Exam: March 29 All the readings Slides / lectures (including today’s lecture

Reminder: Homework #1 How manageable and practical do you think an international market for trading emissions of CO2 would be? What major obstacles to a smooth functioning of such a market could you foresee? And what major obstacles to such a market do already exist – given that the market does exist? What would be the advantages of such a market if it worked? Plus: how successful is the market in the ultimate end goal? By Tuesday – March 22 (via . By 8 am.) A paper – in which you answer those questions 2

Methodology Missing from Tobacco and Cucumbers Ms Amal Salibi would answer your questions. She has all the statistical figures, and she's an agricultural economist. Her office phone nb is:

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Economic growth and sustainability Growth of economic activity: / growth of human impacts on the environment: Population Growth: Each individual has certain basic needs for food, water, and living space, so a large population will generally have a higher resource requirement and higher environmental impact. Economic Growth: As per capita income rises, each individual tends to consume more, increasing resource demand and waste production. From Growth to sustainable development IPAT -> I = P*A*T 9

IPAT equation the environmental impact I of human economic activity P: the population involved in the activity; A: the affluence factor, which represents the standard of living of this population –usually measured by an indicator of income or consumption per capita; T: the technological factor, indicating the environmental impact per unit of income. considering CO2 emissions in the atmosphere, the global impact I is the total amount of emissions which is the product of: the #of people P * the affluence factor A which can be measured by the amount of energy use per person * the technological factor T which measures the amount of CO2 released in the atmosphere for each unit of energy produced and consumed. 10

Sustainable development Difference between strong and weak sustainability Weak -> any loss of natural capital should be balanced by creation of new capital of at least equal value. a developing nation could cut down its forests, replacing them with plantations and sawmills, or destroy its natural fisheries and replace them with aquaculture facilities where fish are raised in pens for human consumption. This would meet the definition of weak sustainability, provided that the productive value of the new facilities was at least equal to that of the former natural systems. 11

Sustainable development Strong -> natural systems should be maintained intact wherever possible. They identify critical natural capital -- such as water supplies -- as resources which must be preserved under all circumstances. In this view, for example, maintaining the natural fertility of the soil is essential -- even if it is possible to compensate for degraded soils with extra fertilizer. 12

Precautionary principle - we should not risk environmental damage which could permanently harm our own society or future generations. when there is any risk of a major disaster, no action should be permitted that increases the risk. If, as so often happens, an action promises to bring substantial benefits together with some risk of a major disaster, no balancing of benefits against risks is to be allowed. Any action carrying a risk of a major disaster must be prohibited, regardless of the costs of prohibition. 13

Precautionary principle could be applied to atmospheric emissions which result in ozone depletion or unpredictable climate change, the release of long-lived chemicals or bioengineered organisms into the environment, or the creation of long-lived nuclear wastes. Thus: tied to? Discount rate Perception of risk / risk assessment 14

FYI: Libertarian principle risks are unavoidable, that no possible course of action or inaction will eliminate risks, a prudent course of action must be based on a balancing of risks against benefits and costs. In particular, when any prohibition of dangerous science and technology is contemplated, one of the costs that must be considered is the cost to human freedom Back to precautionary principle 15

Discount rate (again) rate at which society as a whole is willing to trade off present for future benefits. Who is ‘society’? Reasons for discount rate 1.a dollar received today is considered more valuable than one received in the future [what is the assumption here?] 2.positive rates of inflation diminish the purchasing power of dollars over time. 3.dollars can be invested today, earning a positive rate of return. 4.there is uncertainty surrounding the ability to obtain promised future income 5.humans are generally impatient and prefer instant gratification to waiting for long-term benefits 16

Calculating – w discount rate Discount rates are used to compress a stream of future benefits and costs into a single present value amount. Thus, present value (PV) is the value today of a stream of payments, receipts, or costs occurring over time, as discounted through the use of an interest rate. PV calculations of B and C are then compared to determine benefit- cost ratios. For example, if the PV of all discounted future benefits of a restoration project is = $30 million and the discounted PV of project costs = $20 million, the BC ratio would be 1.5 ($30 million / $20 million), and the net benefit would be $10 million ($30 million — $20million). Thus positive economic returns to society. 17

DR equation PV = FV / ( 1+i) n Where PV = the present value of a benefit or cost, FV = its future value, i = the discount rate n = the number of periods between the present and the time when the benefit or cost is expected to occur. Assume that a future benefit of a salmon habitat restoration project is an expanded catch valued at $10,000,000 in Year 10. Here is how we would calculate the present value of that benefit, assuming a 3 % discount rate. PV = $10,000,000 / (1+.03) 10 = $10,000,000 / 1.34 = $7,440,940 18

More on discount rate - the inverse of compound interest. Whereas compounding measures how much present-day investments will be worth in the future, discounting measures how much future benefits are worth today. What rate to use? The National Oceanic and Atmospheric Administration (NOAA) recommends using the social, or consumer, rate of time preference for discounting interim service losses and restoration gains when scaling compensatory restoration (NOAA 1999). NOAA has adopted a 3.0 percent discount rate Since 1992, the US federal Office of Management and Budget (OMB) has recommended a 7 percent real discount rate for the analysis of federal programs. The OMB notes that “this rate approximates the marginal pretax rate of return on an average investment in the private sector” 19

Eco-centric discount rate Ecological economists on the discount rate: - presumption that a unit of something is worth more to an individual today than years from now to the presumption that this would also be true if it were different individuals at different points in time. To avoid this individualistic presumption, economists have suggested using rates of social time preference, which reflect how much an existing society would discount the same society's benefits in the future. The problem with even this social concept is that it places the members of the present society in a position of dictating the legacy to be passed to the future, with the weighting of future generations' welfare less than the current generations'. A discounting procedure consistent with sustainability goals could be as follows. In making decisions over the management of ecosystems, those changes that would enhance or degrade the human life support capacity of the ecosystem, in the sense of providing for basic physical and biological needs would not be discounted at all; i.e., have a zero discount rate. Those ecosystem changes that impacted welfare above the threshold basic needs level would be discounted, but at the social rate of discount (Mikesell, 1977). 20

Risk assessment Back to precautionary principle. What do we know about risk? 21

Hazard “the potential to cause harm” Can be defined as “a property or situation that in particular could lead to harm” Risk A more difficult concept to define Used to mean “chance of disaster” In the process of risk assessment, most commonly means: ‘the combination of the probability, or frequency, of occurrence of a defined hazard and the magnitude of the consequences of the occurrence.” Risk = Severity x Likelihood Risk assessment the evaluation of the degree of harm or danger from some condition such as exposure to a toxic chemical - either quantitatively or qualitatively The process of determining an expected annual mortality Carried out to examine the effects of an agent on: Humans (health risk assessment) Ecosystems (ecological risk assessment) 22

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Risk assessment - again Risk = Severity x Likelihood a technical, four-step procedure: Hazard identification. What is the potential source of danger? For example, does a waste incinerator emit highly toxic dioxins or other hazardous chemicals? Assessment of human exposure. Are any human populations exposed to this hazard? If so, can the various routes or pathways of the hazardous substance to specific organs or tissues of human bodies be traced? Finally, how much (what dosage) of this substance enters these human bodies? Modeling of the dose responses. What is the relationship between the dosage that is received and harmful responses or illnesses in the exposed population? Characterization of the overall risk. What are the overall implications of the dose responses for the health of the exposed population? Technical models of risk assessment use the resulting numerical value as the basis for judgments of what is an “acceptable risk. This judgment involves values. 24

Limitations of technical model exceedingly difficult to trace the “pathway need to show direct correlation between particular chemicals and the specific illnesses Cultural-Experiential Model of Risk technical models conflate numerical risk (expected annual mortality) with judgments about the experience of those forced to live with imposed or involuntary risks big difference between those who take risks and those who are victimized by risks others take 25

As Lois Gills of Love Canal stated ‘From a community’s perspective, risk assessments are ‘the risks that someone else has chosen for you to take.’ What is a life worth … but equally important is whose life”’  Is risk a technical matter that is determined objectively or a social construction that emerges from communication among experts, affected parties, and public agencies? 26

Finding the Optimal Outcome A.An allocation is efficient or has achieved static efficiency if the net benefit from the use of those resources is maximized by that allocation. If at an allocation marginal cost is greater than marginal benefit, then net benefits are less than the maximum possible, and the allocation is inefficient (too much has been produced). Likewise, if marginal benefit is greater than marginal cost, net benefits can be increased by increasing the allocation. Thus, an efficient allocation will be achieved when marginal benefit and marginal cost are equal. Inefficient allocations do not maximize net benefit. B.The first Equimarginal principle says that net benefits are maximized when the marginal benefits from the allocation equal the marginal costs. C.An allocation is Pareto optimal if no other feasible allocation could benefit some people without any negative effects on at least one other person. 27

Utopian Capitalist View: Pareto Optimality Conditions of Pareto Optimality You cannot make one party better off without making another worse off. Parties involved in exchange bear the full true cost of the transaction.(no externalities)

Is the cap and trade policy clear? 29

Allowance Trading Basics An emissions "cap": A limit on the total amount of pollution that can be emitted (released) from all regulated sources (e.g., power plants); the cap is set lower than historical emissions in order to reduce emissions. Allowances: An authorization to emit a fixed amount of a pollutant. Measurement: Accurate tracking of all emissions. Source:

Allowance Trading Basics Flexibility: Sources can choose how to reduce emissions, including whether to buy additional allowances from other sources that reduce emissions. Allowance trading: Sources can buy or sell allowances on the open market. Because the total number of allowances is limited by the cap, emission reductions are assured. Compliance: At the end of each compliance period, each source must own at least as many allowances as its emissions. Source:

Trading the Right to Pollute The NO x Budget Trading Program is a market-based cap and trade program created to reduce emissions of nitrogen oxides (NO x ) from power plants and other large combustion sources in the eastern United States. Source :

Trading the Right to Pollute Market-based sulfur dioxide (SO 2 ) allowance trading component of the Acid Rain Program Utilities regulated under the program, decide the most cost-effective way to use available resources to comply with the acid rain requirements of the Clean Air Act. Purchase pollution allowances. Switching to lower sulfur fuel. Reduce emissions by employing energy conservation measures Source:

Success of Acid Rain Program which includes trading pollution allowances Reduced SO 2 emissions by over 5.5 million tons from 1990 levels, or about 35 percent of total emissions from the power sector. Compared to 1980 levels, SO 2 emissions from power plants have dropped by more than 7 million tons, or about 41 percent. Cut NO x emissions by about 3 million tons from 1990 levels, so that emissions in 2005 were less than half the level anticipated without the program. Other efforts, such as the NO x Budget Trading Program in the eastern United States, also contributed significantly to this reduction. Led to significant cuts in acid deposition, including reductions in sulfate deposition of about 36 percent in some regions of the United States and improvements in environmental indicators, such as fewer acidic lakes. Source:

Kyoto Protocol Industrialized nations reduce CO 2 5 percent from 1990 levels by compliance period. United States withdrew in China and India are not required to comply because they are developing nations. By 2002 Kyoto only covered about 30 percent of global CO 2 emissions. Too little too fast. Not enough change to make a difference. Difficult to comply with for countries who experienced substantial growth in the 1990’s.

European Union Emissions Trading Scheme (ETS) Kyoto with teeth. Covers half of Europe’s carbon emissions. (8% of global) Each country creates a national allocation plan for specifying caps on greenhouse gases. Businesses can either reduce their emissions or purchase allowances from facilities with an excess of allowances. Allowances traded in the ETS are not printed but are held in electronic account registries set up by Member States and are overseen by a Central Administrator at the EU. Emissions considered a service under EU’s VAT. Sources: and Nordhaus, William D. The American Economic Review, “After Kyoto: Alternative Mechanisms to Control Global Warming” 96(2) May 2006, 31-34http://ec.europa.eu/environment/climat/emission.htm

37 Reminder: Externality Defined An externality is present when the activity of one entity (person or firm) directly affects the welfare of another entity in a way that is outside the market mechanism. Negative externality: These activities impose damages on others. Positive externality: These activities benefits on others.

38 Examples of Externalities Negative Externalities Pollution Cell phones in a movie theater Congestion on the internet Drinking and driving Student cheating that changes the grade curve The “Club” anti-theft devise for automobiles. Positive Externalities Research & development Vaccinations A neighbor’s nice landscape Students asking good questions in class

39 Nature of Externalities Arise because there is no market price attached to the activity. Can be produced by people or firms. Can be positive or negative. Public goods are special case. Positive externality’s full effects are felt by everyone in the economy.

40 Graphical Analysis: Negative Externalities For simplicity, assume that a steel firm dumps pollution into a river that harms a fishery downstream. Competitive markets, firms maximize profits Note that steel firm only care’s about its own profits, not the fishery’s Fishery only cares about its profits, not the steel firm’s.

41 Calculating gains & losses raises practical questions What activities produce pollutants? With acid rain it is not known how much is associated with factory production versus natural activities like plant decay. Which pollutants do harm? Pinpointing a pollutant’s effect is difficult. Some studies show very limited damage from acid rain. What is the value of the damage done? Difficult to value because pollution not bought/sold in market. Housing values may capitalize in pollution’s effect.

42 Private responses Coase theorem Mergers Social conventions

43 Coase Theorem Insight: root of the inefficiencies from externalities is the absence of property rights. The Coase Theorem states that once property rights are established and transaction costs are small, then one of the parties will bribe the other to attain the socially efficient quantity. The socially efficient quantity is attained regardless of whom the property rights were initially assigned.

44 Illustration of the Coase Theorem Recall the steel firm / fishery example. If the steel firm was assigned property rights, it would maximizes its profits. If the fishery was assigned property rights, it would initially mandate zero production, which minimizes its damages.

45 Coase Theorem – assign property rights to steel firm Consider the effects of the steel firm reducing production in the direction of the socially efficient level, Q *. This entails a cost to the steel firm and a benefit to the fishery: The steel firm (and its customers) would lose surplus between the MB and MPC curves between Q 1 and Q 1 -1, while the fishery’s damages are reduced by the area under the MD curve between Q 1 and Q Note that the marginal loss in profits is extremely small, because the steel firm was profit maximizing, while the reduction in damages to the fishery is substantial. A bribe from the fishery to the steel firm could therefore make all parties better off.

46 Coase Theorem – assign property rights to steel firm When would the process of bribes (and pollution reduction) stop? When the parties no longer find it beneficial to bribe.

47 When is the Coase Theorem relevant or not? Low transaction costs Few parties involved Source of externality well defined Example: Several firms with pollution Not relevant with high transaction costs or ill- defined externality Example: Air pollution

Next: Externalities Remember externalities – positive and negative Remember the pursuit for efficiency So how to solve an externality between two parties? 1.Private resolution through negotiation is the simplest means of restoring efficiency. For example, a downstream firm hurt by an upstream polluter could negotiate or bribe the upstream polluter to reduce pollution. “Victim pays” outcomes tend to be unsatisfactory to most students. Other options include consumer boycotts or other means of imposing costs on the polluters. 48

How to solve externalities? 2. Property rights that are not well-defined and lead to inefficiencies can be corrected by a court system which imposes either property rules or liability rules. Examples relevant to the upstream polluter example include discharge permits. 3. Legislative and executive regulation are remedies that can take several forms, including taxes and regulatory laws. Gasoline taxes and regulations on unleaded fuels are potential discussion topics as are proposals for carbon taxes. The subject of zoning laws also typically makes for a lively discussion topic and serves as introductions to later chapters. 49

Coase theorem The Coase Theorem says that when negotiation costs are negligible and affected parties can freely negotiate, the entitlement can be allocated by the courts to either party and an efficient allocation will result. Only the distribution of costs and benefits among the effective parties is changed. Regardless of which party the property right is assigned to, an efficient level of production will result. Inefficiency causes the pressure for improvement. The Coase Theorem is not without problems. If the property right is assigned to the polluter, pollution could become a profitable activity. Also, the Coase Theorem relies on some very restrictive assumptions such as the number of polluters being small. If the number of polluters is large, negotiation is difficult and free-riders more prevalent. The Coase Theorem also relies on transactions costs being small. The courts can use liability rules if negotiation is not practical, however transactions costs such as lawyers fees and administrative costs could be large. 50

51 of 49 Externalities and Environmental Economics Internalizing Externalities Bargaining and Negotiation Coase theorem Under certain conditions, when externalities are present, private parties can arrive at the efficient solution without government involvement. Legal Rules and Procedures injunction A court order forbidding the continuation of behavior that leads to damages. liability rules Laws that require A to compensate B for damages imposed.

52 of 49 According to the Coase theorem, in order to arrive at an efficient solution to an externality problem associated with a given activity: a.No party should be given the right to that activity prior to negotiation; otherwise, that party would have no incentive to bargain. b.The right to an activity must be decided during the negotiation process. c.It doesn’t matter which party is initially assigned the right to that activity. d.Both parties must feel that they have equal rights to the activity prior to negotiation.

53 of 49 According to the Coase theorem, in order to arrive at an efficient solution to an externality problem associated with a given activity: a.No party should be given the right to that activity prior to negotiation; otherwise, that party would have no incentive to bargain. b.The right to an activity must be decided during the negotiation process. c.It doesn’t matter which party is initially assigned the right to that activity. d.Both parties must feel that they have equal rights to the activity prior to negotiation.

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