Bankable permits for the control of environmental pollution

Intertemporal trading of emission permits (banking) is often identified as one of three promising market mechanisms for controlling pollution (along with averaging and trading). Surprisingly, the efficiency properties of permit banking systems have not been investigated. Using a simple optimal control model, this paper investigates firms' incentives for banking or borrowing emission permits and compares the emission and output streams firms would choose with the socially optimal solution. We find that in many cases firms will suboptimally choose excessive damage and output levels in early periods and correspondingly too few in later periods if given the opportunity to freely move emissions between time periods. We propose a simple alternative trading scheme we term modified banking that counters this problem and should be no more difficult for an environmental authority to implement than a straight banking system.