2. Ch. 15 Economics of Pollution Control: An Overview

3. Introduction n Two key questions: –1) What is the appropriate level of waste flow? –2) How should the responsibility of achieving this flow level be allocated among the various sources of the pollutant when reductions are needed? n We need to define efficient and cost effective allocations for pollution and compare to market allocations. n Examine policy approaches of the U.S. and world.

4. A Pollutant Taxonomy Pollutant Accumulation Pollution Damage Emissions Load Absorptive Capacity of Environment Fig. 15.1 Relationship between Emissions and Pollution Damage

5. Pollutant Taxonomy n Pollutant types: n 1) stock pollutants: environment has little absorptive capacity –examples: bottles, heavy metals (lead), persistent synthetic chemicals such as dioxin and PCBs (polychlorinated biphenyls) n 2) fund pollutants: as long as emission rate does not exceed absorptive capacity –examples: organic wastes and carbon dioxide

6. Pollutant Taxonomy n Pollutant types are also classified by zone of influence: n horizontal: –1) local: near the source –2) regional: travel great distances n vertical: –1) surface: damage occurs in near surface –2) global: damage occurs in upper atmosphere »examples: carbon dioxide may cause greenhouse effect »cholorflourocarbon emissions may cause ozone hole

7. Stock Pollutant n Efficient allocation of occurs when the present value of net benefit is maximized n Note that controlling pollution is costly!!! n Efficient quantity of resource (and the corresponding pollutant) declines over time n Price of resource rises over time n Ultimately a steady state is reached where additional pollution stops. n All further pollution is controlled through recycling

8. Fund Pollutant n Key characteristic: current pollutant only causes current damage, if emission is low n Two type of costs: n 1) Damage costs –marginal damage costs increase as pollutant increases n 2) Control costs –marginal control costs increase as more pollution is controlled –e.g. 1st precipitator controls 80%, next one controls 80% of remaining 20% (16%) for same cost

9. Quantity of Pollution Emitted Marginal Damage Cost Marginal Control Cost Q*Q* Total Damage Cost Total Control Cost Marginal Cost Fig. 15.2 Efficient Allocation of a Fund Pollutant

10. Fund Pollutant (cont.) n Optimal pollution level occurs where marginal damage cost equals marginal control cost. n Optimal pollution is not zero!!! Surprised n Do we want zero deaths on highways? n Yes, but is it optimal? No. It would cost too much--no one would be allowed on freeways. n Do we want zero crime? Yes, but is it optimal? No. It costs too much. n The total cost of control plus damage is minimized where marginal cost of control equals marginal damage cost. Can you show why?

11. Market Allocation of Pollution n Market will not provide efficient allocation of pollution due to negative externalities and poorly specified property rights. n Too much pollution, too much production of good, too low price for good.

12. Efficient Policy Responses n We could use a command and control (CAC) approach n We could tax emissions. n Cost of determining optimal pollution is high. n Alternatively we could try to meet some pollution standard at the least cost as follows. n See Ex. 15.1: Environmental Taxation in China –World Bank (1997) : if value of life is $8,000, emissions should be reduced by 79%.

13. Cost Effective Policies for Uniformly Mixed Fund Pollutants n For a given level of pollution reduction, the marginal cost of control from all sources should be equal: MC 1 = MC 2 n Be careful to note that Fig. 15.3 measures pollution reduction, not pollution emission. n Suppose you want to minimize the cost of achieving 15 units of pollution reduction. n Source 1 should reduce 10 units of pollution and firm 2 should reduce 5 units of pollution. However, this may not seem fair to firm 1.

14. 1514131211109876543210 MC 1 MC 2 Quantity of Emissions Reduced Source 1 Source2 Fig. 15.3 Cost Effective Allocation of a Uniformly Mixed Pollutant T= AB

15. Cost Effective Policies for Uniformly Mixed Fund Pollutants n Note that a relatively equal reduction of pollution would not be efficient. Suppose Firm 1 reduces 7.5 units of pollution where marginal cost is 15 cents and Firm 2 reduces an equal amount (7.5 units) at a marginal cost of 90 cents. n This is inefficient. If we let firm 1 control one more unit and firm 2 control one less unit, firm 1 could control another unit at a cost of roughly 20 cents and firm 2 would save 90 cents. n Thus society would save 70 cents.

16. Cost Effective Policies for Uniformly Mixed Fund Pollutants n How can the EPA determine the cost effective pollution control policy if it can not determine the Marginal Control Costs for each firm? n Emission standard: these will require each firm to reduce pollution the same amount, but this is inefficient as shown in Fig. 15.3 n Emission Charges: charge each firm a per unit pollution fee. Then each firm will determine the amount of pollution reduction up until the point where the fee equals the marginal cost of control.

17. MC 1 Quantity of Emissions Controlled Fig. 15.4 Cost Minimizing Control of Pollution with an Emission Charge T= AB DC

18. Emission Charges n At an emission charge of T= $0.30, how much pollution will firm 1 control in order to minimize the cost of control plus fees? n It will control 10 units because the marginal cost of control is equal to the fee. n If it controlled the 11th unit it would cost $0.38 but would only save $0.30 (by not paying charge), thus it should not control the 11th unit. n If the firm controlled none of its pollution it would pay OTBC in fines.

19. MC 1 Quantity of Emissions Controlled Fig. 15.4 Cost Minimizing Control of Pollution with an Emission Charge T= AB DC

20. Emission Charges n But if it controlled 10 units, and did not control the remaining 5 units, its total costs would be OABC, a smaller amount than the fees (with no control) OTBC. This cost has 2 parts, the control cost, OAD, for the 10 units controlled and the fees, ABCD, for the five units not controlled. n Amazingly, each firm will control the optimal amount. Firm 1 will control 10 units and firm 2 will control 5 units. Since the per unit fee is the same, no one is likely to complain that the emission charge system is unfair.

21. MC 1 Quantity of Emissions Controlled Fig. 15.4 Cost Minimizing Control of Pollution with an Emission Charge T= AB DC Pollution Control Costs for 10 units controlled Pollution Charges for 5 units not controlled

22. Emission Charges n The EPA may not know the appropriate charge to set at first. It may have to lower it or raise it to get the desired level of control. n The charge system not only causes sources to choose a cost-effective allocation of control responsibility, it also encourages technological innovation. Why? n With emission standards, firms have incentive to hide new methods for fear of forced implementation by the EPA. With the charge system, they can reduce their costs with technol.

23. MC 0 T Q 0 =Q* Q1Q1 $/unit Quantity of Emissions Reduced MC 1 Fig. 15.5 Cost Savings from Technological Change: Charges versus Standards Savings due to lower control costs on Q 0 units A Savings due to controlling Q 1 -Q 0 units at a lower cost than the charge formerly paid B

24. Transferable Emission Permits n Is it possible for the EPA to find the cost- minimizing allocation without going through a trial and error process? Yes, with a transferable emission permit system. n EPA can issue a number of permits equal to the optimal level of pollution. n The permits are freely tradable.

25. Transferable Emission Permits n Suppose each firm is currently emitting 15 units of pollution. n Suppose firm 1 receives 7 emission permits, implying that it must clean up 8 units of pollution. n Suppose firm 2 receives 8 emission permits, implying that it must clean up 7 units of pollution. n Since firm 2’s marginal control cost is much higher than firm 1’s, it will be profitable to buy some of firm 1’s permits.

26. Transferable Emission Permits n In Fig. 15.6, Firm 1 could sell a permit to firm 2 for maybe $0.60. Firm 1 must now control a unit of pollution at a cost of $0.25, thus gaining $0.35. Firm 2 would not have to spend $0.90 to control the 7th unit and would spend only $0.60, thus gaining $0.30. This is mutually beneficial trade. n These trades will continue until the marginal control costs are equal. Firm 1 will sell 2 permits to firm 2 and society uses less resources to obtain the goal of 15 units of pollution (half the original level of 30).

27. 1514131211109876543210 MC 1 MC 2 Quantity of Emissions Reduced Source 1 Source2 Fig. 15.6 Cost Effectiveness and the Emission Permit System B A C

28. Cost-Effective Policies for Nonuniformly Mixed Surface Pollutants n Problems become more complicated with nonuniformly mixed pollutants. n Location matters. Polluters closer to receptor cause more damage than ones farther away. n Notation: a i = transfer coefficient, the amount the concentration at the receptor will rise if source “i” emits one unit of pollution.

29. Stream Flow D DA D C B R Fig. 15.7 Effect of Location on Local Pollutant Concentration

30. Cost-Effective Policies for Nonuniformly Mixed Surface Pollutants: Single Receptor Case n Problems become more complicated with nonuniformly mixed pollutants. n Location matters. Polluters closer to receptor cause more damage than ones farther away. n Notation: a i = transfer coefficient, the amount the concentration at the receptor will rise if source “i” emits one unit of pollution. n assume a 1 =1.0 and a 2 = 0.5; firm 1 is closer so it has higher transfer coefficient.

31. MC 1 =MC 2

32. Cost-Effective Policies for Nonuniformly Mixed Surface Pollutants: Single Receptor Case n Suppose the concentration needs to be reduced 7.5 units at the receptor. n The cost-effective allocation would be achieved when the marginal costs of concentration reduction (not emission reduction) are equalized. n This occurs when source 1 reduces emissions 6 units (6 units of concentration) and source 2 reduces emissions 3 units (1.5 units of concentration). Marginal cost of concentration reduction is $6 for both sources

33. Policy Approaches n use ambient charge: n t i = a i F, where t i is the per unit charge paid by the ith source on each unit emitted, a i is the transfer coefficient, and F is the marginal cost of a unit of concentration reduction. Source 1 pays $6 per unit of pollution, source 2 pays $3 per unit. n Note that sources will, in general, pay different charges when the objective is to meet an ambient standard at minimum cost because their transfer coefficients differ.

34. Policy Approaches n use ambient permit system: n ambient permit system allows the owner to cause concentration to rise at the receptor by a specified amount, rather than allowing the same amount of emission to each owner. n  K R /a i =  E i where  K R represents the the permitted rise at the receptor and  E i represents the units of emissions allowed. n A larger transfer coefficient implies a smaller amount of emissions for any given permit.

35. Other Policy Dimensions n The Revenue Effect: –Taxes and auctioned permits raise revenues, but permits allocated free to user do not. –Does this effect matter? Yes for 2 reasons. »1) revenues could be used reduce distortionary taxes »2) Political feasibility: difficult to gain support for environ. regulations if the permits are not given freely. n Ex. 15.3 Swedish nitrogen charge. –If everyone gets revenue back, they have little incentive to reduce pollution –Swedish Tax is based on emissions, but revenues are rebated based on energy output –Gives incentives to produce most output per unit of pollution.

36. Response to Changes in Regulatory Environment n Two main pollution control policy instruments rely on economic incentives: n 1) Charges n 2) transferable permits n major difference is that charges will need to be adjusted in trial and error process to reach efficient pollution control level while the permit system immediately achieves it. n Other important differences: n 1) growth in number of sources; 2) inflation; 3) technological progress

37. 1) growth in number of sources n Under fee system, each firm will still control its optimal amount of pollution, but more firms exist, so more pollution will result. n Under permit system, demand for fixed number of pollution permits will rise, so will their market price. But pollution will remain the same. n Conclusion: permit system is better under growth in number of sources.

38. 2) inflation n Under fee system, each firm will control less pollution because the real price of the fee has declined. n Under permit system, demand for fixed number of pollution permits will rise, so will their nominal market price. But pollution will remain the same. n Conclusion: permit system is better under inflation

39. 3) technological progress n Under fee system, each firm will control more pollution because marginal cost of control is less. n Under permit system, demand for fixed number of pollution permits will decrease, so will their nominal market price. But pollution will remain the same. n Conclusion: fee system is better under technological progress

40. Instrument Choice Under Uncertainty n Charges are preferable when control costs are more important. n Under permit system, there is more certainty regarding quantity of pollution. Permits are preferred when the costs of being wrong are more sensitive to changes in the quantity of emission than to changes in the marginal cost of control.

41. Instrument Choice Under Uncertainty n When the marginal damage curve is steeply sloped and the marginal cost curve is rather flat, certainty about emissions is more important than certainty over control costs. n Thus, permit system will be preferable because it prevents less fluctuation in damage costs.

42. Instrument Choice Under Uncertainty n When the marginal control cost curve is steeply sloped and the marginal damage curve is rather flat, certainty about control costs is more important than certainty over emission levels. n Thus, charge system will be preferable because it prevents less fluctuation in control costs.

43. Pollution 0 $ MB MD 0 Permit is preferable: MD is steeper than MB’ MB MB’ true MD Z* Permit Z Welfare loss w/ permit Charge t Z’ Welfare loss w/ charge Charge is preferable: MB’ is steeper than MD MD MB MB’ true Z* Permit Z Welfare loss w/ permit a b t Z’ Welfare loss w/ charge d e a b e c d c

44. Product Charges: Another Form of Environmental Taxation n Sometimes it is difficult to measure pollution emissions. n An indirect method of charging pollution is to charge the product, e.g. gasoline tax n Ex. 15.4: The Irish Bag Levy –15 cent tax on plastic bags in 2002 –95% reduction in plastic bag use –Used cloth “bags for life”

45. Ch. 15 Problem 1a n Suppose MC 1 = $200q 1 and MC 2 = $100q 2, where q 1 and q 2 are, respectively, are the amounts of emission reduced by firms 1 & 2. Assume that both firms are emitting 20 units. What is the cost effective allocation of control responsibility to reduce 21 units? –1) set MC 1 = MC 2 or $200q 1 = $100q 2 –2) q 1 + q 2 = 21 –3) solve 1st eqn to get q 1 = 0.5 q 2 –4) insert into step 2 to get 0.5q 2 + q 2 = 21 –5) q 2 = 21/1.5 = 14 –6) q 1 = 7

46. Ch. 15 Problem 1b n Suppose a 1 = 2.0 and a 2 = 1.0, where a 1 and a 2 are, respectively, transfer coefficients for firms 1 & 2. Assume the desired ambient standard is 27 ppm. What is cost effective allocation of control responsibility? –1) set MC 1 /a 1 = MC 2 /a 2 or $200q 1 /2 = $100q 2 /1 –2) a 1 (20-q 1 ) + a 2 (20-q 2 ) = 27 – or 2(20-q 1 ) + 1(20-q 2 ) = 27 – 3) solve 1st eqn to get q 1 = q 2 –4) insert in step 2 to get 2(20-q 1 ) + 1(20-q 1 ) = 27 –5) 40 -2q 1 + 20 - q 1 = 27 ; 3q 1 = 33 –6) q 1 = 11; q 2 = 11

47. The End