ERE11: Instruments of Environmental Policy

1
ERE11 Instruments of Environmental Policy

• Criteria, incl. cost-effectiveness
• Instruments
• Institutional
• Command and control
• Market based
• A comparison

2
Last week

• Targets of Environmental Policy
• Optimal targets
• Flow pollution
• Stock pollution
• Steady state
• Dynamics
• Alternative targets

3
Criteria

• Cost-effectiveness
• Dependability, environmental effectiveness
• Information requirements
• Enforceability
• Long-run effects
• Dynamic efficiency
• Flexibility
• Equity
• Uncertainty

4
Cost-effectiveness

• The firms abatement cost
• The least cost formulation
• The Lagrangian
• The necessary condition
• Marginal costs are equal for all producers

5
The firms abatement cost function
Ci
?i


Emissions
6
Marginal abatement cost functions for two firms
MC
200
MCB 3ZB
?
CB 1002.5Z2B
MCA 3ZA
100
?
CA 1001.5Z2A
75
?
?
?
?
?
?
?
?
?
?
?
5
Z
10
15
35
30
25
20
40
Pollution abatement
Pollution abatement
7
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

8
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 polluters
  conscience
• Or, the government may establish property rights

9
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

10
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

11
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

12
An economically efficient emissions tax
Marginal benefit (before tax)
Marginal damage
Marginal benefit (after tax)
?
0
M
M
Marginal cost of abatement
Marginal benefit of abatement
?
0
Z
Z
The economically efficient level of emissions
abatement
13
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

14
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

15
Marketable permits and efficient abatement
MC
200
MCB
?
MCA
125
?
75
?
40
?
?
?
?
?
?
?
?
?
5
Z
10
15
35
30
25
20
40
Pollution abatement
16
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

17
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

18
Cost-effectiveness (2)
Cost function
Least cost formulation
Necessary condition
Taxes, subsidies and permits
19
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

20
Environmental Effectiveness (2)
taxes
permits
A
A
l(t)
(l)t
L(M)
M
A1
A
A1
A
A2
l1
A2
l
t
l2
L(M)
M
M1
M2
21
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

22
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

23
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

24
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

25
Uncertainty about abatement cost cost
overestimated
MD
Loss when licenses used
tH
t
MC (assumed)
Loss when taxes used
MC (true)
M
Emissions, M
LH
Mt
26
Uncertainty about abatement cost cost
overestimated (2)
MD
tH
t
MC (assumed)
MC (true)
M
LH
Mt
Emissions, M
27
Uncertainty about abatement cost cost
underestimated
MD
t
tL
MC (true)
MC (assumed)
M
LL
Mt
Emissions, M
28
Uncertainty about abatement cost cost
underestimated (2)
MD
t
tL
MC (true)
MC (assumed)
M
LL
Mt
Emissions, M