Early HistoryDESCRIBING THE EVOLUTIONTraditional PolicyTHE EVOLUTION OF EMISSIONS TRADINGThe Offset Policy: The Problem Becomes the SolutionThe U.S. Emissions Trading Program: Expanding the ScopeGetting the Lead Out: The Lead Phase-out ProgramReducing Ozone-Depleting ChemicalsTackling Acid Rain: The Sulfur Allowance ProgramRECLAIM: The States Take the InitiativeThe NOx Budget ProgramThe Chicago Emissions Reduction Market SystemEmissions Trading in the Kyoto Protocol on Climate ChangeControlling Particulates in Santiago, ChileTHE EVOLUTION OF DESIGN FEATURESPermit DenominationsBaselineCapsShifting the PayoffSubstituting For vs. Complementing Traditional RegulationI / IntroductionA long tradition in economics suggests that treating resources as a commonsthat are shared jointly by many users could lead to overexploitation in theabsence of some kind of access rationing (Ostrom et al. 2002). Since theatmosphere is one such commons, it is not surprising to find that in theabsence of some kind of access rationing for polluters, the atmosphere wouldbe excessively polluted. The policy question, therefore, is what form should thecontrol over access take?One increasingly common form involves the use of emissions trading. Incontrast to more traditional regulation, where the regulatory authorityspecifies a specific maximum level of emissions for each emissions sourcewithin a plant, emissions trading is a regulatory program that allows pollutionemittters considerable flexibility in how they comply with the regulation. Withemissions trading, as long as the total emissions reduction is the same orgreater, firms can comply by either: (1) reducing emissions from anycombination of sources within the plant; or (2) acquiring emissions reductionsfrom another facility. 1-1The logic behind the growing prominence of this approach is simple. One ofthe insights derived from the empirical literature is that traditional command-and-control regulatory measures, which depend upon government agencies todefine not only the goals but also the means for reaching them, are in manycases insufficiently protective of those resources or economically inefficient.Emissions trading provides, at least in principle, a cost-effective alternative.Applications of this general approach have spread not only to many differenttypes of pollution in many different countries but are also being used to rationaccess to many other resources, including fisheries, forests, water, and landuse control, among others.1 Though the lessons from emissions trading arecertainly useful for those considering this approach for other resources, thisbook will focus on the use of this technique to control air pollution.Early HistoryBy the late 1950s, both economists and policymakers had formed well-developed and deeply entrenched visions of how pollution control policyshould be conducted. Unfortunately, the two visions were worlds apart.1 For an extended bibliography of works that describes these various applications see http://www.colby.edu/~thtieten/trade.html1-2Economists viewed the world through the eyes of Pigou (1920). Professor A. C.Pigou had argued that in the face of an externality such as pollution, theappropriate remedy involved imposing a per-unit tax on the emissions from apolluting activity. The tax rate would be equal to the marginal external socialdamage caused by the last unit of pollution at the efficient allocation. Facedwith this tax on emissions, firms would “internalize” the externality. Byminimizing their private costs, firms would simultaneously minimize the coststo society as a whole. According to this view, rational pollution control policyinvolved putting a price on pollution.Policymakers, particularly, but not exclusively, in the United States, held anequally firm, if substantially different, view. According to this view, the properway to control pollution was through a series of legal regulations ranging fromcontrolling the location of polluting activities (to keep them away from people)to the specification of emissions ceilings (to limit the amount ejected into theair). Under this regulatory regime, the public sector would be responsible for:(1) figuring out how much pollution to allow each emitter (usually byidentifying the specific control technology that should be used); (2) mandatingeither a specific technology or level of emissions flow achievable by thattechnology; (3) monitoring emissions to verify compliance with these1-3mandates; and (4) using financial penalties or other sanctions to bring non-complying sources into compliance.While some exchanges of ideas took place between the two groups, most of itwas highly critical and not viewed by the recipients as particularly helpful.Economists would point out, for example, that legal regimes, which becameknown as “command-and-control” regimes, generally were not cost-effective.Hence, they argued that by simply switching to Pigouvian taxes, morepollution control could be gained with the same expenditure or the samepollution control could be gained with less expenditure.Policymakers responded that the information burden imposed on thebureaucracy by the design of efficient taxes was unrealistically high. And taxesbased upon very limited information might not be any better than legalregulations. Furthermore, they argued, if bureaucrats had sufficientinformation to set efficient tax rates, they could use the same information toset efficient legal regimes.The result was a standoff in which policymakers focused on quantity-basedpolicies while economists continued to promote price-based remedies. While1-4the standoff continued, legal regimes prevailed. Taxes made little headway,particularly in the United States.In 1960, Ronald Coase published a remarkable article in which he sowed theseeds for a different mind-set. Arguing that Pigou had used an excessivelynarrow focus, Coase went on to suggest:It is my belief that the failure of economists to reach correct conclusionsabout the treatment of harmful effects cannot be ascribed simply to afew slips in analysis. It stems from basic defects in the current approachto problems of welfare economics. What is needed is a change