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Economic Solutions to Environmental Problems The Market Approach Chapter 5 © 2007 Thomson Learning/South-WesternCallan and Thomas, Environmental Economics.

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Presentation on theme: "Economic Solutions to Environmental Problems The Market Approach Chapter 5 © 2007 Thomson Learning/South-WesternCallan and Thomas, Environmental Economics."— Presentation transcript:

1 Economic Solutions to Environmental Problems The Market Approach Chapter 5 © 2007 Thomson Learning/South-WesternCallan and Thomas, Environmental Economics and Management, 4e.

2 2 Overview Market approach refers to incentive-based policy that encourages conservative practices or pollution reduction strategies Difference between market approach and command-and-control approach is how each approach attempts to achieve its objectives Types of Market Instruments Pollution charge Subsidies Deposit/refund systems Pollution permit trading systems

3 Pollution Charges

4 4 Pollution Charge Fee that varies with amount of pollutants released Based on “Polluter-Pays Principle” Types of pollution charges Effluent/emission fees Product charge User charge Administrative charge

5 5 Product Charge Fee added to price of pollution-generating product, which generates negative externality Impose product charge as per unit tax on product, e.g., gas tax How does the tax on gasoline in the US compare with that of other nations? If the tax equals the marginal external cost (MEC) at Q E, it is called a Pigouvian tax

6 6 Selected International Gasoline Tax Rates NationTax Rate % of Price (2004) United States20 U.K.73 France71 Italy65 Japan50 Spain59 Source: International Energy Agency, August 13, 2004

7 7 Modeling a Pigouvian Tax $ Q of gasoline MPB = MSB MPC MSC = MPC + MEC 0 QEQE QCQC MPC t b a Amount of tax

8 8 Assessing the Model In theory, achieves an efficient outcome In practice, difficult to identify the value of MEC at Q E Allows only for an output reduction to reduce pollution

9 9 Emission (Effluent) Charge A fee imposed directly on the discharge of pollution Assigns a price to pollution Typically implemented through a tax

10 10 Model: Single Polluter Case Government sets an abatement standard at A ST Policy options to polluter are: Abate up to A ST and incur those costs OR Pay a constant per unit tax, t, on any abatement less than A ST  Total Tax = t(A ST - A O ) where A O is actual abatement level  Marginal Tax (MT) = t Because t is constant, t = MT Firm will choose the least-cost option: the marginal tax (MT) or the marginal abatement cost (MAC)

11 11 Modeling Emission Charge Single Polluter $ Abatement (A) 0 MAC MT t AOAO A ST a b c Firm abates up to Ao since MAC < MT; firm pays tax between A O and A ST, since MAC > MT in that range 0aA O = cost to abate A O A O abA ST = tax on pollution not abated up to A ST

12 12 Model: Multiple Polluter Case To facilitate comparison, we use the same model as in the uniform standard case Assumptions 2 polluting sources in some region Each generates 10 units of pollution Government sets emissions limit for region as 10 units, which implies A ST = 10 Policy: To achieve A ST, government imposes an emission charge as a unit tax (t) of $5

13 13 Model: Multiple Polluter Case Each firm responds as in the single polluter case Abates as long as MAC < MT Pays emission charge when MAC > MT Polluter 1: TAC 1 = 1.25(A 1 ) 2 MAC 1 = 2.5(A 1 )  where A 1 is pollution abated by Polluter 1 Polluter 2: TAC 2 = 0.3125(A 2 ) 2 MAC 2 = 0.625(A 2 )  where A 2 is pollution abated by Polluter 2 Find each firm’s abatement level. Then, find each firm’s total abatement costs (TAC) and tax payment at that level. Support with a graph.

14 14 Solution Polluter 1: Abates up to the point where MAC 1 = MT,  Set 2.5(A 1 ) = $5, or A 1 = 2 Incurs TAC 1 = 1.25(2) 2 = $5 Incurs Total Tax = 5(10 - 2) = $40 Polluter 2: Abates up to point where MAC 2 = MT  Set 0.625(A 2 ) = $5, or A 2 = 8 Incurs TAC 2 = 0.3125(8) 2 = $20 Incurs Total Tax = 5(10 - 8) = $10

15 Modeling An Emission Charge Multiple Polluter MAC 1 MAC 2 0 10 0 25.00 6.25 Polluter 1’s Abatement Polluter 2’s Abatement 2 8 MT = 5.00 MAC 1 MAC 2 Total Abatement Level = 10 = A s TAC 1 + TAC 2 = $25 (right triangles) Total Tax Payments = $50 (rectangles)

16 16 Assessing the Model (pros) Abatement standard is met Generates $40 in tax revenues from high-cost abater and $10 from low-cost abater Low-cost abaters do most of cleaning up Cost-effective solution is obtained MACs are equal at $5 tax rate Combined TAC of $25 is lower than $39.06 under command-and-control with a uniform standard

17 17 Assessing the Model (cons) Tax authority will not know where MACs are equal Will have to adjust rate until objective achieved Monitoring costs potentially higher Firms might evade tax by illegally disposing pollutants Distributional implications Consumers may pay higher prices due to tax Job losses may result from polluter paying new taxes and/or changing technology to abate

18 18 Pollution Charges in Practice Internationally, the pollution charge is the most commonly used market-based instrument Some countries use effluent charges to control the noise pollution generated by aircraft Others levy charges on products such as motor vehicles, pesticides, fertilizers, batteries and gasoline

19 Environmental Subsidies

20 20 Environmental Subsidies Two major types of subsidies: Abatement equipment subsidies Pollution reduction subsidies

21 21 Abatement Equipment Subsidy Defined as a payment aimed at lowering the cost of abatement technology  Goal is to internalize the positive externality associated with the consumption of abatement activities If the subsidy (s) equals the marginal external benefit (MEB) at Q E, it achieves an efficient equilibrium and is called a Pigouvian subsidy

22 22 Pigouvian Subsidy Market for Scrubbers ($ millions) MSC MPB MSB 0Q C = 200Q E = 210 P C = 170 P E = 175 Subsidy = $14 million MPB S Q of scrubbers P E – s = 161 K L

23 23 Assessing the Model It is difficult to measure the MEB May bias polluters’ decisions about how best to abate

24 24 Pollution Reduction Subsidy To implement, government pays the polluter a subsidy (s) for every unit of pollution abated below some pre-established level Z ST Per unit subsidy = s(Z ST - Z O ), where Z O is the actual level of pollution Analogous to an emission charge

25 25 Assessing the Model Might be less disruptive than an equipment subsidy Can have the perverse effect of elevating pollution levels in the aggregate since the subsidy lowers unit costs and raises profit, encouraging entry

26 26 Subsidies in Practice Environmental subsidies typically are implemented as grants, low-interest loans, tax credits or exemptions, and rebates Many countries around the world use these instruments, including Austria, Finland, Japan, and Turkey In the U.S., common uses include federal funding to build publicly-owned treatment works and subsidies to encourage the development of cleaner fuels and low- emission vehicles

27 Deposit-Refund Systems

28 28 Deposit/Refund Systems A deposit/refund system is a market instrument that imposes an up-front charge to pay for potential damages and refunds it for returning a product for proper disposal or recycling Targets the potential vs. actual polluter The deposit is intended to capture the MEC of improper waste disposal (IW) in advance Preventive vs. ameliorative

29 29 Modeling Deposit/Refund System IW disposal market MEC IW : health damages + aesthetic impairment from litter, trash accumulation, etc. MPC IW : costs to disposer (e.g., trash receptacles, collection fees, plus forgone revenue from not recycling) MSC IW = MPC IW + MEC IW MPB IW : demand for improper disposal  Assume MEB IW = 0, so MPB IW = MSB IW

30 Deposit-Refund Model $ Improper Waste Disposal (%) MPB IW = MSB IW MPC IW MSC IW 0 QEQE Q IW MPC IW + Deposit b a Deposit=MEC at Qe 100 Proper Waste Disposal (%) 0 100 Deposit converts % of overall waste disposal, measured by (Q IW - Q E ), from improper methods to proper

31 31 Assessing the Model Promotes responsible behavior Requires minimal supervision by government Can help slow the use of virgin raw materials by improving availability of recycled materials

32 32 Deposit/Refund Systems in Practice Deposit/refund systems are used worldwide Many nations use these systems to encourage proper disposal of beverage containers  In the US, 11 states have bottle bills Other applications include systems used to promote responsible disposal of used tires, car hulks, and lead-acid batteries

33 Pollution Permit Trading Systems

34 34 Pollution Permit Trading Systems A pollution permit trading system establishes a market for rights to pollute by issuing tradeable pollution credits or allowances Credits are issued for emitting below a standard Allowances indicate how much can be released Two components of the system are 1. Fixed number of permits is issued based on an “acceptable” level of pollution set by government 2. The permits are marketable Bargaining gives rise to a market for pollution rights

35 35 How Permit Trading Works There is an incentive to trade as long as polluters face different MAC levels Suppose a firm has 50 permits but normally emits 75 units of SO 2. What must it do? Answer  Abate 25 units of emissions OR  Buy 25 permits from another producer Which option will the firm choose? Answer  Whichever option is cheaper

36 36 Result Low-cost abaters will clean up pollution and sell excess permits to other firms They will sell at any P higher than their MAC High-cost abaters will buy permits rather than abate They will buy at any P lower than their MAC Trading will continue until the incentive to do so no longer exists, at which point, the cost-effective solution is obtained, i.e., the MACs across firms are equal

37 37 Assessing the Model Trading establishes the price of a right to pollute without government trying to “search” for a price No tax revenues are generated Trading system is flexible Note that an emissions standard can be adjusted by changing the number of permits issued

38 38 Pollution Trading Systems in Practice International examples Trading of greenhouse gas allowances are part of the Kyoto Protocol, an international accord aimed at global warming Canada has a trading program for ozone-depleters Denmark has one for carbon dioxide emissions Most of the evolution of trading is occurring in the U.S. An important example is the establishment of an allowance-based trading program to control sulfur dioxide emissions under the Clean Air Act Amendments of 1990

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