Policy for Market Failure: Market-based strategies Price Instruments

1. Policy for Market Failure: Market-based strategies Price Instruments Jeffrey Ely and Lam Thuy Vo / NPR

2. Instrument taxonomy

3. Price-based policy examples Fees/taxes/charges to disincentivize activity • User fees (e.g. National Parks) • Congestion fees, road tolls (e.g. London congestion charge, 8 £) • Emissions fees (e.g. GHG tax) Subsidies to incentivize activity • Abatement subsidies (reduce “bads”) • E.g. NC bill to provide $50B to reduce hog farm waste • Subsidies to encourage “goods” • California Million Solar Roofs Initiative • 2008 Farm Bill • $14B in subsidies for various crops • $27B to conserve environmentally sensitive farmland

4. Emissions charge (tax) mechanics Suppose: emissions tax of $120/ton. What is the predicted (rational) response? • polluter objective: minimize TCC • Define: TCC = TAC + TEF Tax has been set at $120/ton/month total compliance cost total abatement cost total emissions fees

5. Tax - mechanics • If the MAC curve shifts down (e.g. MAC’) • does the predicted level of abatement go up or down (tax unchanged)? MAC’

6. Arthur Cecil Pigou “…investments in which marginal private net product falls short of marginal social net product, (or)…marginal private net product is greater than marginal social net product. … Thus, incidental uncharged disservices are rendered to third parties when the game-preserving activities of one occupier involve the overrunning of a neighbouring occupier's land by rabbits—unless, indeed, the two occupiers stand in the relation of landlord & tenant, so that compensation is given in an adjustment of the rent. …. …third parties…suffer incidental uncharged disservices from…motor cars that wear out the surface of the roads. The case is similar (with the) sale of intoxicants.” The Economics of Welfare, 1921 h/t Krugman thedodo.com

7. Pigovian tax: a fee ($/unit of emissions) set to produce the efficient level of emissions. • Need: MD function • tax = MD at the efficient level of emissions $ $

8. Setting an efficient tax Questions: Identify… • Efficient emissions • Given t*: • TAC: Total abatement cost • TEF: Total emissions fees (“tax bill”) • TB: Total benefit from damages averted.

9. Equimarginal principle 1. look for outcomes in which MACs are equalized • Major strength of emissions charges: • IF same tax rate applied to different sources with different MAC functions (and each reduces it emissions as predicted such that MAC = tax) THEN, MAC’s will be equalized across sources. Cost effectiveness achieved ***Does the regulator have to know the MAC functions for • a tax to be cost-effective? • a tax to achieve the socially optimal level of aggregate abatement? 2. stop when you find the outcome that achieves the required aggregate abatement

10. Should there be limits to the use of prices to achieve public objectives?

11. Should we achieve water conservation goals via command & control or market based approaches?

12. “Ever since Santa Fe introduced its tiered system (for water pricing), water consumption per person has fallen” (NY Times, 5/6/15) ~$6/Kgal to 7Kgal (winter) or 10Kgal (summer) then ~$22/Kgal ….no other major U.S. city so steep

13. http://cityofdavis.org/city-hall/public-works/water/water-conservationhttp://cityofdavis.org/city-hall/public-works/water/water-conservation

14. We’re not going to cover the model on the next slide in detail this quarter. But I’d like you to still take in the following stylized fact  Under the model presented on the next slide… • Market based instruments (MBI) that put a price on pollution (i.e. pollution taxes and cap & trade) generate stronger incentives (than standards) for polluters to innovate in ways that make it cheaper to abate (i.e. drive their MAC down.) • This is because the reduction in their total compliance cost (TCC) from innovation is greater under an MBI than a standard.

15. Incentives to innovate Baseline, MAC1: what level of emissions is chosen and what is the total compliance cost? • TCC1 = TAC1 + TEF1 = ? After innovation (MAC2): what level of emission is chosen and what is the TCC? • TCC2 = TAC2 + TEF2 = ? What is the firm’s benefit (incentive) for innovating (cost savings)? • TCC1 – TCC2 =? Compare to incentive under performance standard e1 Story: -Initially at MAC1. --After costly R&D, develop new method, move to MAC2. -Emissions charge is constant at t.

16. Incentives to innovate are greater under emissions charges than standards • R&D efforts will lead to a bigger reduction in compliance costs for firms (abatement plus taxes) under a tax compared to a standard. • Under a tax: a firm will automatically reduce its emissions as it finds ways to shift its MAC function downward • Same incentive not present under standards.

17. Market-based instruments have key advantages over C&C • cost effectiveness • incentives for technology innovation • take advantage of private information that polluters have • RE: means and procedures they could use to reduce pollution Can be used to induce an outcome that satisfies the equimarginal principle: MACA(eA*)= MACB(eB*)

18. Subsidy policies • Payments to reduce pollution (less of a bad) • Payments to increase/support an activity (more of a “good”, e.g. price supports in agriculture) • Deposit-refund systems • Subsidy is the refund (deposit funds the subsidy payment). • Subsidy removal

19. Optional additional slides

20. A diversion: • Swiss millionaire (est. wealth: $20M) • Ferrari Testarossa driver (red) • a repeat traffic offender “Roland S*” • Caught driving “35 miles an hour faster than the 50-mile-an-hour limit” • fined $290,000 for speeding (Swiss court in St. Gallen) • record-breaking fine • Price instrument in combination with performance standards – tailored to the agent (Assoc. Press, Jan 7, 2010) Source: http://www.blick.ch/news/schweiz/ostschweiz/st-galler-ferrari-raser-ich-bin-diplomat-137378

21. Subsidies • Pollution context: polluter paid per unit of reduction below some benchmark level • generates an incentive: opportunity cost for polluting • emitting a given unit of pollution means forgoing the subsidy payment. • Subsidies to reduce pollution are not common. Why? • Violates “polluter pays” principle • Can potentially lead to more pollution: Subsidies decrease firm pollution  increase industry profits encourage new entrants  more production  more pollution

22. Federal energy subsidies, 2002-2008 Environmental Law Institute, 2009

23. “Antibiotics Research Subsidies Weighed by U.S.” (A. Pollack, NYT, 11/5/10) • “Worried about an impending public health crisis, government officials are considering offering financial incentives to the pharmaceutical industry, like tax breaks and patent extensions, to spur the development of vitally needed antibiotics. • …bacteria (have) steadily become resistant to virtually all existing drugs at the same time that a considerable number of pharmaceutical giants have abandoned this field in search of more lucrative medicines.”

24. “Antibiotics Research Subsidies Weighed by U.S.” (NYT, 11/5/10) • “While the notion of directly subsidizing drug companies may be politically unpopular in many quarters, proponents say it is necessary to bridge the gap between the high value that new antibiotics have for society and the low returns they provide to drug companies. • `There is a market failure,’ said Representative Henry A. Waxman, a California Democrat and the chairman of the House Energy and Commerce Committee, who said he was considering introducing legislation. `We need to look at ways to spur development of this market.’” • Alternative approach: Generating Antibiotic Incentives Now bill: “provide certain antibiotics with five extra years of protection from generic competition” <What type of approach is that?>

25. Subsidy removal example: Below-cost timber sales • Moving timber from U.S. public lands into the marketplace frequently costs the Federal government more than it gets in return implicit subsidy • Common form: credits to private lumber companies for road building • 1964 Forest Roads and Trails Act • companies deduct road construction expenses (credits) directly from the amount they pay the Forest Service for the timber they extract. • Removal of these subsidies could foster environmental protection and save taxpayers up to (an estimated) $1.2 billion over five years (U.S. CBO, 1990). (Stavins, 1998)