© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Environmental Economics & Management: by Scott J. Callan and Janet M. Thomas Slides created by Janet M. Thomas Theory, Policy, and Applications 5e

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Economic Solutions to Environmental Problems The Market Approach Chapter 5

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Pollution Charges

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. Internalization 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

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Selected International Gasoline Tax Rates NationTax Rate % of Price (2008) United States18.5 U.K.67.8 France67.4 Germany70.3 Japan45.8 Spain Source: International Energy Agency, November, 2008

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Modeling a Pigouvian Tax 8 $ Q of gasoline MPB = MSB MPC MSC = MPC + MEC 0 QEQE QCQC MPC t b a Amount of tax

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Emission (Effluent) Charge A fee imposed directly on the discharge of pollution Assigns a price to pollution Typically implemented through a tax 10

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Modeling Emission Charge Single Polluter 12 $ 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

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 = (A 2 ) 2 MAC 2 = 0.625(A 2 ) where A 2 is pollution abated by Polluter 2 Find each firms abatement level. Then, find each firms total abatement costs (TAC) and tax payment at that level. Support with a graph. 14

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 = (8) 2 = $20 Incurs Total Tax = 5(10 - 8) = $10 15

Modeling An Emission Charge Multiple Polluter MAC 1 MAC Polluter 1s Abatement Polluter 2s 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) © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 Assessing the Model (cons)

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Pollution Charges in Practice Internationally, the pollution charge is the most commonly used market-based instrument Australia, Bulgaria, France, and Japan, use fees or taxes to control noise pollution generated by aircraft France, Mexico, and Poland are among the nations using effluent charges to protect water resources. Others levy charges on products such as batteries, tires, lubricant oil, packaging, paint, paint containers, and gasoline 19

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Environmental Subsidies

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Environmental Subsidies Two major types of subsidies: Abatement equipment subsidies Pollution reduction subsidies 21

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Pigouvian Subsidy Market for Scrubbers 23 ($ 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

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Assessing the Model It is difficult to measure the MEB May bias polluters decisions about how best to abate 24

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 25

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Assessing the Model Might be less disruptive than an equipment subsidydoesnt influence the technology Can have the perverse effect of elevating pollution levels in the aggregate since the subsidy lowers unit costs and raises profit, encouraging entry 26

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 Belgium, Denmark, 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

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Deposit-Refund Systems

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 (%) Deposit converts % of overall waste disposal, measured by (Q IW - Q E ), from improper methods to proper © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. in Michigan, for example, the return rate of containers one year after the program was implemented was 95 percent (Porter 1983); and in Oregon, littering was reduced and long-run savings in waste management costs were achieved (U.S. General Accounting Office 1990).

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 Deposits range from 2 cents to 15 cents per container Other applications include systems used to promote responsible disposal of used tires, car hulks, and lead-acid batteries 34

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Glass container deposit-refund systems are widely used in other OECD countries, including Australia, Austria, Belgium, Canada, Denmark, Finland, Iceland, the Netherlands, Norway, Portugal, Sweden, Germany, Sri Lanka, and Switzerland (OECD 1993a).

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Pollution Permit Trading Systems

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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: cap-and-trade system 37

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 38

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 39

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Pollution Permit System 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 = (A 2 ) 2 MAC 2 = 0.625(A 2 ) where A 2 is pollution abated by Polluter 2 Each firm releases 10 units of pollution, government: acceptable level of pollution: 10 units; 10 permits are issued5 to each polluter.

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Round 1 Polluter 1: current pollution level: 10 units Permits: 5 Abatement required: 5 MAC(1)=2.5(5)=12.50 TAC(1)=1.25(5)sq=31.25 Polluter 2: current pollution level: 10 units Permits: 5; Abatement required: 5 MAC(2)=.625(5)=3.13, TAC(2)=.3125(5)sq=7.81

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Round 2: Polluter 2 sells one permit to polluter 1 at price=8 Polluter 1: current pollution level: 10 units Permits: 6; Abatement required: 4 MAC(1)=2.5(4)=10 TAC(1)=1.25(4)sq=20 Cost of 1 permit purchased: 8 Polluter 2: current pollution level: 10 units Permits: 4; Abatement required: 6 MAC(2)=.625(6)=3.75, TAC(2)=.3125(6)sq=8 Revenue from one permit sold: $8

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Final round of trading; 3 units traded at P=8, 7 and 5 Polluter 1: current pollution level: 10 units Permits: 8; Abatement required: 2 MAC(1)=2.5(2)=5 TAC(1)=1.25(2)sq=5 Cost of 3 permits purchased: 20 Polluter 2: current pollution level: 10 units Permits: 2; Abatement required: 8 MAC(2)=.625(8)=5, TAC(2)=.3125(8)sq=20 Revenue from 3 permits sold: $20

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 44

© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Pollution Trading Systems in Practice Most of the evolution of trading is occurring in U.S. An important example is the allowance-based trading program to control sulfur dioxide emissions under the Clean Air Act Amendments of 1990 More innovation has occurred at state and local levels Ozone Transport Commission in the Northeast California Regional Clean Air Incentives Market (RECLAIM) Key international example Trading of greenhouse gas allowances are part of the Kyoto Protocol, an international accord aimed at global warming Includes the European Union Greenhouse Gas Emission Trading System (EU ETS), launched in