The second method of regulatory intervention is cap and trade. Here, the system sets a maximum value for the emissions; this is the cap. It also provides allowances, in emission permits, to firms to cover each unit of CO2 (or any other pollutant) produced. The company can redeem one for every emission unit or trade it to another party, who can then use it.
As expected, the price will now move up to P*. What is the value of the permit? You will see that in the following.
The value is the green box of the figure, identical to that of the revenues in the carbon tax scheme. But how does that value per unit (the line, ab, joining the supply and demand curve or the) exactly match with the unit tax of the previous scheme? Did the government charge the permit to the firms by that amount? Well, it doesn’t matter – the permits can be free or can come with a price, and yet the eventual price in the market (for trading) reaches that value. It is because, in a trade, each permit comes with an opportunity cost for the selling firm or the maximum price it can afford for the buying firm. Anything beyond that price will make the total cost (marginal cost + permit) cross the willingness to pay of the consumer. Therefore, the final price (set by its supply-demand curves) settles to ab.
Free or fee?
While the offering price doesn’t matter to the outcome (the number of emissions), it differs in the final destination where the money (the green box) ends up. If the regulator charges a price ab to the permit, the entire green box becomes its revenue. If not, it adds to the firm’s bottom line. You then expect companies to pass the benefit to the consumers, but this seldom happens.
