Environmental Economics

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Environmental Economics

• Lecture 6 and 7

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Regulatory Options Efficiency

• Goal Generate regulatory tools to fix
  environmental problems

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?

• 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)

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• 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.

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• 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 Agencys influential World
  Energy Outlook 2006.

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• 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?

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Types of questions in regulation

1. What is the optimal amount of pollution?
2. To reduce by X, who should reduce and by how
   much?
3. What regulatory instrument(s) should be used to
   achieve that level?

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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?

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BOD Removal, Costs of Current US Regulations
Industry Subcategory Marginal Cost
Poultry Duck-small plants 3.15
Meat Packing Simple Slaughterhouse 2.19
Cane Sugar Crystalline Refining 1.40
Leather tanning Hair previously removed 1.40
Paper Unbleached Kraft 0.86
Poultry Chicken small plants 0.25
Raw Sugar Processing Louisiana 0.21
Paper NSSC Sodium Process 0.12
Poultry Chickenlarge plants 0.10
Source Magat et al (1986) units dollars per
kilogram BOD removed
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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

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More GenerallyThe efficient amount of pollution
Marginal Control Cost
/unit
Marginal Damage Cost
Total Damage Cost
Total Control Cost
Q
Units of pollution
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With mixed high and low cost firms abating, we
could

• Either
• Reduce more pollution for the same amount of
  moneyor
• Reduce the same amount of pollution for less
  money.
• So we always want low-cost firm to shoulder
  abatement.

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If costs arent constant two firms, greenhouse
emissions of Nitrogen
Abatement Cost (/unit)
Who should abate the 1st unit of N?
MCA
MCB
N Reduction
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How much abatement from each?
(A)
MCA
Loss from equal reduction
(B)
MCB
0
A
40
80
25
80
0
40
55
B
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How did he do that?

1. Determine how much total abatement you want (e.g.
   80)
2. Draw axis from 0 to 80 (A), 80 to 0 (B)
3. Sum of abatements always equals 80.
4. Draw MCA as usual, flip MCB
5. Lines cross at equilibrium
6. Price is MC for A and for B.

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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.

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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

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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
  distn mechanisms.

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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
  ltlt MB of abatement.

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Example 2 Bubble policy in RI

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

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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

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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

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Basic Setup Env Costs, Private Costs, Social
Costs
/unit
MSC
MPC
P
MEC
Pp
D
Dirty Good
Qc
Q
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MPC (with tax)
/unit
MSC
t
MPC (no tax)
P
Pp
D
Q (pollution)
Qc
Q
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Problem How to reduce VOC emissions in LA
without increasing costs?

• Where do VOCs come from?
• Painting, cleaning in manufacturing, cars
• Current regime command and control
• NSPS Control Technology Guidelines (New Source
  Perf. Stand)
• SIPs 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?)

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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?

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Incentive Based Regulation Basic Concepts

• Up to this point, the focus has been on resource
  allocation.
• 1) how much waste is appropriate and
• 2) what are the appropriate means for pollution
  reduction?

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A Pollutant Taxonomy

• The ability of the environment to absorb
  pollutants is called its absorptive capacity.
• Stock pollutants are pollutants for which the
  environment has little or no absorptive capacity.
  Stock pollutants accumulate over time and include
  things like nonbiodegradable bottles, heavy
  metals and chemicals.

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• Fund pollutants are pollutants for which the
  environment has some absorptive capacity. If the
  emission rate does not exceed the absorptive
  capacity, fund pollutants do not accumulate.
  These include organic pollutants and carbon
  dioxide.

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• Local pollutants cause damage near the source of
  emissions while regional pollutants cause damage
  at greater distances. A pollutant could fit both
  categories (e.g. sulfur and nitrogen oxides).
  This is the horizontal dimension of influence.

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• Surface pollutants (water pollution) cause damage
  near the earths surface, while global pollutants
  (carbon dioxide and chlorofluorocarbons) cause
  damage in the upper atmosphere. Some air
  pollutants are both surface and global
  pollutants.

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Efficient Allocation of Polutants Review and
Summary of What we Have Learned Today
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• Pollution control is most easily analyzed from
  the perspective of minimizing cost 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.

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• Marginal damage costs generally increase with the
  amount of pollution. With small amounts, the
  pollutant can be diluted in the environment.
  Larger amounts will tend to cause substantially
  more damage. This relationship can be represented
  by an upward sloping function in a graph
  illustrating marginal cost as a function of
  pollution emitted.

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• Marginal control costs typically increase with
  the amount of pollution that is controlled or
  abated. Since the axis of this graph is pollution
  emitted, this will be a downward sloping
  function. This is equivalent to an upward sloping
  function if the axis were to measure pollution
  controlled or if the graph is read from right to
  left.

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Market Allocation of Pollution

• Damage costs are externalities. Damages are
  downwind or downstream of the sources (firms)
  that emit the pollutants. Thus, the uncontrolled
  market will produce too much.
• For stock pollutants, the market would commit too
  few resources to pollution control and the burden
  on future generations would be inefficiently
  large.

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

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

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• Another approach would be to internalize the
  marginal damage caused by each unit of emissions
  by means of a tax or charge per unit of
  emissions. The charge could be constant or it
  could rise with emissions. The efficient charge
  would be equal to the marginal damage and
  marginal control cost at the point where they are
  equal.

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• Knowing the level of pollution at which these two
  curves cross is difficult at best. Control cost
  information is not always available to the
  pollution control authority and estimates of
  damage costs are very difficult. Review
  nonmarket valuation.

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• In the absence of that knowledge, pollution
  control authorities could select legal levels of
  pollution based on some other criteria such as
  safety, human health or ecological heath. Once
  this level is set, the most cost-effective policy
  could be chosen.

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Cost Effective Policies

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

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• The cost-effective allocation is found by
  equating the marginal control costs of the two
  sources. Since total cost is the area under the
  marginal control cost curve, total costs across
  the two firms is minimized by minimizing the two
  areas and is found by equating the two marginal
  costs. Any other allocation would result in
  higher total cost.

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• While simple in theory, the situation is more
  difficult for control authorities because control
  authorities do not often have access to good
  information about firms costs. Plant managers
  have incentives to overstate costs. Other policy
  options or pollution control policies must be
  utilized.

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Pollution control policies

• 1. Emission Standards
• a. An emission standard is a legal limit on the
  amount of the pollutant an 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 standard should be allocated
  across sources. The simplest means of allocation
  allocating an equal share to each source is
  rarely cost-effective. In the example given, it
  is not cost-effective.

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

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

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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.

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Regulatory Innovations

• What are some of the new and innovative ways to
  regulate environmental protection?

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Motivation

• Group Project The Clean Air Act is up for
  renewal and your group project has been tasked
  with coming up with new and innovative ways of
  achieving the same objectives.
• but in a more flexible and less burdensome way.

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Todays Menu

• Command-and-Control Improving on it
• Technology standards vs. performance standards
• Bubbles
• Technology forcing
• Marketable permits
• Auction initial issuance
• Freely distribute
• Voluntary Approaches
• Unilateral initiatives on part of firms
• Bilateral agreements between firms and regulators
• Voluntary programs that firms may opt into
• Information disclosure regulations
• Banking of credits

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Command-and-Control

• Problems
• Failure of Equimarginal Principle
• Reduced incentives to find better ways to control
  problem
• Regulator needs private info from polluter
  tough
• Advantages
• Flexibility in defining standard
• Verification can be easy (is equipment in place?)
• Greater certainty regarding extent of pollution
• Intuitively attractive to engineers

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Command-and-Control Innovations

• Technology standards vs. Performance Standards
• Most inflexible is standards specifying type of
  control technology
• Somewhat more flexible are standards stipulating
  overall emission level
• Bubbles
• Firm may have multiple plants, each subject to
  regulation
• Bubble allows firm to put all plants under a
  bubble and only count what leaves bubble
• Offsets
• New firm wants to enter polluted urban area
• Must induce another firm to reduce emissions,
  offsetting new emissions
• How is this similar/dissimilar to a marketable
  permit system?
• Technology forcing
• Stipulate regulation that is not currently
  technologically feasible
• If credible, can reduce costs in long run
• Subject to manipulation through the ratchet effect

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Marketable Permits--Examples

• Acid Rain Allowance System (SO2)
• RECLAIM in LA (NOx and SO2)
• EU Carbon Trading (CO2)
• Wetlands banking
• Habitat Plans
• Lead in gasoline phasedown
• Fishing Quotas

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Marketable Permits /-

• Advantages
• Informational requirements can be smaller
• Provides incentives for polluters to reduce costs
• Equimarginal principle automatically satisfied
• Disadvantages
• Can be difficult in complex world of spatial and
  temporal variation
• Political problems associated with making firms
  pay more or from setting up property rights to
  pollute

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Marketable Permits Innovations

• Auction or free?
• Auction generates revenue for gov
• Free distribution solves major political problem
• Safety Valve
• Big issue for climate is cost uncertainty
• Allow trading of permits but make available extra
  permits from gov at price perhaps double expected
  market price
• For example, for greenhouse gases, expect permits
  to trade for 25 make extra permits available at
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• What advantage does this have?
• Feebates
• Above average performers get subsidies for good
  performance
• Below average performers pay penalites (fees) for
  poor performance
• Net payments approximately zero
• Provides upward pressure on performance.

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Voluntary Actions Examples

• Unilateralism
• BPs program to reduce GHG emissions
• ISO 14000 management plan
• Bilateral Agreements
• Project XL allows firms to violate statutes if
  they can show they will achieve greater
  environmental performance
• Voluntary Opt-in Programs
• 33/50 Program at EPA 33 redux of certain
  toxics by 1992 50 redux by 1995, relative to
  1988 firms voluntarily opt-in and agree to make
  the reductions
• Conservation Reserve Program pay subsidies to
  participate

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Why do firms participate in voluntary programs?

• Seems like no firm would voluntarily incur extra
  costs
• Reasons for undertaking
• Way of fending off non-voluntary regs
• Way of establishing a green image and enhancing
  product marketing
• Reduce perceived environmental risk to investors,
  thus reducing the cost of capital
• Social responsibility (?)
• Bottom line firms are generally assumed to still
  be acting in their own self interest, broadly
  defined.

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Information disclosure

• Toxic Release Inventory (TRI) started in 1986 to
  provide public information about release of toxic
  substances
• 640 chemicals
• Also voluntary agreements (e.g. 33/50)
• Local environmental groups use TRI to pressure
  report on industry
• More info yields better economic performance.
  Good starting point for new regulations.

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Conclusions

• Innovations in regulation is where the action is
• Marketable permits have achieved great success
  and will probably continue to expand
• Voluntary approaches have had questionable
  success in terms of improving environmental
  performance at reduced costs