Space or Power: Which Matters More In Permit Markets?

Permit markets to control pollution have long been popular with economists. In recent years they have been embraced increasingly by policymakers as well. Conventional wisdom holds that a permit market must be competitive to be successful. In the case of the U.S. SO2 allowance market, avoiding market power was deemed sufficiently important that the law created a single national market for allowances. Thus, any significant control over the spatial distribution of emissions was sacrificed. I argue that this prioritization was misguided. I develop a spatial framework that explicitly accounts for both costs and damages in a set of regions between which a single pollutant can travel. I show that the welfare losses due to spatial misallocation of emissions are likely to be much larger than any potential losses due to market power in the smaller regional markets. Moreover, I argue that a small number of traders is unlikely to be a problem, for two reasons. First, they will be on opposite sides of the permit market, so bilateral monopoly is more apt than the usual monopoly or monopsony analogy. Second, because they are large but few in number, such firms are likely to achieve a bargaining outcome that leads to the least-cost distribution of emissions.