the permitted pollution levels, Congress would select a "base year" - say, 1988 - when 15 million tons of SO2 were dumped into America's air. The Treasury Department would then auction off 15 million tons of SO2 permits. Thousands of firms, each in need of certificates, would bid against each other to secure these property rights.

Extended markets

The market easily could be extended to other pollutants. Chemical makers would bid for various hydrocarbon permits. Auto manufacturers would bid for "auto emission" permits, since each vehicle sold would be required to carry a permit to cover its lifetime emissions. Private and public, large and small, every organization and individual polluting the air or water, would have to own enough EcoTrust permits to cover their use of formerly free resources. And the final prices of products would reflect their permit costs.
At first glance, one might think a polluter loses the incentive to reduce emissions once it has purchased a permit, but this ignores the fact that no one wants to tie up money in paper issued by the EcoTrust. If an electric utility is forced to buy $30 million worth of SO2 permits, that's $30 million unavailable for investment, or several million dollars a year in foregone earnings. Under the permit systems, pollution's costs will show up where they belong - on the polluter's annual profit and loss statement.
Under the present regulation-based system, it makes powerful economic sense for polluters to drag their feet by lobbying and litigating with state and federal agencies. The longer a company can put off installing mandated anti-pollution equipment, the more it saves. Stiff resistance to environmental regulations makes economic sense. Delay, in and of itself, is profitable.
But a green market in pollution permits instantly reverses this logic. For the first time, it would cost polluters money not to reduce emissions as soon as possible. Any change in a firm's operating methods or technology that cuts emissions for less than the cost of a permit would become economically sensible. In effect, establishing a market price for a pollutant puts a price on its head. If the market priced SO2 for $1,000 per ton, then any new technology that could scrub a ton for significantly less would get a trial in the marketplace.

Innovation slow

By contrast, under today's command-and-control system, innovation by pollution-cleanup firms has been sluggish. Before developing a new product, environmental technology firms must know what technical standards the EPA will mandate next. Besides, firms selling anti-pollution gear have no way to cost-justify their equipment to potential customers. No matter how cheap an anti-pollution technology gets, it can't beat the alternative free dumping. In short, with today's laws fixing the cost of pollution at zero, the normal capitalist process of technical innovation, cost reduction and performance improvement cannot get rolling.
But if green markets existed, society would employ the signals that entrepreneurs and corporations understand: revenues and profits. By placing a fluctuating dollar value on air and water, the market will instantaneously stimulate desired changes in our collective economic behavior. Creating green markets in pollution rights would establish a set of information-feedback loops linking the economy to the ecosystem. As in every other aspect of economic life, free markets would generate intelligent solutions to problems far too complex to solve through command-and-control rules.

Markets, not taxes

Green markets also avoid the pitfalls of pollution taxes, a method often proposed as an alternative to command-and-control regulations. Remember, tax rates on each type of pollutant would have to be written into law. But no one knows what those tax rates should be. Which should be assigned a higher tax, a pound of ozone or a pound of nitrogen oxide?
As with all tax legislation, special interests would exert every ounce of leverage they command to extract favored treatment from their pet politicians. By their very nature, pollution taxes create the fetid conditions that lead to corruption. No such problems pertain to green markets. There is no one to bribe. A decentralized market, not politicians, would set the relative costs of various pollutants.
Green markets also would be flexible. For example, if society later decides that the amount of SO2 authorized by the initial sale of EcoTrust permits exceeds the desired level, tax revenues could be used to buy up and retire a portion of the permits, just as tax money is used to purchase parkland from private owners. As the supply of permits shrinks and prices ratchet up, the incentives for further emissions cutbacks and investment in more sophisticated antipollution technologies would become stronger. Conservation groups, like the Sierra Club and the Nature Conservancy, could accelerate this process by buying up permits and destroying them. A positive self-reinforcing market process would replace today's morass of bureaucracy litigation.
Green markets could be set up anywhere in the world. Any country could sell points for its existing pollution levels. Carbon monoxide and ozone permits could be traded on world markets just like tin and cocoa futures. A worldwide problem demands a pragmatic solution that can be scaled up quickly to global proportions.

Successful trials

But at Rio, no one even mentioned market solutions. As usual, all the talk was about the form and severity of future regulations. Nonetheless, in the 20 years since green markets were first proposed, they have been tried a few times. In one case - the rapid phase-out of leaded gasoline - a special EPA program allowed refineries to trade lead permits among themselves as they worked through the transition period. It worked beautifully.
Most recently, a provision of the 1990 Clean Air Act allowed electric utilities to trade SO2 permits that were granted to them. Trading has just started, but with the economic incentives properly aligned, the market for smokestack scrubbers already has taken off.
Advanced technology can make an enormous contribution to the quality of our environment, but as the Cold War should have taught us, only decentralized markets can stimulate innovation and entrepreneurship. Now is the time to harness high-tech capitalism in the service of the environment.
Green markets will make it happen.