ERE9: Targets of Environmental Policy Optimal targets –Flow pollution –Stock pollution When location matters Steady state –Stock-flow pollutant Steady state Dynamics Alternative targets

Last week Valuation theory Total economic value Indirect valuation methods –Hedonic pricing –Travel cost method Direct valuation methods

Environmental & Resource Economics Part 1: Introduction –Sustainability –Ethics –Efficiency and optimality Part 2: Resource economics –Non-renewables –Renewables Part 3: Environmental economics –Targets –Instruments Part 4: Miscellaneous –Valuation (next course) –International environmental problems (next course) –Environmental accounting

Pollution Pollution is an externality, that is, the unintended consequence of one‘s production or consumption on somebody else‘s production or consumption Pollution damage depends on –Assimilative capacity of the environment –Existing loads –Location –Tastes and preferences of affected people Pollution damage can be –Flow-damage pollution:D=D(M); M is the flow –Stock-damage pollution:D=D(A); A is the stock –Stock-flow-damage pollution:D=D(M,A)

Economic activity, residual flows and environmental damage

Efficient Flow Pollution Damages of pollution D=D(M) Benefits of pollution B=B(M) Net benefits NB=B(M)-D(M) Efficient pollution Max NB

Maximised net benefits M*M* ** M D(M) B(M) D(M) B(M) M Efficient level of flow pollution emissions Total damage and benefit functions Marginal damage and benefit functions

Marginal damage Marginal benefit Costs, benefits 0 M Quantity of pollution emission per period M*M* B C A The economically efficient level of pollution minimises the sum of abatement and damage costs M’M’ D X Y

Types of externalities Area B: Optimal level of externality Area A+B: Optimal level of net private benefits of the polluter Area A: Optimal level of net social benefits Area C+D: Level of non-optimal externality that needs regulation Area C: Level of net private benefits that are unwarranted M*: Optimal level of economic activity M‘: Level of economic activity that maximises private benefits

Efficient Flow Pollution (2) Optimal pollution is greater than zero The laws of thermodynamics imply that zero pollution implies zero activity, unless there are thresholds (e.g., assimilative capacity) Optimal pollution is greater than the assimilative capacity Pollution greater than the optimal pollution arises from discrepancies between social and private welfare

Stock pollutants lifetime Source: IPCC(WG1) 2001

S1S1 S2S2 R4R4 R3R3 R2R2 R1R1 S: Source R: Urban area Stock pollutants with short lifetime: When location matters Wind direction and velocity

Stock pollutants with longer lifetime: Efficient pollution Damages of pollution Benefits of pollution Stock Net current benefits Efficient pollution Max NPVNB Hamiltonian:

Steady State Static efficiency Dynamic efficiency Steady state

Steady State (2) Marginal benefit of the polluting activity equals the net present value of marginal pollution damages Benefits of pollution are current only Damages of pollution are a perpetual annuity The decay rate ( ) acts as a discount rate

Steady State (3) Distinguish four cases:

Steady state: Case A Case A Equation collapses to In the absence of discounting, an efficiency steady-state rate of emissions requires that –the marginal benefits of pollution should equal the marginal costs of the pollution flow –which equals the marginal costs of the pollution stock divided by its decay rate

M*M* ** M Steady state: Case A (2) In the steady-state, A will have reached a level at which  A*=M*

M*M* ** M  ** M ** Steady state: Cases A and B Case B: Case A:

Steady State: Cases C and D Case C: Case D: The pollutant is perfectly persistent In the absence of assimilation, the steady state can only be reached if emissions go to zero Clean-up expenditures might allow for some positive level of emissions

Efficient Stock-Flow Pollution Pollution flows are related to the extraction and use of a non-renewable resource –For example, brown coal (lignite) mining What is the optimal path for the pollutant? Two kind of trade offs –Intertemporal trade-off –More production generates more pollution Pollution damages through –utility function –production function E is an index for environmental pressure V is defensive expenditure

The optimisation problem Current value Hamiltonian: Control variables: C, R, V State variables: S, K, A Co-state variables: P, , subject to

Static Efficiency

Dynamic Efficiency

Shadow Price of Resource Gross price = Net price + extraction costs + disutility of flow damage + loss of production due to flow damage + value of stock damage Flow and stock damages need to be internalised!

time, t Units of utility P t = net price  Pt+GRPt+GR Stock damage P t +  G R -U E E R P t +  G R -U E E R -  Q E E R P t +  G R -U E E R -  Q E E R - M R Net price Production flow damage Utility flow damage Marginal extraction cost Gross price Optimal time paths for the variables of the pollution model

time, t Units of utility P t = net price  P t +  G R = Gross price Stock damage tax Net price Pollution flow damage tax Utility damage tax Marginal extraction cost Private costs A competitive market economy where damage costs are internalised Social costs

Efficient Clean-up The shadow price of capital equals the shadow price of stock pollution times the marginal productivity of the clean-up activity Ergo, environmental clean-up (defensive expenditure) is an investment like all other investments

Alternative Standards Optimal pollution is but one way of setting environmental standards and not the most popular The main difficulty lies in estimating the disutility of pollution Alternatives –Arbitrary standards –Safe minimum standards –Best available technology (not exceeding excessive costs) –Precautionary principle