1. Section 6 API-135 / Econ 1661 April 5, 2013 Rich Sweeney 0

2. Agenda Review of Instrument Choice Clean Air Act Practice Problem: Hybrid Mechanisms 1

3. Quick review of where we are in the semester… 2 Total Benefits and Costs

4. Overview of instrument choices 3 Command and Control Market Based Price based vs. Quantity based Market Based Price based vs. Quantity based Voluntary Programs or Information Disclosure Programs (not covered in detail in this course) Voluntary Programs or Information Disclosure Programs (not covered in detail in this course) -Taxes (Charges) - Subsidies -Mandated abatement technology - Uniform (non tradable) performance standard -Tradable Permits - Emissions Reductions Credits -Quotas Hybrid approach (e.g, “safety valve”) See Prof. Stavins’ Handbook Chapter (on syllabus) for a comprehensive overview of these instruments and experience with each to date.

5. How do you choose the right instrument? 4 1.Achieve stated goals/standards? (whether or not efficient) 2.Cost-effective? 3.Provide government with information it needs 4.Monitoring and enforcement possibilities? 5.Flexible in the face of change (in tastes, technology, or resource use)? 6.Dynamic incentives for research, development, adoption, and diffusion of better pollution-control technologies? 7.Equitable distribution of economic and environmental impacts 8.Purpose and nature of policy understandable to general public? 9.Feasible, in terms of enactment and implementation?

6. When are market based instruments not a good idea? 5 When the pollutant is highly localized/ non-uniformly mixing When damages are highly non-linear When costs are homogenous across sources Remember the Coase Theorem! Cap and trade may not be cost effective when transaction costs are high and permits are not auctioned.

7. Agenda Review of Instrument Choice Clean Air Act Practice Problem: Hybrid Mechanisms 6

8. Clean Air Act of 1970 Key pollutants: Criteria pollutants – may cause and contribute to air pollution from various sources – conventional pollutants – not toxic – Carbon Monoxide, Sulfur Dioxide, Nitrogen Oxides, Ozone, Particulate Matter, Lead Hazardous air pollutants (“haps”) – Have acute health problems- toxics – National emission standards 7

9. CAA Features: EPA must publish and revise list of criteria pollutants Must include each air pollutant that may cause or contribute to air pollution that may reasonably be anticipated to endanger public health and welfare – NAAQs - National Ambient Air Quality Standards – After listed must set NAAQ’s within 12 months – EPA has only added one pollutant since start program Shall set primary and secondary standards – Primary includes a margin of safety, health-based – Secondary includes visibility, agriculture, etc. welfare- based 8

10. CAA Features: system of shared responsibility EPA must establish NAAQ’s for the pollutants – State gov then decide how the existing levels of these pollutants ought to be controlled in order to meet those NAAQs for their jurisdictions Each state sets up regulations to meet NAAQ’s called State Implementation plan (SIP) – Approved by EPA – Areas that continue to exceed the NAAQ’s are classified as non-attainment – Non-attainment are subject to much more stringent regulation (e.g., EPA can halt new construction) New Source Review set by EPA for stationary sources – Common example of Vintage-Differentiated Regulation 9

11. Clean Air Act Amendments of 1990 Major Points: Broad legislation covering many sectors. Only two parts were market-based: – Acid Rain: SO 2 Allowance Trading System – NO x & VOC emission trading Ended up being much less costly than anticipated – Part of this was fortunate developments in unrelated areas (like railroads). – But there is considerable evidence that the trading program encouraged better emissions reduction decisions than a non market policy would have. Benefits ended up being much greater than expected. 10

12. SO 2 Allowance Prices and the Regulatory Environment 1994-2012 (1995 $ per ton) 11 Allowance prices stable until 2004 Congress defeats Clear Skies Act, Bush develops Clean Air Interstate Rule (CAIR) Exogenous factors increase demand for allowances Legal challenges kill expectations of more stringent SO 2 cap, and may invalidate interstate trading Clean Air Transport Rule limits interstate trading Cross-State Air Pollution Rule further reduces scope for c/e trades What the Government Gives, It Can Take Away – The Broader Regulatory Environment Ended the Life of the SO 2 Allowance Market CSAPR Invalidated

13. “Four Ironies” of Acid Rain Program (from Schmalensee & Stavins 2012) 12 1.The Government Did the Right Thing for the Wrong Reason 2.Non-Environmental Policies Helped Produced Success for Environmental Policy 3.Conservatives Demonize Their Own Innovation 4.What the Government Gives, It Can Take Away Make sure you read this article!

14. Agenda Review of Instrument Choice Clean Air Act Practice Problem: Hybrid Mechanisms 13

15. Safety-Valve Problem (2012 Final) Definition: A hybrid or “safety-valve” policy instrument refers to a combined cap-and- trade and tax system. In the context of a cap-and-trade system, the government announces in advance that it is willing to sell (an unlimited number of) additional allowances at a specific price (the trigger price). Once it is reached, this trigger price becomes a tax on additional pollution, and thereby places a cap on marginal abatement costs, but expands the original cap on aggregate emissions. Advantage: cost containment Disadvantage: emissions no longer capped 14

16. Safety-Valve Problem – Setup Congress is considering a policy to reduce emissions of gunk. Although this pollutant is currently unregulated, an independent review of the issue has found that marginal costs and marginal benefits of pollution control follow the following schedule: MC = 3 + Q MB = 9 -.5Q Where Q is the quantity of gunk emission reductions. 15

17. Safety-Valve Problem – Part A Calculate the statically efficient level of emissions reductions, Q*, and the marginal cost of emissions reductions at this level, P*. What are the static net benefits of this policy if the regulator chooses this level? 16

18. Safety-Valve Problem – Part B It turns out that the estimated marginal cost schedule is actually an average of two competing reports, a high cost estimate and a low cost estimate, which the independent agency considers equally likely. MC H = 6 + Q MC L = Q Given this uncertainty in costs, would you recommend that the regulator use a price or a quantity instrument to regulation gunk? Explain the intuition for your answer. 17

19. Safety-Valve Problem – Part C Congress chooses to use a quantity instrument, mandating emissions reductions equal to the efficient level, Q*. Calculate the expected net benefits of this policy, taking into consideration the fact that marginal costs are uncertain. Assume that there is a 50% chance MC = MC L, and a 50% chance MC = MC H. 18

20. Safety-Valve Problem – Part D Industry is worried about prices spikes if emission reductions turn out to be expensive. In order to allay their fears, Congress writes a “safety valve” in to the law. As an alternative to purchasing permits for their emissions, polluters can pay a penalty of $8 for each unit of gunk that they emit. Calculate expected the expected emissions reductions and net benefits with the safety valve in place. 19