Environmental Economics
Lecture 6 and 7
Regulatory Options &
Efficiency
Goal: Generate regulatory
tools to fix environmental
problems
?
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)
It has been found predicted that global energy
use will grow by 53 per cent by 2030! But,
inspite of energy efficient and non-fossil fuel
power pushing across the world as an
alternative, the world is moving into a “dirty,
insecure and expensive” energy future!
* The solution
The problem or the solution lies not in the
availability of alternative clean fuel, but policies.
It is unless the policies are changed,
irrespective of all investments behind
producing bio-fuels, fossil fuels will
account for 83 per cent of the increase!
And carbon emissions will grow by 55
per cent in line with energy
consumption, predicted by the
International Energy Agency’s influential
World Energy Outlook 2006.
A consortium of international researchers has
found that it is only between 2000 and 2005;
emissions grew four times faster than in the
preceding 10 years! From 1990 to 1999, global
growth rates were 0.8 per cent and they reached
3.2 per cent just from 2000 to 2005!
* But, again if policies and guidelines are set,
how far can the alternative energies satisfy
both the consumption demand and the
environmental concerns?
www.greendiary.com/
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?
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?
BOD Removal, Costs of Current US
Regulations
Industry
Subcategory
Marginal Cost
Poultry
Duck-small plants
$3.15
Meat Packing
Simple Slaughterhouse
$2.19
Cane Sugar
Crystalline Refining
$1.40
Leather tanning
Hair previously removed
$1.40
Paper
Unbleached Kraft
$0.86
Poultry
Chicken – small plants
$0.25
Raw Sugar Processing
Louisiana
$0.21
Paper
NSSC – Sodium
Process
$0.12
Poultry
Chicken—large plants
$0.10
Source: Magat et al (1986); units: dollars per kilogram BOD removed
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
More Generally:
The efficient amount of pollution
$/unit
Marginal
Control
Cost
Total
Damage
Cost
Marginal
Damage
Cost
Total Control
Cost
Q*
Units of pollution
With mixed high and low cost
firms abating, we could
Either:
 Reduce more pollution for the same
amount of money…or
 Reduce the same amount of pollution for
less money.
So we always want low-cost firm to shoulder
abatement.
If costs aren’t constant: two
firms, greenhouse emissions of
Nitrogen
Abatement
Cost
($/unit)
MCA
Who should abate
the 1st unit of N?
MCB
N Reduction
How much abatement from
each?
$ (A)
Loss from equal
reduction
MCA
$ (B)
MCB
A: 0
B: 80
25
55
40
40
80
0
How did he do that?
1. Determine how much total abatement
2.
3.
4.
5.
6.
you want (e.g. 80)
Draw axis from 0 to 80 (A), 80 to 0 (B)
Sum of abatements always equals 80.
Draw MCA as usual, flip MCB
Lines cross at equilibrium
Price is MC for A and for B.
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.
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
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.
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.
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
Example 3: SO2 Allowances
1990 CAAA sought to reduce SO2
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
How big the tax or how many
We know:
permits?
– Optimal level of pollution is Q*
– Marginal Social Cost at the optimum is P*
– Marginal Private Cost at optimum is Pp.
Optimal tax exactly internalizes externality:
– t* = P* - Pp
Effectively raises MC of production
Basic Setup: Env Costs, Private Costs, Social Costs
$/unit
MSC
MPC
P*
MEC
Pp
D
Q*
Qc
Dirty Good
$/unit
MPC
(with tax)
MSC
t*
P*
MPC
(no tax)
Pp
D
Q*
Qc
Q (pollution)
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?)
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?
Incentive Based Regulation: Basic
Concepts
Up to this point, the focus has been on
resource allocation.
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.
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.
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:
Review and Summary of What we
Have Learned Today
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.
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.
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?
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 authorities
because 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-andcontrol.
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
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.
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.
Regulatory Innovations
What are some of the new
and innovative ways to
regulate environmental
protection?
Motivation
Group Project: The Clean Air Act is up for
renewal and your group project has been
tasked with coming up with new and
innovative ways of achieving the same
objectives….
– but in a more flexible and less burdensome
way.
Today’s Menu
Command-and-Control: Improving on it
– Technology standards vs. performance standards
– Bubbles
– Technology forcing
Marketable permits
– Auction initial issuance
– Freely distribute
Voluntary Approaches
– Unilateral initiatives on part of firms
– Bilateral agreements between firms and regulators
– Voluntary programs that firms may opt into
Information disclosure regulations
Banking of credits
Command-and-Control
Problems
– Failure of Equimarginal Principle
– Reduced incentives to find better ways to control problem
– Regulator needs private info from polluter – tough
Advantages
–
–
–
–
Flexibility in defining standard
Verification can be easy (is equipment in place?)
Greater certainty regarding extent of pollution
Intuitively attractive to engineers
Command-and-Control:
Innovations
Technology standards vs. Performance Standards
– Most inflexible is standards specifying type of control technology
– Somewhat more flexible are standards stipulating overall emission level
Bubbles
– Firm may have multiple plants, each subject to regulation
– Bubble allows firm to put all plants under a bubble and only count what
leaves bubble
Offsets
– New firm wants to enter polluted urban area
– Must “induce” another firm to reduce emissions, offsetting new emissions
– How is this similar/dissimilar to a marketable permit system?
Technology forcing
– Stipulate regulation that is not currently technologically feasible
– If credible, can reduce costs in long run
– Subject to manipulation through the ratchet effect
Marketable Permits--Examples
Acid Rain Allowance System (SO2)
RECLAIM in LA (NOx and SO2)
EU Carbon Trading (CO2)
Wetlands banking
Habitat Plans
Lead in gasoline phasedown
Fishing Quotas
Marketable Permits: +/Advantages
– Informational requirements can be smaller
– Provides incentives for polluters to reduce costs
– Equimarginal principle automatically satisfied
Disadvantages
– Can be difficult in complex world of spatial and temporal
variation
– Political problems associated with making firms pay more
or from setting up property rights to pollute
Marketable Permits: Innovations
Auction or free?
– Auction generates revenue for gov
– Free distribution solves major political problem
Safety Valve
– Big issue for climate is cost uncertainty
– Allow trading of permits but make available extra permits from gov at
price perhaps double expected market price
For example, for greenhouse gases, expect permits to trade for $25;
make extra permits available at $50
– What advantage does this have?
Feebates
–
–
–
–
Above average performers get subsidies for good performance
Below average performers pay penalites (fees) for poor performance
Net payments approximately zero
Provides upward pressure on performance.
Voluntary Actions: Examples
Unilateralism
– BP’s program to reduce GHG emissions
– ISO 14000 [management plan]
Bilateral Agreements
– Project XL [allows firms to violate statutes if they can show they will
achieve greater environmental performance]
Voluntary Opt-in Programs
– 33/50 Program at EPA
[33% redux of certain toxics by 1992; 50% redux by
1995, relative to 1988; firms voluntarily opt-in and agree to make the reductions]
– Conservation Reserve Program [pay subsidies to participate]
Why do firms participate in
voluntary programs?
Seems like no firm would voluntarily incur extra
costs
Reasons for undertaking
– Way of fending off non-voluntary regs
– Way of establishing a “green” image and enhancing
product marketing
– Reduce perceived environmental risk to investors, thus
reducing the cost of capital
– Social responsibility (?)
Bottom line: firms are generally assumed to still be
acting in their own self interest, broadly defined.
Information disclosure
Toxic Release Inventory (TRI) started in 1986
to provide public information about release of
toxic substances
640 chemicals
Also voluntary agreements (e.g. 33/50)
Local environmental groups use TRI to
pressure & report on industry
More info yields better economic performance.
Good starting point for new regulations.
Conclusions
Innovations in regulation is where the
action is
Marketable permits have achieved great
success and will probably continue to
expand
Voluntary approaches have had
questionable success in terms of
improving environmental performance at
reduced costs