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

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

•

•

2*ii

*iiii MδMβαC

Ci

i

i*i M̂M 0M*

i *iM

The firm’s abatement cost function

Emissions

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

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

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

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

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

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 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

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

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 permits

*=(t*)*=)t*

t*

1

2

M*

M* M1M2

*

L*(=M*)

L*=(M*)

M̂ M̂

M̂M̂

A* A*

A*A*

A1A1

A2

A2

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

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

t*

M*Emissions, M

MC (true)

MC (assumed)

tH

LHMt

MD

Uncertainty about abatement cost – cost overestimated (2)

t*

M*

Emissions, M

MD

MC (true)

MC (assumed)

tL

LL Mt

Uncertainty about abatement cost – cost underestimated

t*

M*

Emissions, M

MC (true)

MC (assumed)

tL

LL Mt

MD

Uncertainty about abatement cost – cost underestimated (2)