Environmental Economics

1. Environmental Economics Lecture 6 and 7

2. Regulatory Options & Efficiency Goal: Generate regulatory tools to fix environmental problems

3. ? • Does free market efficiently provide goods and services? • Market failure (externalities, public goods, etc.) • Market power (monopolies inefficiently restrict production to raise prices) • Information problems (damages uncertain, food safety, env. quality)

4. It has been found predicted that global energy use will grow by 53 per cent by 2030! But, inspite of energy efficient and non-fossil fuel power pushing across the world as an alternative, the world is moving into a “dirty, insecure and expensive” energy future! • * The solution • The problem or the solution lies not in the availability of alternative clean fuel, but policies.

5. It is unless the policies are changed, irrespective of all investments behind producing bio-fuels, fossil fuels will account for 83 per cent of the increase! • And carbon emissions will grow by 55 per cent in line with energy consumption, predicted by the International Energy Agency’s influential World Energy Outlook 2006.

6. A consortium of international researchers has found that it is only between 2000 and 2005; emissions grew four times faster than in the preceding 10 years! From 1990 to 1999, global growth rates were 0.8 per cent and they reached 3.2 per cent just from 2000 to 2005! • * But, again if policies and guidelines are set, how far can the alternative energies satisfy both the consumption demand and the environmental concerns? www.greendiary.com/

8. Types of questions in regulation • What is the “optimal” amount of pollution? • To reduce by X%, who should reduce and by how much? • What regulatory instrument(s) should be used to achieve that level?

9. Problem • EPA has regulations to control biological oxygen demand (BOD). EPA would like your advice on how to improve water quality (lower BOD) without increasing costs. • What is your advice?

10. BOD Removal, Costs of Current US Regulations Source: Magat et al (1986); units: dollars per kilogram BOD removed

11. Principle of efficiency • Most common approach: uniform burden (e.g., everyone cuts pollution by x%) • Two possible results • Too much pollution for the total amount of pollution control costs • Too much cost for a fixed level of pollution reduction • Burden of pollution control should fall most heavily on firms with low costs of pollution control

12. More Generally:The efficient amount of pollution Marginal Control Cost $/unit Marginal Damage Cost Total Damage Cost Total Control Cost Q* Units of pollution

13. With mixed high and low cost firms abating, we could Either: • Reduce more pollution for the same amount of money…or • Reduce the same amount of pollution for less money. So we always want low-cost firm to shoulder abatement.

14. If costs aren’t constant: two firms, greenhouse emissions of Nitrogen Abatement Cost ($/unit) Who should abate the 1st unit of N? MCA MCB N Reduction

15. How much abatement from each? $ (A) Loss from equal reduction MCA $ (B) MCB A: 0 40 25 80 80 B: 55 40 0

16. How did he do that? • Determine how much total abatement you want (e.g. 80) • Draw axis from 0 to 80 (A), 80 to 0 (B) • Sum of abatements always equals 80. • Draw MCA as usual, flip MCB • Lines cross at equilibrium • Price is MC for A and for B.

17. The “equimarginal principle” • Not an accident that the marginal abatement costs are equal at the most efficient point. • Equimarginal Principle: Efficiency for a homogeneous pollutant requires equating the marginal costs of control across all sources.

18. Control costs • Should include all other costs of control • monitoring & enforcement • administrative • Equipment • Regulatory uncertainty increases costs. • If you are a polluter, what would be your response to uncertainty in what you have to do? • Does this increase your costs? • Would like to design instruments that provide incentive to innovate

19. Common Instruments for regulation • Command and Control: Centralized determination of which firms reduce by how much, or technology restrictions. • Taxes: charge $X per unit emitted. This increases the cost of production. Forces firms to internalize externality (what is correct tax?) • Quotas/standards: uniform standard (all firms can emit Y) or non-uniform. • Tradable permits: All firms get Y permits to pollute, can buy & sell on market. Other initial dist’n mechanisms.

20. Example 1: Taxes in China • China: extremely high air pollution – causes significant health damage. • Instituted wide-ranging system of environmental taxation • 2 tiers • World Bank report estimates that MC of abatement << MB of abatement.

21. Example 2: Bubble policy in RI • Narraganset Electric Company: • 2 generation facilities in Providence, RI. • Required to use < 2.2% sulfur in oil. • Under bubble policy: • Used 2.2% in one plant, burned natural gas at other plant • Savings: • $3 million/year

22. Example 3: SO2 Allowances • 1990 CAAA sought to reduce SO2 emissions from 20 million tons/yr to 10 million tons/yr • Set up market in emission allowances • 97% of 10 million tons allocated to polluters • Rest auctioned at CBOT – anyone can buy: see http://www.epa.gov/airmarkets/forms

23. How big the tax or how many permits? • We know: • Optimal level of pollution is Q* • Marginal Social Cost at the optimum is P* • Marginal Private Cost at optimum is Pp. • Optimal tax exactly internalizes externality: • t* = P* - Pp • Effectively raises MC of production

24. Basic Setup: Env Costs, Private Costs, Social Costs $/unit MSC MPC P* MEC Pp D Q* Qc Dirty Good

25. MPC (with tax) $/unit MSC t* MPC (no tax) P* Pp D Q* Qc Q (pollution)

26. Problem: How to reduce VOC emissions in LA without increasing costs? • Where do VOC’s come from? • Painting, cleaning in manufacturing, cars • Current regime: command and control • NSPS: “Control Technology Guidelines” (New Source Perf. Stand) • SIP’s: firm by firm rules (state implementation plan) • Example: automobiles • Technology requirements • Emission limits per mile • How could this be done differently? • Alternatives • #1: emmission fees, $1/lb. of VOC • #2: marketable permit – issue permits for 500 tons • Get equimarginal principal in either case (Why?)

27. Problem: Too many houses being built in SB; want to slow growth. How? • Current regime: command-and-control tools • Zoning • Lengthy permit requirements • Infrastructure fees • Limit critical inputs (eg, water) • Alternative approaches • Fees • Increased property tax • Building permits: $1000/square foot • Land conversion fee • Marketable permits • Issue 100 permits per year (or 200,000 sq. ft.) • Auction permits • Give away permits – what is effect? • What are differences with between fees and marketable permits?

28. Incentive Based Regulation: Basic Concepts • Up to this point, the focushas been on resource allocation. • 1) how much waste is appropriate and • 2)what are the appropriate means for pollution reduction?

29. A Pollutant Taxonomy • The ability of the environment to absorb pollutants is called its absorptivecapacity. • Stock pollutants are pollutants for which the environment has little or noabsorptive capacity. Stock pollutants accumulate over time and includethings like nonbiodegradable bottles, heavy metals and chemicals.

30. Fund pollutants are pollutants for which the environment has someabsorptive capacity. If the emission rate does not exceed the absorptivecapacity, fund pollutants do not accumulate. These include organicpollutants and carbon dioxide.

31. Local pollutants cause damage near the source of emissions whileregional pollutants cause damage at greater distances. A pollutant couldfit both categories (e.g. sulfur and nitrogen oxides). This is the horizontaldimension of influence.

32. Surface pollutants (water pollution) cause damage near the earth’ssurface, while global pollutants (carbon dioxide and chlorofluorocarbons)cause damage in the upper atmosphere. Some air pollutants are bothsurface and global pollutants.

33. Efficient Allocation of Polutants: Review and Summary of What we Have Learned Today

34. Pollution control is most easily analyzed from the perspective of minimizingcost rather than maximizing the net benefits from pollution. • Two types of costs associated with pollution are: 1. Damage costs; and 2. Pollution control or avoidance costs.

35. Marginal damage costs generally increase with the amount of pollution. Withsmall amounts, the pollutant can be diluted in the environment. Largeramounts will tend to cause substantially more damage. This relationship canbe represented by an upward sloping function in a graph illustrating marginalcost as a function of pollution emitted.

36. Marginal control costs typically increase with the amount of pollution that iscontrolled or abated. Since the axis of this graph is pollution emitted, this willbe a downward sloping function. This is equivalent to an upward slopingfunction if the axis were to measure pollution controlled or if the graph is readfrom right to left.

37. Market Allocation of Pollution • Damage costs are externalities. Damages are downwind or downstream ofthe sources (firms) that emit the pollutants. Thus, the uncontrolled marketwill produce too much. • For stock pollutants, the market would commit too few resources topollution control and the burden on future generations would beinefficiently large.

38. Firms that attempt to control pollution unilaterally are placed at acompetitive disadvantage. • Therefore, the market fails to generate the efficient level of pollutioncontrol and penalizes firms that attempt to control pollution.

39. Efficiency is achieved when the marginal cost of control is equal to themarginal damage caused by the pollution for each emitter. • One policy option for achieving efficiency would be to impose a legal limit onthe amount of pollution allowed by each emitter.

40. Another approach would be to internalize the marginal damage caused byeach unit of emissions by means of a tax or charge per unit of emissions. Thecharge could be constant or it could rise with emissions. The efficient chargewould be equal to the marginal damage and marginal control cost at the pointwhere they are equal.

41. Knowing the level of pollution at which these two curves cross is difficult atbest. Control cost information is not always available to the pollution controlauthority and estimates of damage costs are very difficult. [Review nonmarketvaluation.]

42. In the absence of that knowledge, pollution control authorities could selectlegal levels of pollution based on some other criteria such as safety, humanhealth or ecological heath. Once this level is set, the most cost-effective policycould be chosen.

43. Cost Effective Policies • 1. Assume two emission sources are currently emitting a total of 30 unitsof emission. • 2. Assume the control authority decided a mandatory reduction of 15units is necessary. • 3. The question then becomes: how should the 15-unit reduction beallocated between the two sources in order to minimize cost?

44. The cost-effective allocation is found by equating the marginal control costsof the two sources. Since total cost is the area under the marginal control costcurve, total costs across the two firms is minimized by minimizing the twoareas and is found by equating the two marginal costs. Any other allocationwould result in higher total cost.

45. While simple in theory, the situation is more difficult for control authoritiesbecause control authorities do not often have access to good information aboutfirms’ costs. Plant managers have incentives to overstate costs. Other policyoptions or pollution control policies must be utilized.

46. Pollution control policies • 1. Emission Standards a. An emission standard is a legal limit on the amount of the pollutantan individual source is allowed to emit. b. This approach is referred to as command-and-control. c. The difficulty with this approach is determining how the standardshould be allocated across sources. The simplest means of allocation –allocating an equal share to each source – is rarely cost-effective. Inthe example given, it is not cost-effective.

47. 2. Emissions charges • a. An emission charge is a per-unit of pollutant fee, collected by thegovernment. • b. Charges are economic incentives that reduce pollution because theycost the firm money. • c. A profit-maximizing firm will control (abate) pollution whenever thefee is greater than the marginal control cost. • d. Each firm will independently reduce emissions until its marginalcontrol cost equals the emission charge. This yields a cost-effectiveallocation • e. A difficulty with this approach is determining how high the chargeshould be set in order to ensure that the resulting emission reduction isat the desired level. An iterative or trial-and-error approach can beused to determine the appropriate rate, but changing tax ratesfrequently is not usually politically feasible. • f. Another difficulty is that with a charge system, the total amount ofpollution cannot be controlled. If many new sources enter the market,they will still pay the fee, but total emissions will rise.

48. 3. Transferable emissions permits • a. With a transferable emission permit system, all sources are requiredto have permits in order to emit. Each permit specifies how much thefirm is allowed to emit. The permits are freely transferable. • b. The control authority issues the exact number of permits necessary toachieve the standard. • c. Firms with high marginal costs of control will have incentives to buypermits from firms with low marginal control costs. Firms with lowmarginal control costs will have incentives to see if the permit price isabove their marginal control cost. The equilibrium permit price will bethe price at which the marginal control costs are equal for both (oracross all) firms. • d. The incentives embedded in this system ensure lowest costs and thecontrol authority does not need information on control costs.

49. A creative quota: bubble policy • Multiple emissions sources in different locations. • Contained in an imaginary “bubble”. • Regulation only governs amount that leaves the bubble. • May apply to emissions points within same plant or emissions points in plants owned by other firms.

50. Regulatory Innovations What are some of the new and innovative ways to regulate environmental protection?