Regulatory Options & Efficiency

Goal: Generate regulatory tools to fix environmental problems

Why regulate?Does free market efficiently provide goods and services? Market failure (externalities, public goods, etc.)Market power (monopolies inefficiently restrict production to raise prices)Information problems (damages uncertain, food safety, env. quality)

Types of questions in regulation1. What is the “optimal” amount of

pollution? 2. To reduce by X%, who should

reduce and by how much?3. What regulatory instrument(s)

should be used to achieve that level?

ProblemEPA has regulations to control biological oxygen demand (BOD). EPA would like your advice on how to improve water quality (lower BOD) without increasing costs.What is your advice?

BOD Removal, Costs of Current US Regulations

Industry Subcategory Marginal CostPoultry Duck-small plants $3.15Meat Packing Simple

Slaughterhouse$2.19

Cane Sugar Crystalline Refining $1.40Leather tanning Hair previously

removed$1.40

Paper Unbleached Kraft $0.86Poultry Chicken – small

plants$0.25

Raw Sugar Processing Louisiana $0.21Paper NSSC – Sodium

Process$0.12

Poultry Chicken—large plants $0.10Source: Magat et al (1986); units: dollars per kilogram BOD removed

Principle of efficiencyMost common approach: uniform burden (e.g., everyone cuts pollution by x%)Two possible results

Too much pollution for the total amount of pollution control costsToo much cost for a fixed level of pollution reduction

Burden of pollution control should fall most heavily on firms with low costs of pollution control

More Generally:The efficient amount of pollution

MarginalControlCost

MarginalDamageCost

$/unit

Units of pollutionQ*

TotalDamageCost

Total ControlCost

Recall example from 1st week60 firms, each pollute 100 tons30 low abatement cost ($100/ton)30 high abatement ($1000/ton)Everyone reduces 1 ton: Cost=$33,000

Total reduction = 60 tons.For same cost how many tons could we have reduced?

With mixed high and low cost firms abating, we could

Either:• Reduce more pollution for the

same amount of money…or• Reduce the same amount of

pollution for less money.So we always want low-cost firm to

shoulder abatement.

If costs aren’t constant: two firms, greenhouse emissions of Nitrogen

AbatementCost($/unit)

N Reduction

MCA

MCB

Who should abatethe 1st unit of N?

How much abatement from each?

MCA

MCB

00

404080

80

$ (A)$ (B)

2555

A:B:

Loss from equalreduction

How did he do that?1. Determine how much total

abatement you want (e.g. 80)2. Draw axis from 0 to 80 (A), 80 to 0

(B)3. Sum of abatements always equals 80.4. Draw MCA as usual, flip MCB

5. Lines cross at equilibrium6. Price is MC for A and for B.

The “equimarginal principle”Not an accident that the marginal abatement costs are equal at the most efficient point.Equimarginal Principle: Efficiency for a homogeneous pollutant requires equating the marginal costs of control across all sources.

Control costsShould include all other costs of control

monitoring & enforcementadministrativeEquipment

Regulatory uncertainty increases costs.If you are a polluter, what would be your response to uncertainty in what you have to do?Does this increase your costs?

Would like to design instruments that provide incentive to innovate

Common Instruments for regulationCommand and Control: Centralized determination of which firms reduce by how much, or technology restrictions.Taxes: charge $X per unit emitted. This increases the cost of production. Forces firms to internalize externality (what is correct tax?)Quotas/standards: uniform standard (all firms can emit Y) or non-uniform.Tradable permits: All firms get Y permits to pollute, can buy & sell on market. Other initial dist’n mechanisms.

Example 1: Taxes in ChinaChina: extremely high air pollution – causes significant health damage.Instituted wide-ranging system of environmental taxation

2 tiersWorld Bank report estimates that MC of abatement << MB of abatement.

A creative quota: bubble policyMultiple emissions sources in different locations.Contained in an imaginary “bubble”.Regulation only governs amount that leaves the bubble.May apply to emissions points within same plant or emissions points in plants owned by other firms.

Example 2: Bubble policy in RINarraganset Electric Company:

2 generation facilities in Providence, RI.Required to use < 2.2% sulfur in oil.

Under bubble policy:Used 2.2% in one plant, burned natural gas at other plant

Savings: $3 million/year

Example 3: SO2 Allowances1990 CAAA sought to reduce SO2 emissions from 20 million tons/yr to 10 million tons/yrSet up market in emission allowances97% of 10 million tons allocated to pollutersRest auctioned at CBOT – anyone can buy: see http://www.epa.gov/airmarkets/forms

SO2 Allowance Prices, 1994--2002

How big the tax or how many permits?We know:

Optimal level of pollution is Q*Marginal Social Cost at the optimum is P*Marginal Private Cost at optimum is Pp.

Optimal tax exactly internalizes externality:

t* = P* - Pp

Effectively raises MC of production

$/unit

Dirty GoodQc

MSC

MPC

MEC

Q*

P*

Pp

D

Basic Setup: Env Costs, Private Costs, Social Costs

$/unit

Q (pollution)Qc

MSC

MPC(no tax)

Q*

P*

Pp

MPC(with tax)

t*

D

Problem: How to reduce VOC emissions in LA without increasing costs?

Where do VOC’s come from?Painting, cleaning in manufacturing, cars

Current regime: command and controlNSPS: “Control Technology Guidelines” (New Source Perf. Stand)SIP’s: firm by firm rules (state implementation plan)Example: automobiles

• Technology requirements• Emission limits per mile• How could this be done differently?

Alternatives#1: emmission fees, $1/lb. of VOC#2: marketable permit – issue permits for 500 tonsGet equimarginal principal in either case (Why?)

Problem: Too many houses being built in SB; want to slow growth. How?

Current regime: command-and-control toolsZoningLengthy permit requirementsInfrastructure feesLimit critical inputs (eg, water)

Alternative approachesFees

• Increased property tax• Building permits: $1000/square foot• Land conversion fee

Marketable permits• Issue 100 permits per year (or 200,000 sq. ft.)• Auction permits• Give away permits – what is effect?

What are differences with between fees and marketable permits?