Class 7 Environmental Policy Tools

Possible Interventions 1. Moral suasion 2. Government provision of goods 3. Damage prevention 4. Command and control 5. Economic Incentives

Economic Incentives 1. Tax (per-unit penalty) 2. Subsidy (per-unit reward) 3. Transferable Permits (market-based)

Focus on case of negative externality and compare: 1. Command and control (direct regulation) 2. Tax 3. Subsidy

Command and Control Set limit on emission or specify technology SMC = PMC + MD Q Q M PMC PMB=SMB MAX

Pigouvian Tax Set tax = marginal damage rate SMC = MC + tax Q MC Tax = MD

Subsidy Often used in conjunction with technology MSC (Tech 1) MPC (Tech 1) MPC (Tech 2) MSC (Tech 2) Subsidy

Command and Control 1. When monitoring costs are high 2. When optimal emission is near zero 3. During random or emergency events Consists of government-specified rules and regulations, often with fines and charges for violations. Most effective:

Drawback of C+C: If marginal abatement costs are different for different pollutors, then C+C will lead to an inefficient allocation of clean up burden among different producers.

Marginal abatement cost function Marginal abatement = pollution reduction of one unit. The marginal abatement cost (MAC) function measures the dollar amount of the cost of reducing pollution by one unit.

Marginal abatement cost function Emissions E1E1 Cost MAC Total Abatement Cost C1C1 EUEU Marginal Abatement Cost Shape of curve depends on technology of clean-up

Marginal damage function Dollar measure of incremental damage from pollution Emissions E Damages MD Total Damage D

Optimal level of pollution Emissions E1E1 MAC Total Abatement Cost EUEU Damages, Costs MD Total Damage

Socially inefficient (sub-optimal) levels of pollution Excess social cost from too much abatement Excess social cost from too little abatement Emissions E1E1 MAC EUEU Damages, Costs MD

Advantages of Economic Incentives 1. In most cases economic incentives will minimize the total costs of abatement. 2. By penalizing polluting behavior or rewarding clean behavior, economic incentives tend to encourage research into better abatement measures.

Pollution tax Goal: set tax = marginal damage cost Why: encourage polluter to “internalize” the externality Key:Tax the externality, not the product.

Actual Tax Payment Tax Avoidance Potential Tax Payment Polluter behavior with tax Emissions E 1 =6 Costs MAC = 10 - E Tax=4 E U =10 T*Q=24

Key points regarding tax 1. Tax achieves socially optimal level of pollution 2. MAC may exceed MD for some levels of pollution. Therefore, the optimal level of pollution is likely to be greater than Individual polluters adjusts emissions to point where MAC = tax, therefore MACs are equal for all polluters, which minimizes total cost of obtaining target level of pollution.

Tradable Pollution Permits 1975 the U.S. EPA started an Emissions Trading Program to reduce air pollution. Support for this market-based approach has grown both among businesses and environmentalists.

What is a tradable permit? Flexible approach to reaching target level of pollution Any source that reduces emissions more than required receives an “emission reduction credit” (ERC). ERCs can be used to satisfy emission targets at other discharge points for which the MAC is higher. ERCs can transferred or sold, thus allowing sources to find the cheapest means to controlling emissions.

Policy context ERC is “currency” Policies governing use include: Offset policy: firm uses ERC to continue polluting at another source Bubble policy: total emissions within “bubble” are regulated, trade within is OK. Emissions banking: firm can “stockpile” ERCs

Applications Air pollution (1975) Lead in gasoline ( ) CFCs and other ozone-depleting chemicals (1988-) SO 2 Acid rain (1993-) Mobile sources (1993-) Greenhouse gases (proposed)

Polluter behavior with regulation: Specify 4 units of emission each E 1 =4 Costs MAC = 10 - E 1 C 1 =6 E 2 =4 Costs MAC = E 2 C 2 =0 E U =10 18

Polluter behavior with permit 1. Total Target Emission Level = 8, so E 1 + E 2 = 8 2. Set MAC 1 =MAC 2 and solve E 1 = 8 - 2E E 1 = 8 - 2(8-E 1 ) = 3 E 1 18 = 3 E 1 6 = E 1

Polluter behavior with permit: firms determine allocation of emissions E 1 =6 Costs MAC = 10 - E 1 C 1 =4 E 2 =2 Costs MAC = E 2 C 2 =4 E U =10 8 E U =4 4

Key messages: 1. Target Emission Level is reached. 2. Total cost of abatement is lower (12 vs. 18) 3. Optimal allocation is reached where firms equate MACs. 4. Permits allow low-cost firms to abate more than they otherwise would.

Implementation Problems: 1. Transaction costs 2. Spatial considerations 3. Temporal considerations 4. Market power 5. Environmental justice (equity)