But how control pollution? By Command or Decree? or Market Mechanism

1. But how control pollution?By Command or Decree? or Market Mechanism Because of pollution from factories (industrialization) cars: emission standards open fires. There are perceived threats to global well-being: ozone layer depleting global warming sea levels rising; damage to low-lying areas (incl. entire countries) catastrophic climate changes reducing biodiversity Globally reducing environmental pollution is extremely high on the international agenda.

2. Global consensus: pollution must be reduced Globally reducing environmental pollution is extremely high on the international agenda. International conventions have been debated and signed: Kyoto Protocol (which some did not sign) ends in 2012 New international conventions being debated today, with renewed calls for even more stringent control of pollution, especially carbon dioxide in the air by countries limiting pollution: successor to Kyoto Protocol Also calls for Government to use public policy to encourage switching to clean energy sources consuming products and services with small “carbon foot-prints”. and reducing pollution by factories and households

3. Pollution must be reduced; but HOW exactly? Decree maximum targets everywhere (pollution capping) countries factories cars products Or use market mechanisms “carbon price” (issue in recent Australian elections) “emissions trading”. Or combination “cap and trade”

4. What economic implications of “Command” or “market” mechanisms? Much disagreement and debate. Is it sensible to order all countries/factories/cars to reduce pollution by the same absolute amount? Or order them to reduce by the same proportionate amount? Is it sensible to order them to reduce to the same level of pollution? Per person? Per country? Per car? Per aeroplane? Are there “market mechanisms” (carbon or emissions trading) which requires minimal “orders” or bureaucrats or monitoring? Is there any combination of all these policies which work best? Is it “fair” that developed countries which have been polluting for a hundred years start imposing trade sanctions on poor developing countries because of their increased pollution in their attempt to accelerate growth so as to reduce their abject poverty?

5. Development debate: trade sanctions on polluting countries? Recent development: developed countries wish to apply trade sanctions on exports of developing countries which are associated with increased pollution Developed countries themselves have been polluting far more for more than a hundred years They have now gone on to “cleaner” technology GDP per capita developed countries: > US$30,000 GDP per capita developing countries: < US$1,000 And developed countries want to impose trade sanctions on poor developing countries whose attempt to reduce their abject poverty results in increased pollution?

6. Is there any ideal target for pollution? You cannot remove all pollution from the planet, How much pollution is the "right" amount to which all pollution must be reduced to? And must all countries, firms, factories, do these things regardless of what it costs them? These are all tough questions, with no easy answers. Important methodology: using marginal cost and marginal benefits approach. But is that good enough to tackle the totality of the problem? Or is there a need for some multi-faceted approach?

7. Is zero pollution a correct objective: marginalist analysis MSC $ Basically all modern industries and agriculture produce some pollution- impossible to reduce it to zero. The Marginal Social Costs of reducing pollution will be generally small at the beginning but keep rising the more and more you succeed in reducing pollution. Conversely, the Marginal Social Benefit of reducing pollution further keeps declining, the more and more you reduce pollution. MSB 0% % Reduction of Pollution per year 100%

8. Optimal rate of pollution reduction: where MSB = MSC MSC $ Anywhere to the left of r (the optimal % of pollution reduction) the MSB is higher than the MSC of reducing pollution, so % of pollution reduction should be increased. Anywhere to the right of r, the MSC is higher than the MSB of pollution reduction, and society would be better off reducing the pollution reduction. Of course the real difficulty is estimating what the actual dollar value of pollution reduction is at any point in time. MSB r 100% % Reduction of Pollution per year

9. Is this command mechanism economically sensible? eg Order all firms in the steel industry to reduce pollution by 50 tons of pollutant pa $ MCb MCa $300 This may seem fair. Suppose that the Australian Government has given a commitment to reduce its pollution by a million tons per year. Government demands that every polluting firm in reduce its pollution by the same quantity- 50 tonnes per year. It appears fair. But is this economically sensible? But what if different firms have different Marginal Costs of reducing pollution? $100 50 Reduction of Pollution per year (tonnes)

10. What would 2 sensible profit maximising firms do, if they knew each other’s marginal costs of reducing pollution to this 50 tonne mark $ cost per tonne MCb 300 B1 Firm B would say to Firm A. Listen it is costing you $100 to reduce 1 tonne of pollution, I will pay you $120 to reduce pollution by an extra ton (ie by 51 tonnes), and I will only reduce 49 tonnes. A “win-win” solution, of course. And govt does not care: pollution is reduced by same 100 tons for these two companies. MCa 100 A1 50 Reduction of pollution per year (tonnes)

11. What would a smart Firm A ask for? $ cost per tonne MCb 300 B1 If Firm A reduces his pollution by 51 tonnes, his MC of course is rising- suppose that it rises to $110. How much will Firm A ask Firm B, in order to reduce his pollution by an extra tonne? Any price more than $110 and he will make a profit. And anything less than $300, and he knows that Firm B will still make a saving. MCa 100 A1 50 Reduction of pollution per year (tonnes)

12. Firm B of course moves down to 49 tonnes of pollution reduction (B2)Firm A moves up to 51 tonnes (A2): what happens next? $ cost per tonne MCb MCa 300 B1 Suppose now MCb = $290, while MCa = $110. It is still cheaper for Firm A to reduce pollution more (to 52 tonnes) while Firm B reduces a lower 48 tonnes (total still being 100 tonnes). Again, a “win-win” situation for both. B2 290 110 A2 100 A1 49 51 50 Reduction of pollution per year (tonnes)

13. The process continues until both firms have the same MC (eg $180) of reducing pollution further MCa $ cost per tonne MCb 300 A1 Perhaps where Firm B has reduced pollution by 40 tonnes, and Firm A by 60 tonnes. Firm A and Firm B will both have become better off by using the market- by trading amongst themselves, by how much each should pollute. And in equilibrium, the MC of reducing pollution is the same. Bonus mark: why is this better than the initial situation? Hint: look at total MC for the two firms of reducing pollution by 1 ton each. 180 100 B1 40 60 50 Reduction of pollution per year (tonnes)

14. ie with target pollution and allowing market trading MCa $ cost per tonne MCb 300 A1 Firm A and Firm B will both have become better off while Govt achieves its target reduction for these two firms. ie Ordering different firms to reduce pollution by the same amount is not economically sensible. But “target reductions” and allowing companies to trade: economically more sensible. 180 100 B1 40 60 50 Reduction of pollution per year (tonnes)

15. Similarly, demanding that each firm reduce its pollution to the same target level also is not economically sensible $ MC of Lowering Pollution to target level The curves here give the Marginal Cost for two firms to reduce their pollution to some target levels- marginal cost becomes extremely large the closer you get to 0. If they have both achieved a reduction to 50 units of pollution, you can see that for one it is costing it $200 per tonne at the margin, for the other it is costing it $100 per tonne A1 200 MCa 100 B1 MCb 50 0 100 Target pollution level per year

16. Again, if trading is allowed and does take place $ MC of Lowering Pollution to target level Bonus mark: what will happen? Firm B will offer to reduce his pollution to a lower level if paid $x > $100 To enable Firm A to increase his pollution level, as long as $x < $200. Process continues until both have the same marginal cost of reducing pollution. A1 200 A2 B2 MCa 100 B1 MCb 50 0 100 To Target pollution level per year

17. Is setting pollution targets for developing countries unfair? When the developed world demand that China and India must reduce their pollution by the same amount every year- what does that mean in practice? The Developed World may be producing (say) 500 million tons of pollution. For them to reduce total pollution by 50 million tonnes means a 10% reduction of total pollution. While the LDCs are producing only 100 million tonnes of pollution, to reduce by 50 million tonnes means a 50% reduction- which would destroy their economic growth, if successful. Any why have targets by “countries”? Given that clean air and environment is a human right, and the responsibility should be equally on all persons, why not have pollution targets “per person” eg so many tonnes of pollution per person will be allowed throughout the world. eg at 1 tonne per person, China will be allowed 1.3 billion tonnes, and US 290 million But currently US has 20 tons of carbon dioxide pollution per capita and China and India have less than 3 tonnes per capita.

18. Is it fair to impose environment standards on LDC exports? eg WTO rules Seen as totally hypocritical in that developed countries have been polluting for two centuries, They still pollute far more in quantity than the developing countries And now that they have gone on to "cleaner" high tech high value added industries (like computers etc) Now they insist on environment standards which must impede the industrial development of LDCs Even doubly hypocritical when quite a bit of the pollution is produced by Developed Country multinationals who have relocated to the LDCs because of the tough environmental standards set by the Developed Countries for themselves. While developing countries cannot afford to have strict environmental standards.

19. Another approach: Firms may derive benefits when they produce/pollute more MPBb MPBa $ MPB B1 Define Marginal Private Benefit MPB = P - MC of production Since Price is given, and MC is rising , then MPB is falling. At some point where P - MC = 0, then the firm derives no further increase in marginal benefit, and that is the amount of pollution it will normally produce 300 A1 100 50 Pollution level per year

20. If both firms are now set the same target pollution level, usuallyone firm will be deriving greater Marginal Private Benefit than the other MPBb MPBa $ MPB Firm B will be prepared to pay more than Firm A for the right to pollute. The more profitable firms should end up polluting more. How ensure this? 300 100 50 Target pollution level per year

21. Can Government get any money out of command mechanisms?1 Bonus mark: think of last week’s lectures If different firms derive different Marginal Private Benefits from polluting, they will be willing to pay some price. Government can auction “pollution rights”: companies have to bid to win the rights to pollute- per tonne of pollution. How much they bid, depends on their Marginal Private Benefits in polluting and their marginal costs of reducing pollution. The highest bids will be accepted by the government. Firms which have not “won” the right to pollute, will then have 2 choices: either reduce pollution themselves to the required targets, or pay someone else to reduce pollution for them: according to the model we have just explained. So firms buy and sell these tradable rights to pollute, depending on what is cheaper for them: reduce pollution themselves, or pay someone else to reduce pollution for them. So once government has auctioned off the pollution rights, thereafter, everything else is initiated by profit seekers- without any need for government action whatsoever.

22. A market based pollution control mechanism does not act as a barrier to new investments For example, in regions or countries where EPA standards are already reached or exceeded, where pollution has been “capped” to some maximum New investments causing pollution would be banned But if a new investment is so profitable, that the new investor can find and trade with "offsetting" pollution reducers in some other parts of the country (or even another country altogether), then investment can still go ahead, while keeping to the overall pollution targets. And government does not have to worry about banning the investment, or itself taking any action to ensure the reduction of pollution. But what does this imply for “cleaner” parts of the country? or the world? What does this imply for other countries where the pollution continues?

23. What is carbon trading? In many countries in the world, Greenhouse Gas emissions (CO2) have been capped. Which means that anyone wanting to pollute more (“Carbon Credit Buyer” has to buy Carbon Credits from those who have forests or land that have “carbon Credits” in them, Or buy “Carbon Credits” from those who offer to reduce their CO2 emiissions by the stipulated amount, for a fee. There are now international markets developing for “carbon trading”.

24. Criticisms of market “cap and trade” mechanisms Weaknesses or failures in “pollution accounting”: who checks how much pollution is produced by factories, vehicles, and countries? How accurate? Regulatory agencies issue too many emission credits, diluting the effectiveness of regulation, and practically removing the cap: polluters pollute more Practice of “grandfathering” where strong lobby group polluters are given free allowances by governments, instead of being made to pay for them The administration and legal costs of cap and trade systems are higher than with a tax Cap and trade systems are seen to generate more corruption than a tax system A cap and trade system is seen to be impractical at level of individual household emissions

25. But what happens to overall pollution, and distribution? No doubt “cap and trade” and “carbon trading” systems could become the basis for international trade in the quota rent resulting in very large transfers across frontiers. But emissions trading does little to solve pollution problems overall, as groups that do not pollute sell their conservation to the highest bidder. Pollution goes on. Can have destructive impacts developing country peoples with clean environments It places disproportionate emphasis on individual lifestyles and carbon footprints, distracting attention from the wider, systemic changes and collective political action that needs to be taken to tackle climate change Would it be better to attack source of pollution and energy policies that are justice-based and community-driven Ultimately, the biggest polluters in the world, ie the developed countries, and increasingly China, India and Brazil, are going to have to take decisive action to reduce their pollution- which will come at a cost to their economy and material living standards Failure to do so: all will suffer, polluters and non-polluters alike.