Perman et al.: Ch. 6

Pollution control: instruments

Outline of lecture

[Previous: Ch. 5. What is the socially optimal pollution level?]

Ch. 6. Pollution control instruments

Focus on cost-effectiveness of control instruments

Cost-Effective Pollution Abatement

• Cost-effective pollution abatement involves using abatement

instruments that can achieve

– target levels of pollution abatement

– at the lowest social cost.

• Consider two firms, A and B

– with marginal abatement costs of 60 and 100 respectively

If B were to reduce abatement by 1 unit and

A were to increase abatement by 1 unit

– Then total abatement would be unchanged

but the total cost of abatement would be reduced by 40 units.

Efficiency condition

Equal marginal abatement costs

• Costs are minimised when

– marginal abatement costs are equal for the two firms A and B

• This means that A will undertake more abatement than B

– to achieve a given aggregate level of pollution abatement.

• The total cost of pollution abatement for each firm is

– the area under its marginal cost curve (Fig. 6.1).

• The total cost of pollution abatement for society is

– the sum of the areas under each firm’s marginal cost curve.

5

10 15 35 40 30 25 20

Pollution abatement

Z

MCA = 3ZA

MC

MCB = 5ZB

75

100

200

Figure 6.1 Marginal abatement cost functions for the two firms.

Politically specified total abatement (A+B) target=40

For least-cost solution: necessary to find levels of ZA and ZB which add up to Z= 40

and which satisfy least-cost condition: MCA=MCB

A undertakes more abatement than B

because MCA<MCB

Two firms, A and B

6.3 Instruments for achieving pollution abatement targets

Instrument category

Institutional approaches

– to facilitate internalisation of externalities

Command and control instruments

Economic incentive (market-based) instruments

Table 6.2 Classification of pollution control instruments

6.3.1 Voluntary approaches

6.3.1.1 Bargaining

……

6.3.1.2 Liability

……

6.3.1.3 Social responsibility

Command and Control Instruments (6.3.2, p 188)

• Most regulators use direct controls to reduce pollution.

• These instruments can be classified according to what they target.

– Figure a illustrates the relationships that link production to pollution.

– Figure b names the instruments used to control pollution according to the

stage of production that they target.

• It is generally best to direct controls

– at the points closest to ambient pollutions levels, which is the target of the

regulation.

Location of

emissions

Ambient pollution

levels

Emissions output

Production technique

Inputs used

Quantity of goods produced

Fig 6.4a The pollution process

For non-UMPs

Start here

Zoning

Ambient pollution

requirements

Emissions

licenses

Technology controls

Input restrictions

Output quotas

Fig. 6.4b Command and control instruments

For non-UMPs

Best practicable means (BPM)

Best available technology (BAT)

Start here

Command and Control Instruments

Inefficient

• Least-cost solution requires that

– marginal abatement costs are equal for all polluters

• Normally, a regulator cannot acquire information about MC of individual

polluters

– Information costs prohibitive

– Information asymmetries

• Therefore, mandatory obligations/restrictions on behaviour of firms and

consumers

– Are not generally least-cost solutions to a pollution control problem.

Economic Incentive Instruments

• Incentive-based instruments create economic incentives

– for polluters to voluntarily change behaviour.

• Incentive-based instruments may be

– Taxes/levies

– Subsidies

– Transferable/tradeable pollution permits.

• Using incentive-based instruments create

– Opportunity costs* of pollution

Which profit maximising firms will take into account.

------------ * The opportunity cost is the value of the best foregone alternative.

Captures the idea that the cost of something is not just its monetary cost but also the value of what you didn’t get.

Input tax on nitrogen fertilizer

• Uncontrolled farmers will use nitrogen fertilizer

– until the marginal benefit of fertilizer application per hectare is zero.

• An input tax can be designed to achieve an socially efficient level of

fertilizer application

– the marginal social costs of pollution abatement are

– equal to the marginal social benefits of pollution abatement (Figures 6.5- 6.6).

Figure 6.5 An economically efficient emissions tax

0 Z* = *MM̂ Z

M̂

Emissions abatement, Z

*

Marginal benefit (for firm) before tax

0

*

Marginal benefit

after tax

M* Emissions, M

Marginal social damage

Marginal cost of abatement

Marginal benefit of abatement

Figure 6.6 The economically efficient level of emissions abatement (Uniformly mixed pollutant)

Efficient

emissions tax

Unregulated profit max. emission level

Socially efficient abatement level

and optimal for firm at tax rate μ*

Pollution tax on emissions

• A tax on emissions at a constant rate per unit of emissions

– Shifts the marginal benefit curve down

– Polluters will again emit pollution until the marginal benefit of emitting pollution is

zero

at a lower pollution level.

• Each firm is free to choose what methods to use to reduce emissions

– and (cost minimizing firms) will use the cheapest methods to do so.

Emissions tax/subsidy

Marginal damage unknown

• Suppose EPA does not have sufficient information

– to deduce the economically efficient level of emissions

– or it wishes to set an overall emissions target on some other basis.

• Figure 6.7 shows that

– to attain ANY specific emissions target using a tax or subsidy instrument,

– knowledge of the aggregate marginal benefit of emissions (= marginal abatement

costs) function would be sufficient

– This due to the fact that polluting firms behaviour is determined by marginal benefits.

M̂

Pre-tax or pre-subsidy marginal benefit

0

Emissions, M

Figure 6.7 Emissions tax and abatement subsidy schemes when marginal damage is unknown, or

when a target is being set on grounds other than economic efficiency

Post-tax or post-subsidy marginal benefit

M~. .

μ~ .

Abatement Subsidies versus Pollution Taxes

Abatement Subsidies

versus

Pollution Taxes

• If an industry is given a subsidy at a fixed rate (μ*) per unit of

pollution abated

– then the same level of emissions reductions would be achieved

– As in the situation where an equivalent tax was imposed.

• Subsidy might enlarge the industry

– Partially or wholly offsetting short run emissions reductions.

• The distributional effects of the tax and subsidy are different

– With subsidy, the industry gains income

– With tax, the industry loses income (Figure 6.8)

M̂

Marginal benefit

(before tax)

0

*

M* Emissions (M)

Marginal social damage

Figure 6.8 Emissions tax and abatement subsidy schemes: a comparison

S3 S4

S6 S2

S1 S5

Subsidy gives firm payment = μ* times (Mˆ – M*) = S1 and S2

minus foregone profits from reducing output = S2

Net gain (payment minus foregone profits from reducing output) = S1

Tax costs firms μ* times M*= S3, S4, S5, S6

+ foregone profits from reducing output = S2

Efficient abatement level

at tax rate or subsidy rate = μ*

Emissions before tax/subsidy

Tradable Emissions Permits

Emissions Permits

Allocated through auction

• We consider tradable permits on quantity of emissions

– Regulator determines total quantity of missions allowed

– Permits are allocated between polluters through a market.

• Emissions permits may be initially allocated through an auction.

– (Figure 6.9)

Figure 6.9 The determination of the market price of emissions permits.

Marginal abatement cost (aggregate)

= demand curve for permits

*

M̂M* M 0

Equilibrium price for permits

Total reduction in emissions = Mˆ – M* Supply of emission permits determined by regulator

Emissions Permits

Distributed at no charge

• If tradable permits are initially allocated arbitrarily to emitting firms,

– initial allocation will not be profit maximising for the firms

• Firms with low abatement costs will reduce their emissions and sell the

excess emissions permits

– at a price higher than their marginal abatement costs

• Firms with high abatement costs will buy permits

o so long as the price of a permit is below their marginal cost of abating

emissions.

• Marginal cost of abatement will be equal for all firms (Figure 6.10)

Demand for permits

*

EP* Emission permits

(EP)

0

Figure 6.10 The determination of the market price of emissions permits:

free initial allocation case.

Supply of permits

by firms

Price of a permit will be equal to the

marginal cost of pollution abatement

Relative advantages of different control systems

Cost-efficiency

• A command and control regulation instrument

– To be cost-efficient

the regulator must know each polluter’s marginal cost of

abatement function

very unlikely that this requirement will be met.

• For a flow pollutant and a uniformly-mixing stock pollutant

– an emissions tax, abatement subsidy or marketable permit system

– can achieve any emissions target at least cost

the regulator needs not know the individual polluter’s marginal

cost of abatement function.

The market mechanism will reveal that information.

Second-best world

• Policy instrument choice takes place in a ‘second-best’ world,

where results are much less clear

– absence of markets (including those for externalities and public

goods)

– asymmetric information, moral hazard and other instances of

market failure

point to possible benefits of command and control-based public

intervention

in particular circumstances.

Non-UMP stock pollutant

• For a non-UMP stock pollutant

– Cost-effective tax and subsidy instruments

require knowledge of individual firms’ marginal cost of

abatement functions.

– only transferable permit schemes do not require that knowledge.

Costs of

monitoring, administering and enforcing compliance

• These costs can be substantial.

• The prevalence of minimum technology requirements may be due

to the fact

– that these costs can be low

– relative to those of instruments that try to regulate emissions

output levels.

6.6.3 Long-Run Effects of Regulation

• The long-run effects of pollution control depend on

– net income effects and

– technological innovation effects.

• Market based pollution abatement regulations create a dynamic

incentive structure

– which continually reward the development of improved pollution

abatement technology.

• Taxes remove income from the targeted industry,

– which will cause it to shrink in the long-run.

• Subsidies will have the opposite effect.

MC1

MC2

£

0 Z Z1*

Figure 6.13 Dynamic incentives under emissions tax controls.

Z2*

New technology reduces marginal cost

of abatement from MC1 to MC2

At lower MC:

firm’s abatement level will increase from Z1* to Z2*

Emission

tax/subsidy

Level of abatement

Firm will save:

Ω due to lower MC of abatement

+ Λ due to reduced tax payment