E C O N O M I C R E P O R T O F T H E P R E S I D E N T

Heterogeneity in Abatement CostsIf the cost of abating emissions varies substantially across sources, thepotential for cost savings through a trading program is great. It would beprofitable for a firm with a high cost of reducing emissions to make a tradewith a firm with a low cost, at a price somewhere between the two costs.Large discrepancies in abatement costs—which may relate to differences inthe age of facilities, in previous investments in pollution control technologies,in fuel inputs, or in other respects—provide the economic incentive fora high volume of trade and can facilitate the development of an emissionsmarket. However, if the costs of reducing pollution are similar across sources,a tradable permit system might not deliver substantial cost savings. Thetransactions costs of participating in trading (for example, from having toseek out another firm with which to trade) may overwhelm the cost savingsassociated with the trade if the two firms have similar abatement costs, andthis may reduce the incentive to trade. In such a situation, a charge or othertype of regulation may be more appropriate than trading.Scope of the Emissions Trading MarketThe size of a potential emissions market can significantly affect thevolume and cost savings of a tradable permit system. A market with a smallnumber of emissions sources may experience low trading volumes andinefficient, monopoly-like behavior—a robust market may never evolve.A larger set of participants can promote a more active, efficient market.Several factors can influence the number of participants in a tradablepermit market. First, the monitoring of emissions sources can significantlyinfluence which sources participate and which do not. If their cost ofmonitoring emissions exceeds the gains from trading, small firms will haveno incentive to join the trading program and will likely prefer a traditionalregulatory approach. Continued technological development in monitoringequipment may help reduce the costs of monitoring and allow for marketsto expand to more sources. However, inability to effectively monitor somesources may make it more difficult to design well-functioning tradablepermit systems and emissions charges.Second, additional scientific research on the human health effects ofvarious types of emissions can influence the size of a market. By takingadvantage of similarities in the effects of different pollutants, tradablepermit markets can be structured to allow for trading across pollutants. Forexample, because both NO Xand volatile organic compounds contribute tothe formation of ozone, the potential is there to allow for trading acrossthese gases. However, some of these compounds may also be carcinogenic,Chapter 7 | 253