1. 1 Topic 3.a: Introduction At the end of Topic 2 we identified the efficient level of abatement/emissions. The question of policy is: What policies can we implement to ensure efficient abatement behavior? Policies we will consider: 1.Emissions standards. 2.Emissions taxes/charges. 3.Transferable/tradable pollution permits. Throughout, we will be interested also in questions about the incentives each policy creates for innovation. We will also continue to analyze the performance of each policy instrument in cases where we have less than full information.

2. 2 Topic 3.a: Command and Control Standards are an example of a policy-type known as command and control (CAC) policy. The key characteristic of CAC regulation: the regulator specifies what individual firms can and cannot do (enforced by the threat of penalties for non-compliance). Dominant regulatory regime in most countries (including Canada). The different forms of CAC regulation can be classified into two main types: –performance standards –design standards

3. 3 Topic 3.a: Command and Control Performance standards place restrictions and conditions on the day-to-day performance of the firm. They include restrictions on –the volume of emissions –the volume of emissions per unit of output –the volume of emissions per unit of a particular input –the use of polluting inputs (or mandated use of non- polluting inputs) When we refer to emissions standard we refer to the volume of emissions, this is the policy we will focus on

4. 4 Topic 3.a: Command and Control Two key points: 1.an emissions standard can implement an emissions target with a smaller adverse effect on profits than other types of standards (such as emissions per unit output standard). –Why? The emission standard gives the firm more flexibility with respect to how it will meet the target. 2.standards other than emissions standards can reduce profits and at the same time potentially have perverse effects on the level of emissions. Example: an emission per unit output standard sets a maximum value for [output/emissions]. –standard can be met by reducing emissions relative to output (which would reduce emissions) or by increasing output relative to emissions (which could increase emissions).

5. 5 Topic 3.a: Command and Control So why are these other types of standards used? Two reasons: Political motives: appear to be restricting emissions but at the same time protecting employment Emissions are often more difficult to monitor than input use. Important examples: –mobile source pollution –non-point source pollution

6. 6 Topic 3.a: Command and Control Design standards (or technology standards) impose requirements for the use of particular pollution control equipment, or a particular production technology. This is the policy we analyzed when we talked about SO 2 scrubbers Design standards often have a “best technology” element to them. “Best available technology” (BAT) regulation requires that firms adopt the cleanest technology available (within some specified period of its innovation). BAT regulation can be extremely costly: innovators have an incentive to develop cleaner technology with little regard to the cost of adoption by the polluting firms (since the regulation creates a captive market).

7. 7 Topic 3.a: Command and Control Recognition of this problem has led to common qualifications of BAT regulation: –“Best commercially available technology” (BACT) regulation requires that firms adopt the technology only if it is “commercially” available. –BATNEC regulation requires adoption of the BAT “not involving excessive cost”. These qualifications attempt to take account of the cost of cleaner technology adoption; there are benefits and costs.

8. 8 Topic 3.a: Command and Control Many other environmental design standards. –building insulation standards –forestry and mining codes –car fuel economy standards –toxic waste disposal regulations Other (non-environmental) exs of CAC policies: –Speed limits & other traffic rules –Occupational health and safety rules Other types of environmental standards: –Ambient standards - the concentration of a pollutant in the atmosphere cannot exceed a certain level. Different from emissions standards which target the flow of a pollutant from a particular source.

9. 9 Topic 3.a: Command and Control Lets go back to our focus: emissions standards Determining the efficient standard is straightforward, given that we understand how to determine the efficient level of emissions. In the case of: –1 firm: find where MAC = MD, set the standard = this E. –2 (or more) firms: find where MAC 1 = MAC 2 = MD and then set individual firm standards equal to the E 1 and E 2 implied.

10. 10 Topic 3.a: Command and Control Example: MAC 1 = 180 - E 1, MAC 2 = 90 - (1/2)E 2, MD = (2/3)E. We already know that efficiency  E 1 = 100 & E 2 = 20. Set E = 100 as standard for firm 1 & E = 20 for firm 2.

11. 11 Topic 3.a: Command and Control 180 90 E1E1 E2E2 80 100 20 Graphically: $ $ 80 MAC 1 MAC 2 E standard for firm 1 = 100 E standard for firm 2 = 20 Note that, because we have chosen individual E standards efficiently, MAC 1 = MAC 2. Abatement costs? TAC 1 = $3,200 & TAC 2 = $6,400  TAC = $9,600 Definition: Compliance cost = cost to the firm of complying with an environmental regulation. In the case of E standards, compliance cost = TAC. TAC 1 TAC 2

12. 12 Topic 3.a: Command and Control Two things to note: 1.In order to set standards efficiently we need to know MAC 1, MAC 2, and MD. 2.Efficiency can require different firms to face different standards. Definition: An individual emissions standard is one that is set for a particular firm, and can be different across firms. Contrast individual emissions standards to uniform emissions standards.

13. 13 Topic 3.a: Command and Control Definition: A uniform emissions standard is one that is the same across all firms. In practice, uniform emissions standards are used much more frequently than individual emissions standards. –For instance, all firms operating in a given industry often face the same standards. Why? Uniform standards require less info to implement.

14. 14 Topic 3.a: Command and Control Example of uniform E standard. Suppose: –2 polluting firms, currently emitting 100 units of E each. –we have no info about firm’s abatement costs; but –we know that MD = E; and –we want to reduce emissions. How do we decide what to reduce E to, if we have no info about the cost side? Efficiency/cost-benefit analysis provides no guidelines.  We need to use other criteria for decision-making.

15. 15 Topic 3.a: Command and Control Policy example: In the US, emissions of air pollutants are governed by the Clean Air Act (CAA). The criteria for standard setting under the CAA is not efficiency, but “harm- based.” Standards are set so as to “limit harm to human health and the environment to acceptable levels.” Suppose in our ex above, this means that we want to reduce aggregate E by 50% (from 200 to 100). After we have picked our target level of abatement (with reference to some criteria other than economic efficiency), we now have to allocate responsibility for abatement. Recall: we have no info about abatement costs, so (again) we can’t set E standards based on efficiency.

16. 16 Topic 3.a: Command and Control What other criteria might be relevant for E standard setting? –Administrative/bureaucratic simplicity. –Minimizing uncertainty for business. –Perceptions of fairness. Each of these points to uniform E standards. So in our example, if we have decided to reduce emissions by 50%, then maybe the best we can do is to require each firm to reduce individual emissions by 50%. –That is, each firm will reduce E from 100 to 50, so that aggregate = 100.

17. 17 Topic 3.a: Command and Control Diagrammatically: Benefit of reducing emissions? –Area under MD curve = $15,000. Cost of reducing emission? –We don’t know…. BUT, doesn’t mean there are no costs. The firms must abate pollution - this is costly. –each firm has MAC curve - we just don’t know what it looks like. E = E 1 + E 2 200 100 MD 200 100 Baseline agg. E (with no reg) Agg. E once uniform standard set at 50

18. 18 Topic 3.a: Command and Control Recall the total abatement cost for a given aggregate target is minimized when marginal abatement costs are equated across sources. If sources are heterogeneous with respect to abatement costs then uniform standards are generally not a cost- effective way of implementing an emissions target, that is, the target will not be achieved at least cost. Least cost implementation of the target will require different standards for different firms. In principle, it is possible for a CAC approach to implement an aggregate emissions target at least cost if the regulator assigns to each firm an emissions target such that marginal abatement costs are equated. The problem with doing so in practice is one of limited information. The regulator generally does not know the MACs for all the sources.

19. 19 Suppose the true (but unknown) MACs are as shown below. Topic 3.a: Command and Control E1E1 E2E2 100 150 MAC 1 MAC 2 50 60 75 50 40 60 Uniform E standard With uniform E standard = 50 for each firm: TAC = TAC 1 + TAC 2 = $1250 + $1875 = $3125 Inefficient way to achieve agg. A = 100, as MAC 2 > MAC 1 If E 1  by 10 units, TAC 1  by $550. If E 2  by 10 units, TAC 2  by $675.  Overall TAC  by $125, so TAC would = $3,000 if we (somehow) reduce aggregate E to 100 efficiently.

20. 20 Topic 3.a: Command and Control Tells us uniform E standard = 50 (per firm) yields $15,000 worth of environmental benefits at cost $3,125. If we were somehow able to induce firms to reduce aggregate emissions to 100 efficiently, this $15,000 of benefit could be obtained for a cost of just $3,000.  Given the target level of emissions = 100, the efficiency loss resulting from our lack if info about MAC = $125. Q for later: Can we eliminate this efficiency loss without having any info about MAC? –We will see that we can, using a different policy

21. 21 Topic 3.a: Command and Control Exercise: Now suppose we do know the firms’ MACs in this example (use MACs from previous slide). Calculate the DWL that results from setting uniform standards = 50. –Calculate the efficient level of agg E given MACs and MD. –Compare NB of abatement at the efficient level to NB generated by the uniform E standard.

22. 22 Topic 3.a: Command and Control Summary of E standards so far: Individual E standards can achieve the efficient level of abatement as long as we (i) know MACs and MD and (ii) use individual standards. Uniform E standards will generally be inefficient (only can be efficient in the special case of identical MACs). Recall that we posed three questions (in Topic 2 Part 6) we wanted to explore with respect to policy: 1.What information does the regulator need in order to implement a particular policy? 2.What incentives to innovate (come up with new abatement technology) are associated with a particular policy? 3.Which policies create the right incentive for firms to remain operating within an industry?

23. 23 Topic 3.a: Command and Control So far, we have assumed that the MAC curve is fixed. It is possible (over time) for the MAC curve to shift down, as we come up with new technologies to reduce pollution. Discovering new technologies is costly; requires investment in research and development (R&D). Note that R&D: –Requires costs to be incurred now. –And will yield benefits in the future.

24. 24 Topic 3.a: Command and Control This is another situation in which we will need to compare current and future dollars. Questions we are interested in: 1.When is it desirable (efficient) to make R&D expenditures that will shift MAC down? 2.Does a given pollution control policy (eg, E standard) create the efficient incentive for the firm to make R&D expenditures?

25. 25 Topic 3.a: Command and Control $ MAC 1 MD MAC 2 E2E2 E1E1 E max a b c e f If MAC 1 it is efficient to set E = E 1.  NB = TB - TC = (a+b+c) - (b+c) = a If we invest $K in R&D NOW, we can permanently shift annual MAC from MAC 1 to MAC 2. If MAC 2 it is efficient to set E = E 2  NB = TB - TC = (a+b+c+e+f) - (c+f) = a+b+e PV of b+e each year forever = (b+e)/r Initially assume that the annual MAC curve is MAC 1 below. MD are also now annual MD. permanent annual increase in NB = b+e.  It is efficient to invest in R&D if (b+e)/r > K

26. 26 From the viewpoint of economic efficiency, we want the firm to adopt the new technology adopted if (b+e)/r > K. BUT, when will the firm want to adopt the new technology? Depends on the regulatory environment. Three possibilities we will consider with respect to E standards: 1.Emissions standard at E 1, (efficient level given MAC 1 ) and will remain there forever, even if new technology is adopted. 2.Emissions standard at E 1, but will be tightened to E 2 (efficient level given MAC 2 ) if new technology is adopted. 3.Emissions standard starts at E 2 and will remain there if new technology is adopted. Topic 3.a: Command and Control

27. 27 $ MAC 1 MD MAC 2 E2E2 E1E1 E max a b c d e f If MAC 1, then compliance cost of achieving E 1 is b+c. If MAC 2, then compliance cost of achieving E 2 is c. Firm will save b per year in compliance costs if it adopts the new technology. 1. Emissions standard is fixed at E 1. If the firm operates forever, then PV of saved compliance costs = b/r.  Firm will want to adopt new technology as long as b/r > K. Recall that it is efficient for the firm to adopt the new tech if (b+e)/r > K.  Firm faces too small an incentive to adopt. If b/r < K < (b+e)/r, then firm won’t choose to adopt the new technology, even though its efficient to do so. Topic 3.a: Command and Control

28. 28 $ MAC 1 MD MAC 2 E2E2 E1E1 E max a b c d e f If MAC 1, then compliance cost of achieving E 1 is b+c. If MAC 2, then compliance cost of achieving E 2 is c+f. Firm will save b-f per year in compliance costs if it adopts the new technology. 2. Emissions standard currently E 1 but will be tightened to E 2 if new technology adopted. Topic 3.a: Command and Control Firm will want to adopt new technology as long as (b-f)/r > K.  Firm faces even smaller an incentive than with fixed E standard. So also true in this case that the firm faces too small an incentive to adopt, from the viewpoint of efficiency. If (b-f)/r < K < (b+e)/r, then firm won’t choose to adopt the new technology, even though its efficient to do so.

29. 29 $ MAC 1 MD MAC 2 E2E2 E1E1 E max a b c d e f If MAC 1, then compliance cost of achieving E 2 is b+c+d+e+f. If MAC 2, then compliance cost of achieving E 2 is c+f. Firm will save b+e+d per year in compliance costs if it adopts the new technology. 3. Emissions standard starts at E 2 (technology forcing). Topic 3.a: Command and Control Firm will want to adopt new technology as long as (b+e+d)/r > K.  Firm faces a large incentive (relative to other cases). In fact, too large! Recall: efficient to adopt if (b+e)/r > K. Possible for (b+e+f)/r > K > (b+e)/r, then firm will choose to adopt the new technology, when it is inefficient to do so.

30. 30 Summary: standards on emissions don’t create the right incentive for firms to invest in abatement. A combination of emissions standards and technology standards could, however result in efficient adoption. Combination of emissions and technology standards: – If (b+e)/r > K, regulator mandates adoption of new technology and set emissions standard at E 2. – If (b+e)/r < K, regulator doesn’t require adoption of new technology and set emissions standard at E 1. Topic 3.a: Command and Control

31. 31 Makes sense that we might need two different policy instruments, as we have two policy goals: 1.Make sure the firm has the right incentive to invest in abatement cost technology. 2.Make sure the firm has the right incentive to reduce emissions, given the abatement cost technology. Topic 3.a: Command and Control