Environmental Economics Class 7

Incentive Based Regulation: Basic Concepts Up to this point, the focus has been on resource allocation. Since the use of resources creates waste, we address the questions of: 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 such as PCBs. 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. The vertical zone of influence refers to whether the pollution damages are mostly at ground level or if they accumulate in the upper atmosphere. 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 Fund pollutants can be examined using a static analysis because the level of future damages is independent of current emissions. Time periods can thus be analyzed separately. 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. 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.

The cost-minimizing solution is found by equating marginal damage costs to marginal control costs (or at Q* in Figure 13.2). Points to the left of Q* (greater control) are inefficient because the marginal cost of control is greater than the marginal damage and reflects higher total costs. Likewise, points to the right of Q* are also inefficient, but now because marginal damage costs are higher than marginal control costs. There is too much pollution. The optimal level of pollution would be zero only if the marginal damage cost function is everywhere above the marginal control cost function. An extremely toxic pollutant would cause this to be the case. [How do you draw this.] Optimal levels of pollution will vary by location and by pollutant.

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. Control costs are not externalities. 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?

Figure 13.3 illustrates the solution to the model. The graph is drawn such that the left-hand vertical axis measures the marginal control cost to emission source 1 and the right-hand vertical axis measures the marginal control cost to emission source 2. The horizontal axis is the constrained to equal 15 – measured from either direction. This ensures that any point will represent some combination allocated across the two sources that adds to 15. [This is equivalent to flipping over a graph measuring control costs for source two and using the box as the constrain.]

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 authoritiesbecause 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 (Figure 13.4). 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.