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ERE10: Instruments of Environmental Policy • Criteria, incl. cost-effectiveness • Instruments – Institutional – Command and control – Market based • A comparison Last week • Optimal targets – Flow pollution – Stock pollution • When location matters • Steady state – Stock-flow pollutant • Steady state • Dynamics • Alternative targets Criteria • • • • • • • • • Cost-effectiveness Dependability, environmental effectiveness Information requirements Enforceability Long-run effects Dynamic efficiency Flexibility Equity Uncertainty Cost-effectiveness The firm‘s abatement cost The least cost formulation Cn n n Mn n Mn2 N min Cn Mn s.t. n 1 The Lagrangian N M n 1 N M N L Cn M Mn n 1 n 1 The necessary condition L n 2 n Mn 0 Mn n CM Marginal costs are equal for all producers The firm’s abatement cost function Ci i • Ci αi βi M*i δi M*i2 M*i 0 • M*i M*i M̂i Emissions Marginal abatement cost functions for two firms MC 200 MCB = 5ZB CB = 100+2.5Z2B MCA = 3ZA 100 75 CA = 100+1.5Z2A 5 10 15 20 25 30 35 40 Z Pollution abatement Pollution abatement: Zi Mˆ i M i* Current emissions: Mˆ A 40 and Mˆ B 50 Abatement target: 40 Z A ZB Cost-effectiveness (2) • Least-cost implies that the marginal cost of abatement is equalised over all polluters • This will in general not involve equal abatement effort by all polluters • Where abatement costs differ, relatively low-cost abaters will undertake most of the total abatement effort Instruments: Overview • Institutional – Bargaining – Legal redress – Information, awareness, responsibility – Property rights – Voluntary agreements • Command and control – Inputs, technology – Output (product, pollutant) – Location (source, individual) – Timing – Prohibition • Market-based – Taxes (inputs, outputs) – Subsidies – Tradeable permits Institutional Instruments • Coase (1960) Theorem: The social optimum can be established through bargaining between polluter and victim • Alternatively, the court may step in • Or, the government may appeal to the polluter‘s conscience • Or, the government may establish property rights Command and Control • Command and control = direct regulation • It is the most common form of environmental regulation, reflecting a natural science frame of mind, and highly successful in past management of point sources of toxics • Essentially, command and control prescribes aspects of the production process, be it inputs, production or outputs • Requires substantial knowledge on the part of the regulator (e.g. abatement cost function of each firm) • Requires homogenous producers Types of Direct Regulation • Inputs, e.g., fuel efficiency • Technology, e.g., catalytic converters – Best practicable means – Best available technology (not exceeding excessive costs) • Outputs – Products, e.g., carcinogenic toys – Waste, e.g., sulphur emissions • Timing, e.g., air traffic • Location, e.g., nature reserves • Prohibition, e.g., CFCs Taxes and Subsidies • Taxes: Pay a charge or levy or penalty for every unit consumed, produced or emitted – It is levied on emissions, not output – Encourages substitution effects • Subsidies: Receive a premium for every unit not consumed, produced or emitted • Uniform taxes and subsidies have a uniform effect on marginal production costs, thus ensuring efficiency • Taxes and subsidies have an equivalent effect on emissions in the short run, but have different budgetary distributional, and long-term effects An economically efficient emissions tax Marginal benefit (before tax) Marginal damage * Marginal benefit (after tax) 0 M M* M̂ Marginal cost of abatement * Marginal benefit of abatement 0 Z* = M̂ M* Z The economically efficient level of emissions abatement Z Tradeable Permits • The government sets an overall target on consumption, production or, most common, emission • Each producer obtains a certain amount of emission permits, can sell these, or buy more at the market place • Creates property rights • If the permit market is perfect, all producers pay the same price, and marginal costs of production increase uniformly • Taxes and tradeable permits are equivalent provided that the regulator knows the marginal abatement costs Permits: Initial Allocation • Auctioning – Sell permits to highest bidder – Generates revenue, perhaps a lot • Grandfathering – Give permits to current polluters – Politically easy, as confirms status quo • To victim – Perhaps fair, definitely complicated – May generate large transfers • Per capita – Perhaps fair, relatively easy – May generate large transfers Marketable permits and efficient abatement MC 200 MCB 125 MCA 75 40 5 10 15 20 25 30 35 40 uncontrolled emissions abatement initial allocation initial abatement final allocation efficient abatement A 40 ? 25 15 15 25 B 50 ? 25 25 35 15 A+B 90 40 50 40 50 40 Z Pollution abatement Voluntary Agreements • Environmental regulation requires a lot of knowledge, perhaps more so than at the disposal of the regulator • Increasingly, governments and industry negotiate over emission targets, the results of which are laid down in a voluntary agreement • This is a euphemism, as the government typically threatens to intervene if no voluntary agreement is used • Voluntary agreements make optimal use of the information within industry but have a problem with public acceptability Cost-Effectiveness • Market-based instruments are costeffective • Command and control is unlike to be costeffective, unless the regulator knows a lot and the industry is homogenous • Institutional instruments may be costeffective (voluntary agreements), and even efficient (bargaining, property rights) • Tradeable permits may also be efficient, if people buy (hold) but not use (sell) permits Cost-effectiveness (2) Cn n n Mn n Mn2 Cost function: N min Cn Mn s.t. Least cost formulation: Necessary condition: n 1 N M n 1 n M L n 2 n Mn 0 C M Mn Taxes, subsidies and permits: CTn n n Mn n Mn2 tMn min Cn Mn CT n 2 n Mn t 0 CTM t Mn CSn s (Mˆn Mn ) (n n Mn n Mn2 ) CLn n n Mn n Mn2 p (Ln Ln0 ) Environmental Effectiveness • The environmental effect of taxes and subsidies is uncertain (but its marginal costs are certain) • The environmental effect of tradeable permits is certain (but its costs are uncertain) • The environmental effects of emission standards are certain (bar illegal dumping), of input and production standards less certain • The environmental effects of institutional instruments are uncertain, and unpredictable as enforcement is not in the hands of the government Environmental Effectiveness (2) taxes A* permits A* *=(t*) *=)t* M* A2 A* L*(=M*) Mˆ A1 A* 1 Mˆ A1 A2 * t* 2 M2 M* M1 Mˆ L*=(M*) Mˆ Dynamic Effects • Taxes and tradeable permits provide a continuous incentive to emit less • Subsidies have the same effect, but may attract new entrants • Direct regulation is static; once the standard is met, there is no need to further reduce emissions • Unless, standards get stricter over time • Institutional instruments are mixed Flexibility • Flexibility is important, as new information may arise • It is easy to lower taxes, make standards less strict; it is hard to do the opposite • The exception is tradeable permits, where the government can release new permits but also buy existing ones Equity • Different instruments have different distributional consequences • In general, environmental policy makes things more expensive; with cost-effective instruments, this effect and hence the distributional effects are less pronounced • If necessary (luxury) goods are regulated, the environmental policy is regressive (progressive) • Tradeable permits have as advantage that cost-effectiveness is secured by the market, and equity perhaps by the initial allocation Uncertainty • Welfare losses can occur as a result of the (unknowingly) selection of incorrect targets • Overregulation is more (less) costly with taxes than with standards if the marginal damage cost curve is steeper (flatter) than the marginal abatement cost curve Uncertainty about abatement cost – cost overestimated MD Loss when licenses used tH t* MC (assumed) Loss when taxes used MC (true) Mt M* LH Emissions, M Uncertainty about abatement cost – cost overestimated (2) MD tH t* MC (assumed) MC (true) Mt M* LH Emissions, M Uncertainty about abatement cost – cost underestimated MD t* tL MC (true) MC (assumed) LL M* Mt Emissions, M Uncertainty about abatement cost – cost underestimated (2) MD t* tL MC (true) MC (assumed) LL M* Mt Emissions, M