Lecture 1

1. Lecture 1 Environmental Policy Objectives • Efficiency (static and dynamic); • Sustainability; • Equity (fairness); • Non-conflict with other objectives.

2. Some “Environmental” Problems Global climate change • Greenhouse gases • Ozone depletion • International air pollution • Acid rain • Local air pollution • Traffic pollution • Factory emissions • Smogs • Water pollution and water scarcity • Nitrate spillovers • Intensive agriculture • Population conglomeration • Others • Loss of biodiversity • Irreversible eco-system change • Soil fertility losses • Accumulation of toxins in various media

3. Economy-Environment Interactions • Economic activity has a material basis. • It draws resources from the environment, and provides flows back into the environment. • These flows must satisfy the laws of thermodynamics: • First law: Conservation of mass/energy (materials balance principle) • Second law: Entropy is non-increasing

4. Environmental resource services and functions • Waste assimilation and re-processing by ecological systems • Environmental systems support processes (air, climate, water, soil) • Provision of productive inputs • Provision of environmental amenities • * that contribute to labour productivity • * that contribute directly to well-being

5. Sustainability and Sustainable Development • 1987 report of the World Commission on Environment and Development (WCED). • Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs.

6. The material basis of sustainability We have seen that economic activity has a material basis. It draws resources from the environment, and provides flows back into the environment. There are interactions between the economic and environmental sub-systems. Key question: How can the stocks and flows in these systems be reproduced over time, at non-diminishing levels and rates?

7. Environmental and economic sustainability • Two systems to be sustained: • Economic system (stocks and flows): Utility • Ecological system (stocks and flows): • And possibly others? • Steve Hackett (1998) “People in a sustainable society enjoy non-diminishing flows of ecological, economic, sociopolitical and cultural benefits.”

8. Economic sustainability Some “economic” concepts of sustainability: Sustainability is defined as... non-declining utility of a representative member of society for millennia into the future. A sustainable state is one in which utility (or consumption) is non-declining through time. The alternative approach [to sustainable development] is to focus on natural capital assets and suggest that they should not decline through time.

9. Some “interdisciplinary” concepts of sustainability: Preserving opportunities for future generations as a common sense minimal notion of intergenerational justice Sustainable activity is...that level of economic activity which leaves the environmental quality level intact, with the policy objective corresponding to this notion being the maximisation of net benefits of economic development, subject to maintaining the services and quality of natural resources over time.

10. CRITICAL ISSUES • Critical to sustainability, however defined, seem to be: • the degree of resource substitutability • the rate of technical progress • the degree of eco-system stability and resilience • irreversibility of “investment” decisions

11. FEASIBILITY OF SUSTAINABILITY Is sustainability feasible? That is, is it possible for the economy to attain a state in which production and consumption track along non-declining paths (or grow at positive rates) over indefinite periods of time, in the presence of finite stocks of exhaustible resources and constraints imposed by natural environmental processes?

12. Irreversibility Suppose that an asset is developed (or used in some way). Now suppose we change our mind about the desirability of that development. Is it possible to reverse the process so that we are back in the original position? Often this is NOT possible; in those cases, the decision is irreversible (for example, depletion of an exhaustible resource, or extinction of a species). This gives us much less room for making mistakes.

13. POLICY IMPLICATIONS • It seems sensible to adopt some form of precautionary principle. But how much premium are we willing to pay to avoid risks of catastrophic failures ? • If sustainability is feasible, can it be achieved through the use of market-based incentives and instruments alone? • Some “sensible” interim goals: • Encourage recycling • Pay attention to safe disposal of wastes • Information flows should be improved • Ensure property rights are clearly established. • Create incentive compatible instruments.

14. Economic Efficiency Efficiency: Is about using resources “wisely.” Which resources are we talking about?

15. Efficiency Criteria • Criteria: • Maximisation of net benefits (benefits - costs) • Two dimensions: • static • dynamic (intertemporal)

16. Net benefit maximisation approach to efficiency. Net benefit = total benefit - total cost NB = B - C Suppose that B and C both depend on X (which may be output, or pollution, or something else) Maximisation of net benefit requires: marginal benefit of X = marginal cost of X

17. Dynamic (intertemporal) efficiency Are resources being used efficiently over time? And Are the best incentives for innovation and productivity improvements being generated?

18. Efficiency and Market Mechanisms Limited resources  Use depletes resource stock  Resource becomes more scarce  Resource cost (price) rises  Opportunity cost of using resource rises  Resource substitution takes place also Higher price increases search and extraction effort

19. Markets and Efficiency • Under a set of “ideal” conditions, market forces alone may lead to efficient (but not necessarily optimal) outcomes. • These include: • Markets exist for ALL goods and services • All markets are competitive • All transactors have perfect information • Property rights are fully assigned • There are no externalities. • All goods and services are private (not public).

20. Under these “ideal” conditions: Supply curves properly reflect true opportunity costs. Demand curves properly reflect true preferences and social benefits. And in each market: P = MC = MB (Market prices correctly reflect marginal costs and benefits; they are equal to the correct shadow prices). And all the efficiency conditions referred to above will be satisfied.

21. Potential causes of Market Failure • Absence of markets • Externalities • Public goods • Poorly defined or difficult-to-enforce property rights (including open access conditions) • Incomplete information and uncertainty • Inability to ascertain preferences of future generations

22. Why do these cause “Market Failure” • Either • Because of absence of markets (so there is no market to work!) • or • Prices (or costs), as expressed through markets, are “incorrect”, and so transmit wrong signals in the market-based resource allocation mechanisms • (The market price does not equal the socially-efficient shadow price.)

23. Potential causes of Market Failure • Externalities • An externality occurs where production and/or consumption activities impact directly upon human well-being, or indirectly via impacts on environmental resources, in uncompensated ways. • Examples: • Electricity production • Car transport • Felling of tropical forests

24. Externalities lead to inefficient outcomes Outcomes do not maximise social net benefits because SMC  SMB • Solutions to externalities: The externality has to be INTERNALISED, so that SMC = SMB

25. Public goods • Two characteristics: • Non-depletability • Non-excludability • Examples: • Clean air • Wilderness areas • Biodiversity

26. Public goods • Non-depletability and non-excludability imply that public goods will not be provided in “efficient” quantities, or will not be provided at all, through standard market mechanisms. • (Nor will quality be maintained appropriately). • Examples again: • Clean air • Wilderness areas • Biodiversity

27. Poorly defined property rights • Limit the scope of bargaining (or judicial) solutions to externalities • (See work of Richard Coase). • This problem interacts with the public goods problem. • Examples again: • Car transport • Felling of tropical forests

28. Poorly defined property rights • Note that property rights do not have to be “private” ones. There are several forms: • Private property rights • Common property rights • State owned property rights • What matters is whether access and use can be controlled by the owner. Where this is not possible we have • Open access resource rights

29. Efficiency and equity and sustainability Note that an efficient outcome is not necessarily a sustainable one, nor is it necessarily an equitable one. There may be an incompatibility between these three goals.

30. Recommended reading Perman, Ma, McGilvray and Common (2nd edition): Chapter 1: An introduction Chapter 2: The origins of the sustainability problem Chapter 3: Concepts of Sustainability Chapter 4: Ethics and the Environment Chapter 5: Welfare economics: efficiency and optimality Chapter 6: Market failure and public policy