Economics of the Environment 1. The economics of pollution 2. Valuation of externalities 3. The optimal level of pollution 4. Methods of pollution control 5. EU & UK policy

Background Pollution Pollution chemical wastes - rivers chemical wastes - rivers noise pollution noise pollution thermal pollution thermal pollution carbon emissions - air carbon emissions - air industrial use industrial use road users road users Table 1 Table 1

Fig 1 The interaction between the economy & environment Wastes Environmental system Production system Consumption system Reclaimed materials

1. The economics of pollution Negative externality Negative externality spillover effect of consumption\ production spillover effect of consumption\ production third party is effected - social costs third party is effected - social costs Price mechanism? Price mechanism? e.g. air is free e.g. air is free e.g. water - very low price e.g. water - very low price Over-consumption Over-consumption consumers\business - private costs consumers\business - private costs society - social costs society - social costs

Economics of pollution Private costs  social costs Private costs  social costs Policy objective Policy objective change consumers\business behaviour change consumers\business behaviour pay full social costs pay full social costs internalise the externality to reduce pollution internalise the externality to reduce pollution Policies Policies standards, taxes, permits standards, taxes, permits … valuation of a negative externality … valuation of a negative externality

2. Valuation: A case study Road traffic congestion Road traffic congestion Road use increased dramatically Road use increased dramatically private (…and freight) private (…and freight) Policy - how to ration a scarce resource? Policy - how to ration a scarce resource? Road use generates several externalities Road use generates several externalities e.g. Global warming, e.g. Air pollution e.g. Global warming, e.g. Air pollution e.g.Congestion e.g.Congestion How big are these social costs? How big are these social costs?

Valuation methods 1. Direct Approaches 1. Direct Approaches Contingent valuation methods Contingent valuation methods questionnaire & survey questionnaire & survey WTP or WTAC WTP or WTAC value of externality = mean WTP or WTAC value of externality = mean WTP or WTAC 2. Indirect Methods 2. Indirect Methods e.g. Hedonic pricing model e.g. house prices, lifetime wages e.g. Hedonic pricing model e.g. house prices, lifetime wages e.g.Total economic value = use value + option value + existence value e.g.Total economic value = use value + option value + existence value

Valuation of road transport externalities, 1993 Externality & cost (£billions) Externality & cost (£billions) Global warming = 0.1 Global warming = 0.1 Air pollution =19.7 Air pollution =19.7 Noise = Noise = Road damage =1.5 Road damage =1.5 Accidents = Accidents = Congestion=19.1 Congestion=19.1 TOTAL= TOTAL= Revenue from road use = £16.4b Revenue from road use = £16.4b

Policies to correct road transport externalites Marginal road user pays about a third of true cost of a journey Marginal road user pays about a third of true cost of a journey Government intervention Government intervention build more roads - no! build more roads - no! improve public transport - yes improve public transport - yes tax - yes tax - yes road pricing - yes road pricing - yes Taxes & pricing depend crucially on value of externalities Taxes & pricing depend crucially on value of externalities

3. The optimal level of pollution How much pollution should Government tolerate? How much pollution should Government tolerate? Not zero pollution. Why? Not zero pollution. Why? …because pollution increases with output …because pollution increases with output …growth of output increases welfare …growth of output increases welfare

3. The optimal level of pollution Quantity of pollution is positively related to output Quantity of pollution is positively related to output Social costs increase with output Social costs increase with output But, the costs of clean-up rise as pollution falls But, the costs of clean-up rise as pollution falls What is the socially optimal level of pollution? What is the socially optimal level of pollution? See Figure 2 See Figure 2

Fig 2: The optimal level of pollution Costs of pollution Quantity of pollution Social costs C2C2 C1C1 Q2Q2 Q1Q1 More untreated waste, the higher the social cost 0 If pollution= 0, output would fall. Welfare?

Fig 2: The optimal level of pollution Costs of pollution control Quantity of pollution C2C2 C1C1 0Q2Q2 Q1Q1 A B Costs of pollution control at each level of discharge Costs of clean-up rise

Fig 2: The optimal level of pollution Costs Quantity of pollution 0 Pollution control costs Social costs R Assume that industry output is fixed X Y

The optimal level of pollution Thinking marginally, optimality is Thinking marginally, optimality is “…the cost of an extra unit of pollution is just equal to the cost of reducing pollution by an extra unit.” “…the cost of an extra unit of pollution is just equal to the cost of reducing pollution by an extra unit.” Point ‘R’ on figure 2 Point ‘R’ on figure 2 pollution is not zero! pollution is not zero! How can Government achieve this? How can Government achieve this?

4. Methods of pollution control No incentive for business & consumers No incentive for business & consumers Government should correct the market failure Government should correct the market failure Methods Methods (a) standards & regulations (a) standards & regulations (b) Pollution tax (b) Pollution tax (c) Tradeable permits (c) Tradeable permits

4. Methods of pollution control (a) Standards & regulations (a) Standards & regulations Traditional approach Traditional approach Set emissions target Set emissions target if targets are too strict - point X if targets are too strict - point X if targets are too lenient - point Y if targets are too lenient - point Y correct targets - point R correct targets - point R Penalties if business is caught in violation of target Penalties if business is caught in violation of target

(a) Standards & regulations Disadvantages Disadvantages (i) Costly (i) Costly (ii) Information requirements (ii) Information requirements (iii) Vague & imprecise (iii) Vague & imprecise (iv) If fines are low, no incentive to comply (iv) If fines are low, no incentive to comply (v) Conflict of standards (v) Conflict of standards Advantages Advantages (i) If all businesses comply - very effective (i) If all businesses comply - very effective (ii) No alternative in some cases (ii) No alternative in some cases

(b) Pollution tax E.g. fuel tax, effluent taxes E.g. fuel tax, effluent taxes Tax is a fee consumers\producers pay Tax is a fee consumers\producers pay Control via price Control via price Tax per unit of output Tax per unit of output Cleaner production process - lower tax Cleaner production process - lower tax See Figure 3 See Figure 3

Fig 3: The pollution tax Output Quantity of pollution Costs, Revenue D = MSB S = MPC QpQp Y PpPp MSC QrQr PrPr R MPC + tax PtPt

(b) Pollution taxes Advantages Advantages (i) Cheaper than standards (i) Cheaper than standards reduce discharge: clean-up cost = pollution tax reduce discharge: clean-up cost = pollution tax (ii) Less information required (ii) Less information required meters & charges meters & charges (iii) Polluter Pays Principle (iii) Polluter Pays Principle price environmental services price environmental services sustainable development sustainable development

Advantages (iv) Raises revenue (iv) Raises revenue (v) Widespread compliance (v) Widespread compliance (vi) Market-based approach (vi) Market-based approach (vii) Producer & consumer share the cost (vii) Producer & consumer share the cost Disadvantages Disadvantages (i) Valuation? Tax rate? (i) Valuation? Tax rate? (ii) Absence of market failure e.g. monopoly (ii) Absence of market failure e.g. monopoly (iii) Assumes Government knows the firms costs (iii) Assumes Government knows the firms costs

(c) Transferable pollution permits Second-hand market in pollution Second-hand market in pollution Regulator sets pollution target Regulator sets pollution target Issue pollution permit Issue pollution permit license to pollute to a certain level license to pollute to a certain level e.g. emissions e.g. emissions Firms buy & sell permits Firms buy & sell permits Firms have a choice Firms have a choice incur the cost of clean-up incur the cost of clean-up buy a permit & continue polluting buy a permit & continue polluting

(c) Permits High clean-up costs - buy permits High clean-up costs - buy permits Outcome Outcome Some pollution is allowed Some pollution is allowed Remaining pollution is cleaned up at low cost Remaining pollution is cleaned up at low cost Control pollution - quantity Control pollution - quantity

(c) Permits Advantages Advantages (I) Market-based approach (I) Market-based approach (ii) Low cost (ii) Low cost (iii) Flexible - regular can buy permits (iii) Flexible - regular can buy permits Disadvantages Disadvantages (I) Valuation? Number of permits (I) Valuation? Number of permits (ii) Initial allocation is important (ii) Initial allocation is important

5. EU & UK policy Traditional approach - set standards Traditional approach - set standards EU sets standards on EU sets standards on quality of water - bathing, drinking, emissions quality of water - bathing, drinking, emissions waste management - sewage, toxic substances waste management - sewage, toxic substances atmospheric pollution - agreed to reduce CO 2 emissions by 2012 (8%) atmospheric pollution - agreed to reduce CO 2 emissions by 2012 (8%)

EU reduction targets for greenhouse gases (% change)

5. EU policy How will this be achieved? How will this be achieved? ‘…markets [will] be harnessed to generate the most efficient method of achieving desired pollution reuctions.’ ‘…markets [will] be harnessed to generate the most efficient method of achieving desired pollution reuctions.’ Government set targets Government set targets Taxes & permits used to find the best method Taxes & permits used to find the best method