Environmental Economics Lecture 6 and 7

Regulatory Options & Efficiency Goal: Generate regulatory tools to fix environmental problems

? 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)

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.

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 Agency’s influential World Energy Outlook 2006.

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? www.greendiary.com/

Types of questions in regulation What is the “optimal” amount of pollution? To reduce by X%, who should reduce and by how much? What regulatory instrument(s) should be used to achieve that level?

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?

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 Paper Unbleached Kraft $0.86 Chicken – small plants $0.25 Raw Sugar Processing Louisiana $0.21 NSSC – Sodium Process $0.12 Chicken—large plants $0.10 Source: Magat et al (1986); units: dollars per kilogram BOD removed

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

More Generally: The efficient amount of pollution Marginal Control Cost $/unit Marginal Damage Cost Total Damage Cost Total Control Cost Q* Units of pollution

With mixed high and low cost firms abating, we could Either: Reduce more pollution for the same amount of money…or Reduce the same amount of pollution for less money. So we always want low-cost firm to shoulder abatement.

If costs aren’t constant: two firms, greenhouse emissions of Nitrogen Abatement Cost ($/unit) Who should abate the 1st unit of N? MCA MCB N Reduction

How much abatement from each? Loss from equal reduction MCA $ (B) MCB A: 25 40 80 B: 80 55 40

How did he do that? Determine how much total abatement you want (e.g. 80) Draw axis from 0 to 80 (A), 80 to 0 (B) Sum of abatements always equals 80. Draw MCA as usual, flip MCB Lines cross at equilibrium Price is MC for A and for B.

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.

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

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 dist’n mechanisms.

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 << MB of abatement.

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

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

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

Basic Setup: Env Costs, Private Costs, Social Costs $/unit MSC MPC P* MEC Pp D Q* Qc Dirty Good

MPC (with tax) $/unit MSC t* MPC (no tax) P* Pp D Q* Qc Q (pollution)

Problem: How to reduce VOC emissions in LA without increasing costs? Where do VOC’s come from? Painting, cleaning in manufacturing, cars Current regime: command and control NSPS: “Control Technology Guidelines” (New Source Perf. Stand) SIP’s: 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?)

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?

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?

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.

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.

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.

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

Efficient Allocation of Polutants: Review and Summary of What we Have Learned Today

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.

Marginal damage costs generally increase with the amount of pollution 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.

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.

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.

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.

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.

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.

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.]

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.

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?

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.

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.

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.

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.

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.

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.

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

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.

Today’s Menu Command-and-Control: Improving on it Marketable permits 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

Command-and-Control Problems Advantages 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

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

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

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

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 $50 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.

Voluntary Actions: Examples Unilateralism BP’s 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]

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.

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.

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