1. Business in a Modern World Fabian Girod Business in a Modern World 1 Markets, Firms, and the Role of Governments Legal systems; externalities and public goods; social security and distribution; imperfect competition. Firms and Governments: The Case of Environmental Policy Pollution; emission standards, taxes and permits; EU emissions trading scheme. The Global Economy I: Trade and Location International trade; comparative versus competitive advantage; location and MNEs. The Global Economy II: Capital and Currencies Capital mobility and market integration, exchange rates. The Global Economy III: Policy and Organisations Trade policy and capital restrictions; the future of nations and organisations Concluding Remarks on Business in a Modern World

2. Business in a Modern World Fabian Girod Part 1: Policy Approaches to Controlling Pollution 1. Introduction 2. Main Objectives 3. Efficient Policy 4. Cost-Effective Policies 5. ‘Dynamic’ Incentives 6. Other Criteria 7. Conclusions 2 Firms and Governments: Environmental Policy

3. Business in a Modern World Fabian Girod 1. Introduction Today’s topic: Policy approaches to control pollution Main issues: –government objectives –efficient & cost-effective policies –incentives to use/invent eco-friendly technologies –policy instruments and information requirement 3

4. Business in a Modern World Fabian Girod 2. Main Objectives Now: Focus on pollution, i.e., flow of waste products from the economy back to the environment. Pollution causes damage (externality) and benefits. Damage includes loss of –use value –option value –existence value.  Take 15 minutes and give me examples! Is it possible to quantify that? Research it! 4

5. Business in a Modern World Fabian Girod 2. Main Objectives Cuts in pollution can be achieved by means of –less output/consumption  check on EUROSTAT GDP in 2008 and 2009 and CO2 emissions! http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/themes –abatement Main objectives of environmental policy: –efficiency –cost-effectiveness –incentives to use/invent eco-friendly technologies  Can you think of other objectives? 5

6. Business in a Modern World Fabian Girod 3. Efficient Policy Efficient policy : cuts in polluting output Determining efficient pollution levels means balancing the trade-off between costs of & benefits from pollution. Efficiency condition: Marginal WTP for a product equals marginal social costs (marginal private plus external costs). 6

7. Business in a Modern World Fabian Girod 7 Price Output Efficient allocation Q* Supply = Private marginal costs Demand = Marginal WTP Social marginal costs Q*Q* Net benefit 3. Efficient Policy cut

8. Business in a Modern World Fabian Girod 3. Efficient Policy But: Environmental costs are ‘external’ costs.  No prices for pollution reflecting environmental scarcity.  Agents do not take environmental damage into account.  Inefficient high pollution levels in market equilibrium. 8

9. Business in a Modern World Fabian Girod 9 Price Output Efficient allocation Q* versus market allocation Q M QMQM Supply = Private marginal costs Demand = Marginal WTP Social marginal costs Q*Q* 3. Efficient Policy

10. Business in a Modern World Fabian Girod 3. Efficient Policy Possible efficient policy 1: “Creating” a substitute for a market price by implementing an emission tax (or charge): resulting tax payment per output unit = marginal damage at Q* –Agents internalise environmental damage. –“Modified” market outcome is efficient. 10

11. Business in a Modern World Fabian Girod 11 Price Output Efficient policy Supply = Private marginal production costs + Tax Demand = Marginal WTP Social marginal costs Q*= Q P Net benefit 3. Efficient Policy QMQM Supply = Private marginal costs

12. Business in a Modern World Fabian Girod 3. Efficient Policy Efficient policy 2: increase in ‘abatement’ Efficient pollution level (which we don’t know!) minimises the sum of –damage costs of pollution & –abatement (or control) costs of pollution. Marginal damage costs increase with the quantity of emissions. Marginal abatement costs increase with the quantity of emissions reduced (i.e., decrease with the quantity of emissions). 12

13. Business in a Modern World Fabian Girod 3. Efficient Policy 13 Quantity of emissions Marginal costs Marginal abatement costs Marginal damage costs Remember a damage has a certain benefit (cause) Q* Emission Cuts Q

14. Business in a Modern World Fabian Girod 3 Assignments 1)Damage includes loss Give examples! Is it possible to quantify that? Research it! 2)Cuts in pollution can be achieved by means of less output/consumption  check on EUROSTAT GDP in 2008 and 2009 and CO2 emissions! 3)Summarize different positions regarding pollution (proof!) from different stakeholders e.g.specific industries, parties,interest groups, NGOs etc. 14

15. Business in a Modern World Fabian Girod emissioncuts in emission marg. costs total costs marg. damage total damage costs + damage 06124200 1510302232 248204626 336126 24 424682026 5122103032 Q = 60001242 Example: Socially optimal outcome

16. Business in a Modern World Fabian Girod emissioncuts in emissio n marg. costs total costs marg. damage total damage costs + damage 06124200 1510302232 248204626 336126 24 424682026 5122103032 Q = 60001242 Example: Socially optimal outcome Cost to reduce the 6 th unit of emissions Reduction costs of 5 emissions units Additional damage caused by the 3 rd emission unit Cumulated damage

17. Business in a Modern World Fabian Girod emissioncuts in emission marg. costs total costs marg. damage total damage costs + damage 06124200 1510302232 248204626 33 6 12 6 24 424682026 5122103032 Q = 60001242 Example: Socially optimal outcome

18. Business in a Modern World Fabian Girod 3. Efficient Policy Efficiency condition: If pollution is efficiently allocated, then the marginal damage costs of pollution equal the marginal abatement costs. Market allocation: Damage costs are externalities, firms’ abatement costs are private.  Firms do not abate  REALITY if no policy applied 18

19. Business in a Modern World Fabian Girod 3. Efficient Policy Possible efficient policy  Pigouvian Tax: Implementing an emissions tax which is equal to the marginal damage at the point where the marginal damage and abatement costs are identical.  Firms cut emissions as long as the marginal abatement costs are below the emissions tax.  Damage costs are internalised. 19

20. Business in a Modern World Fabian Girod 3. Efficient Policy 20 Quantity of emissions Marginal costs Marginal abatement costs Marginal damage costs (socialized without any measure) Q* Tax Emission Cuts Q

21. Business in a Modern World Fabian Girod 3. Efficient Policy Major Problem: –lack of information about marginal damage costs (despite of a wide range of valuation methods) –lack of information about abatement costs & differences in abatement costs between emission sources –Difficulties in evaluating the efficient intertemporal use of resources Less ambitious policy assessment criterion: –cost-effectiveness  But what could be there reason for implementing it? 21

22. Business in a Modern World Fabian Girod 4. Cost-Effective Policies “Exogenous” environmental targets determined in the political process. Cost-effectiveness: An allocation is cost-effective if it meets a given environmental target in a manner that minimises total abatement costs. Simple case (Example): –2 emission sources –abatement costs differ between emission sources –given pollution target 22

23. Business in a Modern World Fabian Girod emissi on cuts in emissi on marg. costs 1 total costs 1 marg. costs 2 total costs 2 061242621 151030515 24820410 3361236 424623 512211 Q = 600000 Question: Cost-effective outcome if total cuts = 6? The case with 2 firms To cut the sixth unit of emission costs 12 Units of money To cut 6 emission units is necessary to minimize sum of total costs (1+2) Cut in emission of firm 2 Cut in emission of firm 1

24. Business in a Modern World Fabian Girod 24 Emission cuts Marginal costs Emission cuts firm 2 Firm 1 Firm 2 6 Cuts firm 1 4. Cost-Effective Policies 6 Initial situation without cuts

25. Business in a Modern World Fabian Girod 4. Cost-Effective Policies Optimality condition: identical If an allocation is cost-effective (i.e., if it minimises total costs of pollution cuts), then the marginal abatement costs will be identical for all emission sources (here: polluting companies).  This principle can be applied to a case with countless companies e.g. the European trading scheme 25

26. Business in a Modern World Fabian Girod 4. Overview of instruments 26 Instruments to cut pollutionMarket based Tax (Pigouvian tax) permits Non- marketed based Emission standards

27. Business in a Modern World Fabian Girod 4. Cost-Effective Policies Command-and-control policy: Emission standards Emission standard: –legal limit on the quantity of emissions –allocation between different emission sources/firms? Any arbitrary allocation between sources/firms does –usually not equalise marginal abatement costs –not lead to cost-effective outcomes. For example: “equal” obligations to cut emissions 27

28. Business in a Modern World Fabian Girod 4. Cost-Effective Policies For example: “equal” obligations to cut emissions - Read article (!) 28

29. Business in a Modern World Fabian Girod 4. Cost-Effective Policies 29 Marginal costs Firm 1 Firm 2 Emission cuts Cuts firm 2 Cuts firm 1 3 6 6

30. Business in a Modern World Fabian Girod 4. Cost-Effective Policies 30 See the difference

31. Business in a Modern World Fabian Girod 4. Cost-Effective Policies Non-market based instrument: See example above (Emission standards): An “equal" cut of three emission units is not cost-effective. Problem: –Cost-effective standards require knowledge of abatement costs that governments do not have. And even if they had, these costs are, due to dynamics, constantly changing ! 31

32. Business in a Modern World Fabian Girod 4. Cost-Effective Policies Market-Based Instruments I: Emission Tax (Pigou) A tax on each unit of pollutant emitted, imposed by the government. Emission tax serves as a substitute for the missing market price of the environment. Response of firms: Firms cut emissions as long as marginal the abatement costs are below the emissions tax. 32

33. Business in a Modern World Fabian Girod 4. Cost-Effective Policies Result: If firms face an identical emission tax, they face identical incentives to cut emissions.  Marginal abatement costs are equalised across firms.  Abatement costs are “automatically” minimised; emission taxes are cost-effective. Note: Knowledge of abatement costs is not needed! 33

34. Business in a Modern World Fabian Girod 4. Cost-Effective Policies 34 Marginal costs Tax Firm 1 Firm 2 Total cuts Emission cuts firm 2 Cuts firm 1 Emission cuts

35. Business in a Modern World Fabian Girod 4. Cost-Effective Policies: Tax Problems: –Iterative trial-&-error process is necessary to achieve environmental targets (Was the tax imposement successful). –Costs of legislative adjustments can be substantial. Discussion: What about using subsidies to install new technology instead of taxes? 35

36. Business in a Modern World Fabian Girod 36

37. Business in a Modern World Fabian Girod 4. Cost-Effective Policies Market-Based Instruments II: Emission Permits Transferable emission permits: Permits that allow a firm to emit a specific amount of pollutant over a specific time period; freely tradable. Basic idea: Generate a market for the environment by setting aggregate “supply” of pollution  setting indirectly the price of the environment.  What does the “price” depend on ? 37

38. Business in a Modern World Fabian Girod 4. Cost-Effective Policies Response of firms: –Firms cut emissions & sell permits not needed as long as the marginal abatement costs are below the permit price. –Firms buy permits and emit more as long as the marginal abatement costs exceed the permit price. Result: –Trade takes place until all firms’ marginal abatement costs are equalised, and are equal to the permit price. –All firms face identical incentives to cut emissions. 38

39. Business in a Modern World Fabian Girod 4. Cost-Effective Policies: Permits 39 Marginal costs Firm 1Firm 2 Total cuts Emission cuts Initial distribution of permits: Incentives to trade emission permits when marginal abatement costs differ

40. Business in a Modern World Fabian Girod 4. Cost-Effective Policies: Permits 40 Marginal costs Price Firm 1Firm 2 Total cuts Equilibrium cuts firm 2 Equilibrium Cuts firm 1 Emission cuts Market equilibrium after trade in permit market

41. Business in a Modern World Fabian Girod 4. Cost-Effective Policies  Abatement costs are ‘automatically’ minimised;  emission permits are cost-effective. Note: –Knowledge of abatement costs is not needed! –Cost-effectiveness is independent of initial permit allocation. –No (costly) iterative trial-&-error process to meet environmental targets. 41

42. Business in a Modern World Fabian Girod 4. Cost-Effective Policies Permits put into practice: How does this work? initial allocation of permits: –auctions –free allocation (grandfathering) Problems: –imperfect competition for permits –new market entries –transaction costs of trade We will discuss this further ! 42

43. Business in a Modern World Fabian Girod 4. Cost-Effective Policies Conclusion: Both market-based approaches, emission taxes & permits, are suitable to achieve cost-effectiveness. Permits enable the government to achieve directly pollution targets; taxes require a (costly) trial-&-error process. 43

44. Business in a Modern World Fabian Girod 5. ‘Dynamic’ Incentives ‘Dynamic’ incentives to use (and invent) eco-friendlier technologies in the case of emission taxes: –lower (marginal) abatement costs –lower tax payment –But: costs of switching to ‘new’ technology Example: –two technologies – ‘old’ and ‘new’ – available to a firm –new technology: lower (marginal) abatement costs –switching to new technology: fixed costs F Example: Carbon Capture & Storage 44

45. Business in a Modern World Fabian Girod 5. ‘Dynamic’ Incentives 45 Quantity of Emissions Marginal Costs Q old Tax Emission Cuts New technology Old technology Abatement costs Tax payment Q Dynamic incentives : Example with tax

46. Business in a Modern World Fabian Girod 5. ‘Dynamic’ Incentives 46 Quantity of Emissions Marginal Costs Q new Price Emission Cuts New technology Old technology Cost reduction Q

47. Business in a Modern World Fabian Girod 5. ‘Dynamic’ Incentives Result: Firm chooses ‘new’ technology if cost reduction is greater than costs of switching to ‘new’ technology F. 47

48. Business in a Modern World Fabian Girod 5. ‘Dynamic’ Incentives Dynamic incentives to use (and invent) use eco-friendlier technologies in the case of emission permits: –lower (marginal) abatement costs –revenues from selling permits (!) Discussion: Is there any difference between taxes and permits? Why? Why not? What about the dynamic incentives of emission standards? 48

49. Business in a Modern World Fabian Girod 5. ‘Dynamic’ Incentives 49 Quantity of Emissions Marginal Costs Q new Price Emission Cuts New technology Old technology Abatement costs Costs of Permits Q

50. Business in a Modern World Fabian Girod 6. Other Criterias argument for market- based approaches Response to economic cycles & growth –E.g. see following example of CO2 prices during the economic crisis Distributional issues Ancillary benefits (‘double dividend’) 50

51. Business in a Modern World Fabian Girod 7. Conclusions The message of economics: In principle, market-based instrument are cost-effective and provide dynamic incentives to use (and invent) eco-friendlier technologies; they are “superior” to traditional command-and-control approaches to controlling pollution. Let’s talk about political experiences in the next lesson! 51

52. Business in a Modern World Fabian Girod Basic Reading Tietenberg (2007), Environmental Economics and Policy, 5th Edition, Boston et al.: Pearson – Addison Wesley, chapter 13. 52