The 'dark side' of stockpiling pollution permits

Corporations that emit pollution can buy up and store so-called pollution permits to save money on future emissions should the cost of offsets rise. But this strategy might not work out as planned.

By , Guest blogger

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    Water vapor billows from smokestacks on Paris in this Dec. 16 photo. Companies that try to stockpile pollution credits might see those credits devalued.
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Suppose that your factory produces greenhouse gases (GHG) as a byproduct of production. To keep this simple, suppose that you emit one ton of GHG per year. If carbon regulation now requires that you must own a "pollution permit" to cover your emissions, you face a choice. You could purchase 1 permit each year. Or, in an early year you could purchase 100 permits (if the price of a permit in that year was low) and "bank" them to use them later. If you can borrow and lend at a constant interest rate r, then a PDV maximizing firm will purchase the permit at time t if (permit price at time t) < (permit price at time t+1)/(1+r).

Now with this setup, we can turn to this NY Times article. Set in Europe, this piece says that dirty firms are banking large numbers of permits that they bought in the past at a very low price.

This article got me thinking that environmentalists may encourage the EU to engage in a type of inflation. Recall that inflation is printing money so that the amount of real goods that you can buy with $100 falls sharply (i.e prices rise).

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In the case of pollution permits, the original contract was; "1 permit = 1 ton of GHG" but imagine if there is a devaluation of the value of permits such that under the new regime "1 permit = .01 tons of GHG". In this case, the factory discussed above would now need to buy 100 permits each year to cover its GHG emissions.

What would be the real effects of changing this "exchange rate"? Firms who have purchased lots of permits in the past and banked them would now own a much less valuable asset. This "devaluation" would be a transfer from the shareholders of the polluting firms to the government who would now receive more revenue when these firms would have to buy more permits.

Now is this a costless transfer? "Fool me once shame on you, fool me twice shame on me". Moving forwards, firms with rational expectations will no longer bank permits and will face more price volatility. Just like in a nation with hyperinflation where nobody wants to hold cash (because it is losing value every second), polluting firms will need to hedge carbon pricing risk and could use futures markets rather than using banking.

I need to think about this but it could be the case that fear of pollution permit "hyperinflation" could accelerate energy efficiency and decarbonization because firms would know that they are likely to face higher price in the future for mitigating carbon. So, is "green inflation" good?

Now, this "inflation" only incentivizes firms who purchased permits before the news of the devaluation become public. In rational expectations finance, the equilibrium price of permits will decline immediately when that news becomes public knowledge and will decline even further if firms believe that the devaluation today implies future devaluations.

So only firms that were the original holders of the asset will suffer an income loss.

This is the "dark side" for firms that held large numbers of permits (because they become less valuable after the devaluation) --- but anticipating this effect may accelerate their transition to becoming "greener" to reduce their total carbon bill.

For a serious study on the economics of banking pollution permits read this .

It appears that the crucial issue here from an environmental point of view is what share of the dirty major producers in the economy were planning on meeting their carbon obligations using banked permits? The larger is this set, then the greater are the benefits of a big one time unexpected pollution permit devaluation.

A final point. The original permit buyers who banked the permits have revealed that at the time they bought the permits they believed it would be costly for them to reduce their GHG emissions. For example, suppose that in 2009 --- your firm buys 1000 tons of GHG permits and banks 990 and you paid $30 per ton for each. You are revealing that a lower bound in 2009 on your marginal abatement cost is $30 per ton. When this firm learns that banked permits are worthless in the near future, if it still costs the firm more than $30 per ton to abate; then this reneging on banking is socially costly. Relatively high abatement cost firms (the original "bankees" will now need to do more private abatement). The environmentalists will be happy but the shareholders will be upset.

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