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

2. Why regulate? 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)

3. Types of questions in regulation 1.What is the “optimal” amount of pollution? 2.To reduce by X%, who should reduce and by how much? 3.What regulatory instrument(s) should be used to achieve that level?

4. 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?

5. BOD Removal, Costs of Current US Regulations IndustrySubcategoryMarginal Cost PoultryDuck-small plants$3.15 Meat PackingSimple Slaughterhouse$2.19 Cane SugarCrystalline Refining$1.40 Leather tanningHair previously removed$1.40 PaperUnbleached Kraft$0.86 PoultryChicken – small plants$0.25 Raw Sugar ProcessingLouisiana$0.21 PaperNSSC – Sodium Process$0.12 PoultryChicken—large plants$0.10 Source: Magat et al (1986); units: dollars per kilogram BOD removed

6. 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

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

8. Recall example from 1 st week 60 firms, each pollute 100 tons 30 low abatement cost ($100/ton) 30 high abatement ($1000/ton) Everyone reduces 1 ton: Cost=$33,000 Total reduction = 60 tons. For same cost how many tons could we have reduced?

9. 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.

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

11. How much abatement from each? MC A MC B 0 0 40 80 $ (A) $ (B) 25 55 A: B: Loss from equal reduction

12. How did he do that? 1.Determine how much total abatement you want (e.g. 80) 2.Draw axis from 0 to 80 (A), 80 to 0 (B) 3.Sum of abatements always equals 80. 4.Draw MC A as usual, flip MC B 5.Lines cross at equilibrium 6.Price is MC for A and for B.

13. 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.

14. 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

15. 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.

16. 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.

17. 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.

18. 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

19. Example 3: SO 2 Allowances 1990 CAAA sought to reduce SO 2 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

20. SO2 Allowance Prices, 1994--2002

21. 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 P p. Optimal tax exactly internalizes externality: t* = P* - P p Effectively raises MC of production

22. $/unit Dirty GoodQcQc MSC MPC MEC Q* P* PpPp D Basic Setup: Env Costs, Private Costs, Social Costs

23. $/unit Q (pollution)QcQc MSC MPC (no tax) Q* P* PpPp MPC (with tax) t* D

24. 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?)

25. 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?