Economic Solutions to Environmental Problems The Market Approach Chapter 5 Economic Solutions to Environmental Problems The Market Approach © 2007 Thomson Learning/South-Western Callan and Thomas, Environmental Economics and Management, 4e.

Overview Market approach refers to incentive-based policy that encourages conservative practices or pollution reduction strategies Difference between market approach and command-and-control approach is how each approach attempts to achieve its objectives Types of Market Instruments Pollution charge Subsidies Deposit/refund systems Pollution permit trading systems

Pollution Charges

Pollution Charge Fee that varies with amount of pollutants released Based on “Polluter-Pays Principle” Types of pollution charges Effluent/emission fees Product charge User charge Administrative charge

Product Charge Fee added to price of pollution-generating product, which generates negative externality Impose product charge as per unit tax on product, e.g., gas tax How does the tax on gasoline in the US compare with that of other nations? If the tax equals the marginal external cost (MEC) at QE, it is called a Pigouvian tax

Selected International Gasoline Tax Rates Tax Rate % of Price (2004) United States 20 U.K. 73 France 71 Italy 65 Japan 50 Spain 59 Source: International Energy Agency, August 13, 2004

Modeling a Pigouvian Tax $ MSC = MPC + MEC MPCt MPC a Amount of tax b MPB = MSB QE QC Q of gasoline

Assessing the Model In theory, achieves an efficient outcome In practice, difficult to identify the value of MEC at QE Allows only for an output reduction to reduce pollution

Emission (Effluent) Charge A fee imposed directly on the discharge of pollution Assigns a price to pollution Typically implemented through a tax

Model: Single Polluter Case Government sets an abatement standard at AST Policy options to polluter are: Abate up to AST and incur those costs OR Pay a constant per unit tax, t, on any abatement less than AST Total Tax = t(AST - AO) where AO is actual abatement level Marginal Tax (MT) = t Because t is constant, t = MT Firm will choose the least-cost option: the marginal tax (MT) or the marginal abatement cost (MAC)

Modeling Emission Charge Single Polluter $ Firm abates up to Ao since MAC < MT; firm pays tax between AO and AST, since MAC > MT in that range MAC 0aAO = cost to abate AO AOabAST = tax on pollution not abated up to AST c a b MT t AO AST Abatement (A)

Model: Multiple Polluter Case To facilitate comparison, we use the same model as in the uniform standard case Assumptions 2 polluting sources in some region Each generates 10 units of pollution Government sets emissions limit for region as 10 units, which implies AST = 10 Policy: To achieve AST, government imposes an emission charge as a unit tax (t) of $5

Model: Multiple Polluter Case Each firm responds as in the single polluter case Abates as long as MAC < MT Pays emission charge when MAC > MT Polluter 1: TAC1 = 1.25(A1)2 MAC1 = 2.5(A1) where A1 is pollution abated by Polluter 1 Polluter 2: TAC2 = 0.3125(A2)2 MAC2 = 0.625(A2) where A2 is pollution abated by Polluter 2 Find each firm’s abatement level. Then, find each firm’s total abatement costs (TAC) and tax payment at that level. Support with a graph.

Solution Polluter 1: Polluter 2: Abates up to the point where MAC1 = MT, Set 2.5(A1) = $5, or A1 = 2 Incurs TAC1 = 1.25(2)2 = $5 Incurs Total Tax = 5(10 - 2) = $40 Polluter 2: Abates up to point where MAC2 = MT Set 0.625(A2) = $5, or A2 = 8 Incurs TAC2 = 0.3125(8)2 = $20 Incurs Total Tax = 5(10 - 8) = $10

Modeling An Emission Charge Multiple Polluter MAC1 MAC2 Total Abatement Level = 10 = As TAC1 + TAC2 = $25 (right triangles) Total Tax Payments = $50 (rectangles) 25.00 MAC1 6.25 MT = 5.00 MT = 5.00 MAC2 10 10 2 Polluter 1’s Abatement 8 Polluter 2’s Abatement

Assessing the Model (pros) Abatement standard is met Generates $40 in tax revenues from high-cost abater and $10 from low-cost abater Low-cost abaters do most of cleaning up Cost-effective solution is obtained MACs are equal at $5 tax rate Combined TAC of $25 is lower than $39.06 under command-and-control with a uniform standard

Assessing the Model (cons) Tax authority will not know where MACs are equal Will have to adjust rate until objective achieved Monitoring costs potentially higher Firms might evade tax by illegally disposing pollutants Distributional implications Consumers may pay higher prices due to tax Job losses may result from polluter paying new taxes and/or changing technology to abate

Pollution Charges in Practice Internationally, the pollution charge is the most commonly used market-based instrument Some countries use effluent charges to control the noise pollution generated by aircraft Others levy charges on products such as motor vehicles, pesticides, fertilizers, batteries and gasoline

Environmental Subsidies

Environmental Subsidies Two major types of subsidies: Abatement equipment subsidies Pollution reduction subsidies

Abatement Equipment Subsidy Defined as a payment aimed at lowering the cost of abatement technology Goal is to internalize the positive externality associated with the consumption of abatement activities If the subsidy (s) equals the marginal external benefit (MEB) at QE, it achieves an efficient equilibrium and is called a Pigouvian subsidy

Pigouvian Subsidy Market for Scrubbers ($ millions) MSC MPB MSB QC = 200 QE = 210 PC = 170 PE = 175 Subsidy = $14 million MPBS Q of scrubbers PE – s = 161 K L

Assessing the Model It is difficult to measure the MEB May bias polluters’ decisions about how best to abate

Pollution Reduction Subsidy To implement, government pays the polluter a subsidy (s) for every unit of pollution abated below some pre-established level ZST Per unit subsidy = s(ZST - ZO), where ZO is the actual level of pollution Analogous to an emission charge

Assessing the Model Might be less disruptive than an equipment subsidy Can have the perverse effect of elevating pollution levels in the aggregate since the subsidy lowers unit costs and raises profit, encouraging entry

Subsidies in Practice Environmental subsidies typically are implemented as grants, low-interest loans, tax credits or exemptions, and rebates Many countries around the world use these instruments, including Austria, Finland, Japan, and Turkey In the U.S., common uses include federal funding to build publicly-owned treatment works and subsidies to encourage the development of cleaner fuels and low-emission vehicles

Deposit-Refund Systems

Deposit/Refund Systems A deposit/refund system is a market instrument that imposes an up-front charge to pay for potential damages and refunds it for returning a product for proper disposal or recycling Targets the potential vs. actual polluter The deposit is intended to capture the MEC of improper waste disposal (IW) in advance Preventive vs. ameliorative

Modeling Deposit/Refund System IW disposal market MECIW: health damages + aesthetic impairment from litter, trash accumulation, etc. MPCIW: costs to disposer (e.g., trash receptacles, collection fees, plus forgone revenue from not recycling) MSCIW = MPCIW + MECIW MPBIW: demand for improper disposal Assume MEBIW = 0, so MPBIW = MSBIW

Deposit-Refund Model $ MSCIW MPCIW + Deposit MPCIW a b MPBIW = MSBIW Deposit converts % of overall waste disposal, measured by (QIW - QE), from improper methods to proper MSCIW MPCIW + Deposit MPCIW a Deposit=MEC at Qe b MPBIW = MSBIW QE QIW Improper Waste Disposal (%) 100 Proper Waste Disposal (%) 100

Assessing the Model Promotes responsible behavior Requires minimal supervision by government Can help slow the use of virgin raw materials by improving availability of recycled materials

Deposit/Refund Systems in Practice Deposit/refund systems are used worldwide Many nations use these systems to encourage proper disposal of beverage containers In the US, 11 states have bottle bills Other applications include systems used to promote responsible disposal of used tires, car hulks, and lead-acid batteries

Pollution Permit Trading Systems

Pollution Permit Trading Systems A pollution permit trading system establishes a market for rights to pollute by issuing tradeable pollution credits or allowances Credits are issued for emitting below a standard Allowances indicate how much can be released Two components of the system are Fixed number of permits is issued based on an “acceptable” level of pollution set by government The permits are marketable Bargaining gives rise to a market for pollution rights

How Permit Trading Works There is an incentive to trade as long as polluters face different MAC levels Suppose a firm has 50 permits but normally emits 75 units of SO2. What must it do? Answer Abate 25 units of emissions OR Buy 25 permits from another producer Which option will the firm choose? Whichever option is cheaper

Result Low-cost abaters will clean up pollution and sell excess permits to other firms They will sell at any P higher than their MAC High-cost abaters will buy permits rather than abate They will buy at any P lower than their MAC Trading will continue until the incentive to do so no longer exists, at which point, the cost-effective solution is obtained, i.e., the MACs across firms are equal

Assessing the Model Trading establishes the price of a right to pollute without government trying to “search” for a price No tax revenues are generated Trading system is flexible Note that an emissions standard can be adjusted by changing the number of permits issued

Pollution Trading Systems in Practice International examples Trading of greenhouse gas allowances are part of the Kyoto Protocol, an international accord aimed at global warming Canada has a trading program for ozone-depleters Denmark has one for carbon dioxide emissions Most of the evolution of trading is occurring in the U.S. An important example is the establishment of an allowance-based trading program to control sulfur dioxide emissions under the Clean Air Act Amendments of 1990