Lecture 4 ECON4910 Environmental Economics Brief summery of previous lectures:
Lecture 1: • Ch. 4 Welfare economics and the environment – Efficiency – Public goods – Externalities Lecture 2: • How to solve external effects by Coasian bargaining – Coase (1960)
Econ 4910 – Spring 2016 – Ingrid Hjort
Lecture 3 and 4:
• Ch. 5 Pollution targets «How do we decide the optimal level of pollution?»
• Ch. 6 Pollution instruments «How can we achieve these targets?»
– Montgomery (1975): Market in licenses – Bård’s blackboard-model: Tax and double dividend
CHAPTER 5
Pollution control: targets
What is the efficient level of pollution?
The Damage function: DDM ()
The Benefit function: BBM ()
n Where M is aggregate emission flow Mm i of all emission sources: i1
• Total damage is thought to rise at an increasing rate, with the size of the emission flow. The more emissions thus more harm on nature. Convex • Total benefits will rise at a decreasing rate as more emissions are used in production, assuming decreasing marginal productivity. Concave What is the efficient level of pollution?
Evaluate the trade-off between benefits from producing more private goods to the increased damage on public goods. Stricter pollution targets will generate benefits but will also generate costs.
Max social net benefit: maxNB B ( M ) D ( M ) M
• Marginal damage of pollution: The harm/reduction of the public environment from one extra unit of pollution.
• Marginal benefit of pollution: The benefits from using one extra unit of pollution to produce private consumption goods.
Figure 5.2 Total and marginal damage and benefit functions, and the efficient level of flow pollution emissions
D(M) B(M) DM()
BM()
Maximised net benefits
Emissions, M
DM'( )
* B
A BM'( )
ˆ M* M Emissions, M Comment to figure 5.2 The efficient level of pollution
The Nash equilibrium: Where marginal damage equal marginal benefits
The trade off is optimized at the point where the marginal benefits of pollution equal the marginal damage from pollution.
DMBM'( ) '( ) There exist different types of pollution problems I
1. Flow-damage pollution: the damage depend on the rate of the emission flow alone. That is, the instant rate at which they are being discharged into the environmental system.
2. Stock-damage pollution: damages depend only on the stock of pollution in the relevant environmental system at any point in time. Stock pollutants accumulate in the environment over time. Stock pollutants are persistent over time, and may be transported over space, two dimensional.
Pollution flows and pollution stocks
• The static flow pollution model: (noise, light, smell, smoke) These problems have no time dimension, the pollution stops when the emissions stops. Flow-damage pollution: D = D(M) (5.1a)
• The stock pollution problem: Emissions (M) accumulate and create a stock (A) of a harmful substance. Stock-damage pollution: D = D(A) (5.1b)
Stock pollutants can create a burden for future generations by passing on damage that persists well after the benefits received from incurring that damage have been forgotten.
The distinction between flows and stocks becomes crucial for two reasons
First, This distinction enables us to understand the science lying behind the pollution problem and translate this into economic models.
Second, The distinction is important for policy purposes.
While the damage is associated with the pollution stock, that stock is outside the direct control of policy makers. Environmental protection agencies may, however, be able to control the rate of emission flows. Even where they cannot control such flows directly, the regulator may find it more convenient to target emissions rather than stocks. Given that what we seek to achieve depends on stocks but what is controlled or regulated are typically flows, it is necessary to understand the linkage between the two.
There exist different types of pollution problems II
3. Uniformly mixing: the damage depends upon the total amount of the pollutant entering the system, independent of geographical location, e.g., green house gases
4. Non-uniformly mixing: the damage is relatively sensitive to where emissions are injected into the environmental system. The concentration rate of the pollutant vary from place to place Uniformly mixing
• By definition, the location of the uniformly mixing (UM) emission source is irrelevant – All that matters, as far as concentration rates at any receptor are concerned, is the total amount of those emissions.
• Mixing of a pollutant refers to the extent to which physical processes cause the pollutant to be dispersed or spread out.
• A pollutant is uniformly mixing if the pollutant quickly becomes dispersed to the point where its spatial distribution is uniform. – That is, the measured concentration rate of the pollutant does not vary from place to place. – This property is satisfied, for example, by most greenhouse gases.
• Policy: Focus on minimizing the total pollution level, finding the cost effective allocation of responsibility.
Non-uniformity • Where pollutants are not uniformly mixing, location matters.
• Non-unifority is of importance as many types of pollution fall into this category. Examples: – Ozone accumulation in the lower atmosphere – Local air pollution: • particulate pollutants from diesel engines and trace metal emissions • Oxides of Nitrogen and Sulphur in urban airsheds – Some local water and ground pollutants do not uniformly mix
• Complicates the policy problem: Total emissions is no longer the sole source of concern, must also consider the emissions site and its impact on concentration levels at other sites. How should emission targets from various sources be calculated?
CHAPTER 6
Pollution control: instruments
The target The target: the emission target should be set such that the aggregate marginal benefit from emissions equals the aggregate marginal damage
MB MD
The instrument
The instrument: should be cost-efficient. – The cost of achieving a given reduction in emissions will be minimized if and only if the marginal costs of emission reduction are equalized for all emitters
One important criteria: Cost efficiency
• The use of cost-effective instruments is necessary to achieve an economically efficient allocation of resources.
• Suppose a list is available of all instruments which are capable of achieving some predetermined pollution abatement target. – If one particular instrument can attain that target at lower real cost than any other can then that instrument is cost-effective.
• Using a cost-effective instrument involves: – Allocating the smallest amount of resources to pollution control, conditional on a given target being achieved. – It has the minimum opportunity cost.
Least-cost theorem
The least cost theorem: A necessary condition to achieve abatement at least cost. The marginal cost of abatement is equalized over all polluting firms (equimarginal principle) – Abatement: Emission reduction
• Focus on abatement effort: polluters that can abate at least cost.
• This result is known as the least-cost theorem of pollution control.
• Illustrated in next figure
Example I: different marginal abatement cost
Marginal abatement cost (MAC)
caBB'( )
caAA'( )
a Pollution abatement
Production yi f i() m i
Abatement ammiˆ i i ˆ Cost of abatement ci()()() a i f i m i f i m i caii'( ) 0 Abatement: emission reduction compared to baseline Abatement cost: decreased production due to decreased inputs Example II: equal marginal abatement cost
The social planner will k minc ( ai ) s . t M M * minimize total abatement cost m i i1 for all firms, given the target
ci()()() a i f i mˆ i f i m i
k mMj i1
kk ˆ f()()* mi f m i m i M ii11
Show that the least cost theorem holds, i.e., the shadow price of emission reduction equals across firms Least-cost theorem: conclusions
• A least-cost control regime implies that the marginal cost of abatement is equalized across firms undertaking pollution control.
• A least-cost solution will in general not involve equal abatement effort by all polluters.
• Where abatement costs differ, cost efficiency implies that relatively low-cost abaters will undertake most of the total abatement effort, but not usually all of it.
Instruments for achieving pollution abatement targets
1) Voluntary approaches 2) Command and control 3) Economic incentive based instruments 1) Voluntary approaches Bargaining solutions • In a classic paper, Ronald Coase (1960) explored the connection between property rights and the likelihood of efficient bargaining solutions to inefficient allocations of resources. – well defined and enforceable allocation of property rights. – No transactions costs. • Bargaining may lead to some abatement as every consumer is willing to pay up something to avoid emissions...... but not enough to reach the social optimum, since the environment is a public good, causing free-rider problems Liability • The judicial system may help to bring about efficient outcomes – An implicit assumption in the discussion of bargaining, enforcement of the contract • Liability can be used to deal with environmental hazards, by incentivize the efficient level of precautionary behavior • Suppose: a general legal principle is established, making agents liable for the adverse external effects of their actions
The challenges with climate change
• The absence of supra-national sovereign institutions makes it difficult to legally enforce the Coasian-bargaining solutions (global climate treaties)
• Compensation: How can we determine whose emissions are causing what damages
• Use of liability face a difficulty where damage appear long time after the relevant pollutants were discharged (such as climate change). How to track down those who are liable? Those responsible – individuals or firms – may no longer exist… – Related to this is a wider class of pollution problems in which actions undertaken in earlier times, often over decades or even centuries, leave a legacy of polluted water, land, or biological resources. – Even if one could identify the polluting culprits and apportion blame appropriately, it is not clear whether an ex post liability should be imposed. 2) Command and control instruments
• The dominant method of reducing pollution in most countries has been the use of direct controls over polluters. – This set of controls is commonly known as command and control instruments.
• Examples: prohibitions, restrictions, production standards
Attractive Properties • Certainty of outcome • Ability to get desired results very quickly.
Unattractive Properties • Likely to be cost-inefficient, contain no mechanisms to bring about: – equalization of marginal abatement costs over the controlled firms in that programme. – equalization of marginal abatement costs across different programmes • Lack good dynamic incentives
Example: Command and control policy
Firms differ in technology, but faces the same cap Each firm maximize profit given maxif i ( m i ) K i s . t . m i m the «command and control»-cap mi imposed by the government:
fi()() m i K i i m i m
The shadow price is no longer fm'( ) equal for all firms, this instrument i i i is not cost effective.
If the government has all information about each firm’s marginal abatement cost function, an individual cap can be imposed on all firms. This would be a cost effective instrument. (Is this feasible?) Command and control
• Required technology controls sometimes blur the pollution target/pollution instrument distinction we have been using.
• The target actually achieved tends to emerge jointly with the administration of the instrument.
• Sometimes government sets a general target (such as the reduction of particulates from diesel engines by 25% over the next 5 years) and then pursues that target using a variety of instruments applied at varying rates of intensity over time.
• Although technology-based instruments may be lacking in cost-effectiveness terms, they can be very powerful; they are sometimes capable of achieving large reductions in emissions quickly, particularly when technological ‘fixes’ are available but not widely adopted.
• Technology controls have almost certainly resulted in huge reductions in pollution levels compared with what would be expected in their absence.
3) Economic incentive instruments
• Incentive-based instruments work by altering the structure of pay-offs that agents face, thereby creating incentives for individuals or firms to voluntarily change their behavior.
• The pay-off structures are altered by changing relative prices.
• This can be done in many ways. 1. By the imposition of taxes on polluting emissions (or on outputs or activities deemed to be environmentally harmful) 2. By the payment of subsidies for emissions abatement (or reduction of outputs or activities deemed to be environmentally harmful) 3. By the use of tradable emission permit systems in which permits command a market price. Those prices are, in effect, the cost of emitting pollutants
• More generally, any instrument which manipulates the price system in such a way as to alter relative prices could also be regarded as an incentive-based instrument.
Example: Economic incentive instrument
• Emission quota: maxif i ( m i ) K i p ( m m i ) m p is the price of quotas i
maxif i ( m i ) K i m i • Tax on emissions mi
• Quotas and taxes equalize if p
maxif i ( m i ) K i s ( mˆ m i ) • Subsidize abatement mi
• Taxes and subsidies are equivalent if s
An economically efficient emissions tax Marginal damage (before tax) DM'( ) (after tax)
Marginal benefit * of emissions B'(M )
M * M BAU emissions, M
The economically efficient level of emissions abatement Marginal cost of abatement ca'( )
Marginal benefit of abatement
a** MBAU M a abatement, a Key result: Taxes/subsidies are cost-efficient policy instruments • The instrument (τ*) – brings about a socially efficient aggregate level of pollution – Achieve the target in a cost-effective way. – Cost-efficiency requires that the marginal abatement cost is equal over all abaters. – Under the tax regime all firms adjust their firm-specific abatement levels to equate their marginal abatement cost with the tax rate. – As the tax rate is identical for all firms, so are their marginal costs. • Knowledge of both the aggregate marginal pollution damage function and the aggregate emissions abatement cost function are necessary for achieving a socially-efficient emissions target at least real resource cost to the economy as a whole. – But it is not necessary to know each firm’s marginal abatement cost function.
• For any emission tax/abatement subsidy, some – probably unknown – amount of emissions reduction would be obtained. – However, as all controlled firms will reduce emissions up to the point where marginal abatement costs are brought into equality with this tax/subsidy rate, marginal abatement costs are equalized and so emissions reduction is achieved at least cost. – Whatever level of abatement is generated would be attained at minimum feasible cost.
Tradable emissions permits
• Marketable permit systems are based on the principle than any increase in emissions must be offset by an equivalent decrease elsewhere.
• There is a limit on the total quantity of emissions allowed
• The regulator does not attempt to determine how quotas are allocated among firms, because they trade until the equilibrium is met.
• However, initial allocation must be determined • Allocate the quotas for free = subsidizing • Firms have to bargain over quotas: may give distributional effects All the way, through out this lecture, we have implicitly assumed perfect information and full understanding of the damages and benefits from pollution.
What about policy regulations under imperfect information?
Readings to next lecture: Weitzman (1974) Prices vs. Quantities Appendix and further reading to lecture 4 Efficient flow-damage pollution Pollution damage depends directly on the level of emissions
5.5 A static model of efficient flow pollution
• Emissions have both benefits and costs. • We call the costs of emissions ‘damages’. • These damages can be thought of as a negative (adverse) externality. • For simplicity, we suppose that damage is independent of the time and the source of the emissions, and that emissions have no effect outside the economy being studied. We relax these assumptions later.
• An efficient level of emissions is one that maximises the net benefits from pollution, where net benefits are defined as pollution benefits minus pollution damages. This is now Figure 5.3 Criteria for choosing emission control instruments Table 6.2 Classification of pollution control instruments
Instrument category
Institutional approaches to facilitate internalisation of externalities
Command and control instruments
Economic incentive (market- based) instruments Instrument category Description
Institutional approaches to facilitate internalisation of externalities
Facilitation of bargaining Cost of, or impediments to, bargaining are reduced Specification of liability Codification of liability for environmental damage Development of social responsibility Education and socialisation programmes promoting ‘citizenship’ Instrument category Description
Command and control instruments Input controls over quantity and/or mix of Requirements to use particular inputs, or inputs prohibitions/restrictions on use of others Technology controls Requirements to use particular methods or standards Output quotas or prohibitions Non-transferable ceilings on product outputs Emissions licences Non-transferable ceilings on emission quantities Location controls (zoning, planning Regulations relating to admissible location controls, relocation) of activities Instrument category Description
Economic incentive (market- based) instruments Emissions charges/taxes Direct charges based on quantity and/or quality of a pollutant User charges/fees/natural resource taxes Payment for cost of collective services (charges), or for use of a natural resource (fees or resource taxes) Product charges/taxes Applied to polluting products
Emissions abatement and resource Financial payments designed to reduce management subsidies damaging emissions or conserve scarce resources Marketable (transferable, marketable) Two systems: those based on emissions emissions permits reduction credits (ERCs) or cap-and-trade Deposit-refund systems A fully or partially reimbursable payment incurred at purchase of a product Non-compliance fees Payments made by polluters or resource users for non-compliance, usually proportional to damage or to profit gains Performance bonds A deposit paid, repayable on achieving compliance Liability payments Payments in compensation for damage • The target: the emission target should be set such that the aggregate marginal benefit from emissions equals the aggregate marginal damage
MB MD
• The efficient level of emissions: the marginal abatement cost should equal the total willingness to pay for a marginal improvement of environmental policy
MAC WTP Preferences How much are U u(,) yi E consumers u'( y ) dy u '( E ) dE 0 Total derivative willing to pay ii for a marginal uE'( ) How much you are willing to give up of dyi dE the private good to achieve a marginal improvement uy'(i ) improvement of the public good in the public zm() Some damage function good of E E0 z() m Environmental quality environment? dE zm'( ) dm Firm’s production yii f() m uE'( ) f'( m ) z '( m ) uy'(i ) B'( M ) f ( m ) Marginal benefits from emissions uE'( ) D'( M ) z '( m ) Marginal damage from emissions uy'(i )