Regulation of Externalities Environmental Protection

Risk & The Environment -- Links Efficient Environmental Protection –Marginal cost of harm –Marginal cost of abatement Key Questions: What is the value of – –A (statistical) life saved? –A (statistical) tree saved? –A (statistical) dolphin saved? Key Issues –Consumer heterogeneity (Costs & Benefits) Income, Geography, Workers –Distribution of costs & benefits Upstream/downstream –“Real” market solutions vs. “Real” regulatory solutions

Regulatory Approaches Prescriptive Limits (Command & Control) –Best Available Technology Cheap enforcement, inflexible, static –Effluent Limits (PPM) Somewhat expensive enforcement, somewhat flexible –Effluent Limits (Total) Expensive enforcement, most flexible (& tradable), dynamic Incentive Systems (Market Mechanisms) –Internalize marginal cost –Firms choose least costly means of abatement –Costs reflected in prices

Tradable Permits Examples –Existing: Sulfur Dioxide (Acid Rain) –Proposed: Greenhouse Gas (Global Warming) System –Allocate emission rights (grants, auctions) –Firms & interest groups make buy/sell decisions –Consumer prices reflect emission prices (shift in supply curve) Example –Market price is t per unit of product for a particular firm –Firm can buy permit or install filters at cost of c with increasing marginal cost (10% cut costs c, 20% costs 4c, 30% costs 9c) –Choice: Reduce emissions until MC=t, then purchase permit Permits vs. Taxes –Known abatement levels, preference heterogeneity, dynamic efficiency

Firm Abatement Decisions % Abatement CostFirm A MCFirm B MC Firm A Efficient Abatement Firm B Efficient Abatement

Global Warming The Ultimate Externality EDF System –Tradable permits for greenhouse gasses –Goal – reduce emissions to 1990 levels –International trades permitted –Trading system reduces cost from $582 to $19.9 billion Issue –Initial allocation –Short-term incentives –Compensated damages & moral hazard –Monitoring