Environmental Regulation

Environmental Economics Fall 2013

Four General Areas of Regulation to Protect Environmental Quality

Regulations (Command and Control) (ex. standards, bans, quotas, take-back laws)

Fixing distortions in economic incentives (using markets)– Direct subsidies or subsidy reductions– Environmental taxes and user fees– Deposit refund systems– Tradable permits

Creation of markets – Tradable permits, carbon markets– Establishing and enforcing property rights– Public ownership

Engaging the Public– Eco-labeling– Education Programs

Criteria for Evaluation• Efficiency

– Maximum net benefits to society

• Cost-effectiveness– Bang for the buck

• Equity– Over time, space, income

• Incentives for innovation• Enforceability• Moral grounds

Command-and-Control Policies

Standard: a mandated level of performance enforced in law.

• Ambient Standards– Water ambient standards– Air quality ambient standards

• Emission Standards– Vehicles

• Technology Standards– BACT

Setting the Standard• A standard is not necessarily set according

to efficiency and/or cost effectiveness considerations.

• Many times standards are uniform, e.g. the same nationally. – This may not be efficient if the damages are

different in different regions.– Not cost effective if the abatement costs are

different for different firms/regions. The equimarginal principle will typically be violated.

Potential Advantages to Regulatory Approaches (standards, bans, quotas,

“command and control”)

• More traditional so parties may feel more comfortable

• Lower administrative costs, responsibilities, and easier enforcement

• Effects are more certain (e.g. amount of pollution reduced)

• Perceived as having less impact on inflation

• Emission standards provide an incentive to innovate (technology standards not so)

Emission Taxes or ChargesFirms are charged for the emission they make on a

per ton or some other basis.

Advantages:– Cost-effectiveness/ flexibility: Allows firms to

chose their level of abatement: • Firms with high abatement cost might chose to pay the taxes while

firms with low abatement costs would rather abate.

– Tax structures already in place– Stimulates development of new technologies

continuously (dynamically efficient).– Uses “free-market”.– Raises revenue – ‘double dividend’. – Can send correct price signal through entire

economy.

Emission Taxes or ChargesDisadvantages:

• Difficult to assess correct level.– Based on damage costs?– Based on marginal abatement costs and

desired level of abatement?

• Unknown emission outcome.• Need to use right tax.• Unpopular.

How to Set the Right Tax level?• Base it on the cost of damages associated with

an activity/pollutant/etc. “Pigouvian Tax” – internalizing the external costs.This is not always easy to assess. Various impacts

need to be considered:– Loss of life– Loss of work days– Discomfort– Damage to material goods (i.e. acid rain)– Impact on natural world– Aesthetic impact

• Base it on the cost of remediation/ amelioration• Base it on mandated emission reductions

Problems with basing tax on damage:

• Doesn't work well with persistent pollutants like PCBs which stay in environment. How do you include future values?

• Uncertainty – how to value uncertain outcomes? ex. climate change.

• Doesn't include interaction between pollutants.

• Different areas might require different costs – i.e. urban areas vs. desert

• Marginal cost of each ton emitted is not necessarily the same. Maybe cost goes up with higher emission levels.

SMC = social marginal costPMC = marginal costMD= marginal damage costsQe = equilibrium quantityQs = social equilibrium quantity

MD

PMC

SMC

Qs Qe Quantity

P

Demand = social benefit

How to set the socially optimal tax?

SMC = social marginal costPMC = marginal costMD= marginal damage costsQe = equilibrium quantityQs = social equilibrium quantity

MD

PMC

SMC

Qs Qe Quantity

P

Demand

How to set the socially optimal tax?

Emissions(e.g. SOx)

Marginal abatement cost (MAC)

Marginal damage cost (MDC) = MB from abatement

e* e1

e* is the socially optimal level.

MAC = least costly way to get a level of abatement

Abatement

Level w/oabatement

Value per unit of emissions or abatement

Tax

Illustration of Optimal Tax

Emissions

e1Abatement

Things are not now optimized; it may be possible to lower emissions and costs.

Value per unit of emissions or abatement

1995 composite figures for cost of damages from criteria air pollutants in

California

Tax values in $/ ton Density NOx CO SOx PM10 High 11,584 2 4,768 37,455 Medium 5,216 0 1,814 4,578 Low 541 0 1,814 753

Tradable Permits• Firms are allowed a certain quota of emissions.

They can make reductions themselves or trade for reductions at other facilities.

• Advantages:– Stimulates new technologies– Promotes efficiency– More certainty about amount of pollution

reduction compared to taxes– More politically accepted than taxes

• Disadvantage: – Require more administrative capacity/high costs– Can be gamed more easily than taxes– Can hurt competition– Geographical distortions

Permits Can Be Gamed

http://www.nytimes.com/interactive/2013/09/15/business/0915-price-of-an-ethanol-credit.html?ref=business

“Traders for big banks and other financial institutions, these people say, amassed millions of the credits just as refiners were looking to buy more of them to meet an expanding federal requirement”.

“JPMorgan Chase and other financial institutions…had helped transform an environmental program into a profit machine, contributing to the market frenzy this year”.

Tax vs. PermitsUnless you know the precise costs of

abatement, you don't know how much pollution

reduction will occur. Costs

Q*

Costs

Q?

Tax

CarbonCap

P? P

MC

Costs

MC

Abatement Abatement

Tax vs. PermitsIdeally, abatement occurs where MB = MC

Costs

Q*

Costs

Q?

Tax

CarbonCap

P? P

MB

Costs

MB

Abatement Abatement

MC MC

Tax vs. PermitsWith very steeply changing marginal benefits,

cap is better.Costs

Q*

Costs

Q?

Tax

CarbonCap

P? P

MB

Costs

MB

Abatement Abatement

EMC EMC

Tax vs. PermitsWith more horizontal marginal benefits, tax is

better. Costs

Q*

Costs

Q?

Tax

CarbonCap

P? P

MB

Costs

MB

Abatement Abatement

EMC EMC

Variations in Cost Structures

Marginal Damage Costs

Marginal Abatement Costs

Mathematical Comparison

• Emission limits (regulation)

• Tax

• Tradable Permit

Mathematical Example of Emission Limits

• Three firms all with different MC of pollution reduction. Each firm emits 100 tons of pollution.

• The three firms have MC of abatement as follows where Q is quantity of emissions reduced:

MCa = 10 + 0.25Qa MCb = 20 + Qb

MCc = 10 + 0.5Qc

Each firm needs to reduce by 20% which is 20 tons.

MCa = 10 + 0.25Qa MC(20) = 10 + 0.25(20) = 15

MCb = 20 + Qb MC(20) = 20 + 20 = 40 MCc = 10 + 0.5Qc MC(20) = 10 + 0.5(20) = 20

Firm A Firm CFirm B20% 20% 20%

10 10

20 20

40

15

MAC

MAC

MAC

If they all reduce by 20 tons, total reduction = 60 tons. The resulting total costs (calculated using area method) for each firm are:

Firm A: (20 x 10) + (20 x 5)/2 = $250

Firm B: (20 x 20) + (20 x 20)/2 = $600

Firm C: (20 x 10) + (20 x 10)/2 = $300

Total costs = $1150

Emission Taxes or ChargesSet tax at $20/ton

Firm A Firm CFirm B

40 tons Zip 20 tons

10 10

20

MAC

MAC

MAC

To find out how much each reduces, set MC = to 20 and solve

for Q.

MCa = 10 + .25Qa = 20 Q = 40

MCb = 20 + Qb = 20 Q = 0

MCc = 10 + .5Qc = 20 Q = 20

Again we have a reduction of 60 tons.

What has been the cost of emission reduction?

Firm A: (40 x 10) + (40 x 10)/2 = $600Firm B: 0Firm C: same as with regulation = $300Total cost = $900

The cost is lower than with CAC. However, firms still need to pay the taxes on the other emissions.

Total cost of emission tax• Taxes for A = $20 x 60tons = $300• Taxes for B = $20 x 100tons = $2000• Taxes for C = $20 x 80tons = $1600• Total cost to industry = $900 + $3900 in taxes

Compared to CAC, cost of reducing same level of emissions is less but total cost to industry is more.

Tradable Permits: 240 permits given away, 80 tons to each firm.

• Firm B is going to realize that it costs them more to reduce pollution than firms A and C so it will want to buy permits from these firms.

• Firm A can sell up to 20 permits for $20 each to Firm B.

• Firm B will pay $20 for permits.• If sale price is $20, total cost of compliance if

permits are given away:Firm A: $600 for emission reduction - $400 from Firm B =

$200Firm B = $400 to pay for permits from Firm AFirm C = $300 for emission reduction

Total = $900

Firm C does not trade permits. Firm B buys 20 tons of permits from firm A.

Firm A Firm CFirm B

40 tons 20 tons

10 10

$20

MAC

MAC

MAC

20 tons

The RECLAIM Experience (Fowlie et al. 2011)

• NOx and SOx trading program started in 1994.

• REgional CLean Air Incentives Market

Industries Are Dynamic

• All this well-developed theory associated with the benefit and costs of various government policies for reducing emissions is all based on static analysis.

• In reality, the world is far more dynamic.

• Well designed regulations can often have private economic benefits to the firms.

Social Value of Regulations

• Often not known in advance.• 1990 Clean Air Act Amendments

(CAAA): SOx regulation, – Benefits were $3300 per ton, – Costs were $270 per ton (1998 dollars).

•

Creating Markets/Enforcing Property Rights

• Tradable permits, carbon markets

• Establishing and enforcing property rights

• Public ownership

The Coase Theorem

Economic efficiency will be achieved as long as: – property rights are fully allocated and – completely free trade of all property

rights is possible.

It does not matter who initially owns the property rights, as long as all rights are defined.

Problems With Coase Theorem

• Transaction costs can prevent markets from developing to internalize external costs even with damager liability rules.

• Agreements can be difficult to enforce.

• Income effects: depending on income of victims, non-market damage optima could vary.

In Reality

• Well defined property rights unlikely to solve many environmental problems

• Government intervention necessary

• Intervention more likely with some environmental problems than others

Characteristics of Environmental Problems and Likelihood of Government Control

Democratic Control

Characteristics Less likely >>> More likely >>> Very Likely

Spatial Scale Global/foreign

Regional* National Local Very Local

Level of Complexity/Uncertainty

High Moderate Medium Low Very Low

Transparency Invisible SomewhatVisible

Medium Fairly Visible Obvious

Temporal Scale ofImpacts

Distant future ModerateFuture

Near Future Very Soon Immediate

Sources Very many Many Moderate Few Very Few

Source and Target Same Mostly Same Similar orMixed

Mostly Differ Differ

Livelihood Impact Very Low Low Medium High Very High

Human HealthImpacts

Indirect SomewhatIndirect

Semi-direct SomewhatDirect

Direct

Level of HealthImpacts

Very Light Light Medium Heavy Very Heavy

* Depends on country size. For large countries, like the United States or China, "national" might be a larger scale

than "regional".

Environmental Problem

Local - 1 Global - 5

Simple, certain - 1 Complex, uncert. - 5

Transpar- ancy

Obvious-1 Invisible-

5

Timing of Effects

Present-1 Future - 5

Sources Few- 1

Many - 5

Source and

Target Differ - 1 Same - 5

Livelihood Impact

High - 1 Low - 5

Human Health Impact

Direct - 1 Indirect –

5

Level of Health Impact

Heavy - 1 Light - 5

Total

Local water quality 1 1 2 1 4 1 4 1 1 16

Urban air pollution from industry

2 2 1 1 1 1 5 2 2 17

Toxic dumps 1 2 3 1 1 1 5 1 5 20

Indoor air pollution 1 1 2 1 5 5 4 1 1 21

Local deforestation 2 2 1 1 2 4 2 5 5 24

Acid rain 3 2 3 2 2 2 3 4 4 25

Pesticides 2 3 4 2 2 2 4 2 4 25

Urban air pollution from mobile sources

2 2 1 1 5 5 5 2 2 25

Soil erosion 2 4 2 2 3 4 1 4 4 26

Ocean pollution 5 3 3 2 2 1 3 4 4 27

Global deforestation, loss of biodiversity

5 2 3 2 4 2 4 5 5 32

Resource depletion 4 3 3 4 4 3 1 5 5 32

Ozone depletion 5 4 4 3 4 3 5 4 2 34

Climate change 5 5 4 5 5 3 5 5 3 40

Other policy options for reducing externalities

Engaging the public• Labeling (e.g. timber certification)• Education programs

Firm Based• Voluntary over-compliance

– Pleasing stake-holders, including employees

– Anticipatory compliance– Saving money– Indivisibility of pollution abatement

technology• Environmental Accounting

Marginal Costs Might Change Abruptly Example: air pollution emission reduction

Marginal Social Value

Marginal Abatement Cost

Emission Reduction

$ per unit reduction

Source: McKinsey and Co. Impact of the financial crisis on carbon economics: Version 2.1 of the global greenhouse gas abatement cost curvehttp://www.mckinsey.com/client_service/sustainability/latest_thinking/greenhouse_gas_abatement_cost_curves

http://www.mckinsey.com/insights/energy_resources_materials/mobilizing_for_a_resource_revolution

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