Emission trading for air pollution hot spots: getting the permit market right

Conventional emission permit markets are inefficient for non-uniformly mixed pollutants that create geographic ‘hot spots’ of different ambient emission concentrations and environmental damage. Economically efficient ambient concentration contribution markets involve difficult interactions among multiple markets that makes them practically infeasible. Extending economic theory by Muller and Mendelsohn (Am Econ Rev 99(5):1714–1739, 2009. doi: 10.1257/aer.99.5.1714) and others about ‘getting the prices right’ through bilateral trading ratios, this paper introduces theoretical simplifications and a novel type of single permit market with a hybrid price-quantity instrument that addresses the dual heterogeneity of firm-specific abatement costs and regional variation in damage. This paper shows how to ‘get the market right’ robustly through simplicity, liquidity, and gradualism. Analytic solutions and simulation results demonstrate the feasibility of the novel market concept. Also discussed is the potential applicability of the market design to interstate trading in the United States in the wake of the recently implemented Cross-State Air Pollution Rule.