Chapter 18: The Economics of the Environment

Start Up: A Market for Carbon Emissions

Emissions of carbon dioxide, a “greenhouse gas,” are limited by terms of the Kyoto accords, a treaty signed and ratified by most of the world’s nations. The treaty requires industrialized nations ratifying it to reduce their emissions of greenhouse gases such as carbon dioxide, which are thought to cause global warming, by 5.2% below their 1990 levels. The treaty also requires industrialized nations to assist developing nations with their efforts to reduce emissions of greenhouse gases. The vast majority of the world’s nations have ratified the accords. The United States is among a minority of nations that are not participating in them.

The Kyoto accords require that each industrialized nation specify quotas for each firm or organization that emits greenhouse gases. Those that emit less than their quotas can sell their unused rights to emit gases to other firms or organizations. Any agent that wishes to exceed its quota must purchase rights from someone else. That exchange permits organizations that can meet their quotas at relatively low cost to sell rights to others for which reductions would be costly. The exchanges still allow the overall target to be met, but at much lower cost.

President George W. Bush’s predecessor, President Bill Clinton, signed the Kyoto agreement, but it was not ratified by the United States Senate. President Bush withdrew the United States from the agreement citing the damage to the economy that implementation would cause, the fact that rapidly industrializing economies, such as China and India, are excluded, and inconclusive science. Despite this, many firms and other organizations in the United States have already agreed to limit their emissions of greenhouse gases. For the more than 100 members of the Chicago Climate Exchange (CCX), companies and organizations including IBM, the Ford Motor Company, Motorola, and the cities of Chicago and Oakland, the idea of exchanging rights to dump greenhouse gases in the atmosphere is already a reality.

Members of the CCX, formed in 2003 by Richard Sandor, a commodities entrepreneur and economist who helped establish markets in financial futures, have pledged to reduce their emissions of greenhouse gases to an annual target. If a member wishes to undertake a project that would generate additional carbon emissions, it purchases rights to the additional carbon from another member. In its first nine months of operation, CCX members traded rights to more than 1,000,000 tons of carbon. The CCX quotas are far less stringent than are those of the Kyoto accords. The chief importance of CCX is that it establishes a model for the exchange of emissions rights should the United States sign the treaty.

The development of a market for pollution rights puts market forces to work in an effort to reduce the potential problem of global warming. The European Union introduced exchanges in rights to emit greenhouse gases and issued quotas to firms for carbon dioxide emissions in its 25 member nations in 2005. Anticipating the limits, firms began trading rights to emit carbon dioxide in 2004, when the European Climate Exchange was announced. The price of the right to dump a metric ton of greenhouse gases was about $20. By 2008, the price had risen to €29, and rights to emit 295 million tons were traded on the ECX in June of that year.ECX Market Update, June 2008 (available at In the purely voluntary Chicago Climate Exchange, rights were traded much more cheaply—for about $5 per metric ton.“A Green Future,” Economist, 372(8392) (September 11, 2004): 69–70; Jeffrey Ball, “New Market Shows Industry Moving on Global Warming,” The Wall Street Journal, 241(11) (January 16, 2003): A1; John J. Fialka, “Russian Interest in Signing Kyoto Spurs Trading,” The Wall Street Journal Online, June 1, 2004. The CCX has since formed a partnership with London’s International Petroleum Exchange and the European Climate Exchange, so that European firms can exchange carbon rights on an international basis.

In this chapter we shall put the analytical tools we have developed to work on the problems of the environment. We will begin with an examination of problems of air and water pollution. We will look also at alternative regulatory approaches to environmental problems. Direct controls, in which government agencies tell polluters what they must do to reduce pollution, remain the primary means of government regulation. Persuasion, seeking voluntary compliance with pollution reduction efforts, is also used. Two alternatives that economists advocate are taxes on pollutants and marketable pollution rights; such systems are gaining in importance.

Related issues include those of common property resources, those scarce resources for which no property rights are defined, and exhaustible natural resources, those resources whose stocks decline as they are used. These topics were discussed in the chapters on efficiency and natural resources, respectively.

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