A third type of incentive based pollution control scheme involves the use of marketable emissions permits (Marketable emission permits – an approach to managing ag impact? (conference on agricultural conservation policies): An article from: Journal of Soil and Water Conservation). In order to implement a system of pollution control using marketable permits, the control authority must
  1. decide how much of the relevant type of pollution is to be allowed;
  2. print sufficient emissions permits so firms may pollute up to the total allowable limit;
  3. sell, or distribute in some other way, the emissions permits to potential polluters;
  4. guarantee that emission permits can be traded between firms;
  5. subject any firm to a prohibitively expensive fine for any pollution it generates in excess of the amount allowed by the permits it possesses;
  6. monitor the operation of the scheme, periodically changing the total allowable amount of pollution as conditions change.
At first site, this system might appear to be no different from the use of simple quantitative controls. But there is one major difference: the permits can be exchanged between firms. The consequences of this are very important, as we shall see in a moment.
How are the permits initially allocated? One method involves giving them to firms, either in proportion to firm size or to the level of their current emissions. A second method involves auctioning of permits. Whatever method is chosen, the same total quantity of permits issued is identical. So the effect on pollution is unaffected by how this initial allocation is made.
What makes this scheme so interesting is what happens next. A market will develop in the transferable permits. Some firms are willing to pay large amounts for permits, others only small sums. In the course of trading, a single market price will emerge. The firms which purchase permits are those willing to pay at least the market price. For them, pollution abatement is expensive and they prefer to buy permits rather than to pay large sums to reduce pollution. On the other hand, those firms which sell permits are those for whom the value of using a permit is less than the market price; these will be firms in which pollution abatement is relatively cheap, and so will prefer to pay to abate pollution, and more than cover these costs by the proceeds from selling permits.
It is this process of trading that leads to the efficiency property of a transferable permit system. The pollution abatement effort becomes concentrated in the hands of those firms which can do it most cheaply. Permits to pollute become concentrated in the hands of firms which have the highest pollution abatement costs. In this way, the total cost of achieving any pollution reduction target is minimised.