ere10: instruments of environmental policy criteria, incl. cost-effectiveness instruments...
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ERE10: Instruments of Environmental Policy
• Criteria, incl. cost-effectiveness• Instruments
– Institutional– Command and control– Market based
• A comparison
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Last week
• Optimal targets– Flow pollution– Stock pollution
• When location matters• Steady state
– Stock-flow pollutant• Steady state • Dynamics
• Alternative targets
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Criteria
• Cost-effectiveness• Dependability, environmental effectiveness• Information requirements• Enforceability• Long-run effects• Dynamic efficiency• Flexibility• Equity• Uncertainty
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Cost-effectiveness
The firm‘s abatement cost
The least cost formulation
The Lagrangian
The necessary condition
Marginal costs are equal for all producers
1 1
min s.t. N N
n n nn n
C M M M
2n n n n n nC M M
1 1
N N
n nn n
L C M M
2 0n n n
n
LM
M MC
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•
•
2*ii
*iiii MδMβαC
Ci
i
i*i M̂M 0M*
i *iM
The firm’s abatement cost function
Emissions
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5
10 15 35 40302520
Pollution abatement
Z
MCA = 3ZA
MC
MCB = 5ZB
75
100
200
Marginal abatement cost functions for two firms
CA = 100+1.5Z2A
CB = 100+2.5Z2B
*ˆi i iZ M M
Pollution abatement:ˆ ˆ40 and 50A BM M
Current emissions: Abatement target:
40 A BZ Z
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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
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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
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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
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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
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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
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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
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An economically efficient emissions tax
0 Z* = *MM̂ Z
M̂
Z
*
Marginal benefit (before tax)
0
*
Marginal benefit (after tax)
M*
M
Marginal damage
Marginal cost of abatement
Marginal benefit of abatement
The economically efficient level of emissions abatement
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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
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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
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5
10 15 35 40302520
Pollution abatement
Z
MCA
MC
MCB
75
200
Marketable permits and efficient abatement
A B A+B
uncontrolled emissions 40 50 90
abatement ? ? 40
initial allocation 25 25 50
initial abatement 15 25 40
fi nal allocation 15 35 50
effi cient abatement 25 15 40
125
40
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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
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Cost-Effectiveness• Market-based instruments are cost-effective• Command and control is unlike to be cost-
effective, unless the regulator knows a lot and the industry is homogenous
• Institutional instruments may be cost-effective (voluntary agreements), and even efficient (bargaining, property rights)
• Tradeable permits may also be efficient, if people buy (hold) but not use (sell) permits
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Cost-effectiveness (2)
min n nC M
2 0n n n M
n
CTM t CT t
M
Cost function: 2n n n n n nC M M
Least cost formulation:
1 1
min s.t. N N
n n nn n
C M M M
Necessary condition:
2 0n n n M
n
LM C
M
Taxes, subsidies and permits:
2n n n n n n nCT M M tM
2 0( )n n n n n n n nCL M M p L L
2ˆ( ) ( )n n n n n n n nCS s M M M M
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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
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Environmental Effectiveness (2)
taxes permits
*=(t*)*=)t*
t*
1
2
M*
M* M1M2
*
L*(=M*)
L*=(M*)
M̂ M̂
M̂M̂
A* A*
A*A*
A1A1
A2
A2
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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
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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
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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
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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
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t*
M* Emissions, M
MD
MC (true)
MC (assumed)
tH
LHMt
Loss when licenses used
Loss when taxes used
Uncertainty about abatement cost – cost overestimated
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t*
M*Emissions, M
MC (true)
MC (assumed)
tH
LHMt
MD
Uncertainty about abatement cost – cost overestimated (2)
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t*
M*
Emissions, M
MD
MC (true)
MC (assumed)
tL
LL Mt
Uncertainty about abatement cost – cost underestimated
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t*
M*
Emissions, M
MC (true)
MC (assumed)
tL
LL Mt
MD
Uncertainty about abatement cost – cost underestimated (2)