WT 2022/23

ENVIRONMENTAL AND RESOURCE ECONOMICS

Chapter 3
Environmental Policy
(little changes to slices 21, 39 and 40. Slide 51 with all fields visible).

Prof. Dr. Karen Pittel

Agenda

3.1 Agents of Environmental Policy

3.2 Environmental Policy Instruments
3.2.1 Basics
3.2.2 Command and Control Instruments
3.2.3 Incentive-based Instruments
3.3 Dynamic Aspects of Environmental Policy
3.4 Environmental Policy under Uncertainty
3.5 Additional Benefits of Environmental Policy
3.6 CGE-Models: Macroeconomic Impacts of Environmental Policy

References:
 Perman et al. (2003), Kapitel 6-8
 Feess, E. (2007), Umweltökonomie und Umweltpolitik, 3. Aufl., München: Vahlen.

2
This Chapter‘s Questions

• What criteria can be used to evaluate different environmental policy instruments and what are
the advantages/disadvantages of different instruments?

• How should optimal environmental taxes that deal with long-run problems be designed?

• How does uncertainty affect the welfare effects of different policy instruments?

• What are additional („secondary“) benefits of environmental policies? What does their
existence imply e.g. for climate negotiations?

• How can long-run macroeconomic effects of climate policy be assessed? What are problems
of such assessments?

3
Preliminaries:
Optimization Problem in Case of Environmental Damages

Marginal damages, marginal utility from emissions and marginal abatement costs

Chapter 2: Optimal level of emissions was determined by maximizing the difference between
utility from emissions and damages caused by emissions.

In the optimum: Marginal utility of emissions = marginal damages/external costs

Alternative interpretation of same problem: Optimal level of emissions determined by minimizing the
sum of abatement costs and damages.

Abatement cost = decrease of utility from emissions due to abatement

 marginal abatement cost = forgone marginal utility of emitting

In the optimum: marginal abatement costs = marginal damages/external costs

4
 Efficient Level of Emissions under Both Approaches

Minimum of the sum of abatement Maximum of utility from emissions

costs and emission damages: minus emission damages:

� − 𝑈𝑈(𝐸𝐸) + 𝐶𝐶(𝐸𝐸)
min 𝑈𝑈(𝐸𝐸) max 𝑈𝑈 𝐸𝐸 − 𝐶𝐶(𝐸𝐸)
𝐸𝐸 𝐸𝐸

→
𝜕𝜕(𝑈𝑈 𝐸𝐸� −𝑈𝑈 𝐸𝐸 )
= 𝑈𝑈𝐸𝐸 = 𝑪𝑪𝑬𝑬 → 𝑈𝑈𝐸𝐸 = 𝐶𝐶𝐸𝐸
𝜕𝜕𝐸𝐸

𝐶𝐶𝐸𝐸 𝐶𝐶𝐸𝐸 𝐶𝐶𝐸𝐸

𝐶𝐶𝐸𝐸

abatement

5
3.1 Agents of Environmental Policy

• National/regional/local institutions
• Federal Ministry for the Environment, Nature Conservation and Nuclear Safety (BMU)
• Bavarian State Ministry for Environment and Consumer Protection (StMUV)
• Department of Environment and Health of the City of Munich

• International Organizations
• Directorate-General for Environment of the European Commission (DG Environment)
• European Environment Agency (EEA)
• United Nations Environment Programme (UNEP)

• Private actors, e.g.:

• NGO's (national and international), corporations, citizens

Who (should) perform which task in such a multi-level system?

6
Subsidiarity Priniciple

According to the subsidiarity principle, (environmental) policy should be implemented on the lowest
hierarchical level on which an internalization of all external effects can be achieved.

 Regional environmental policy, if external effects are limited to a region

 National environmental policy, if external effects are limited to a country

 International Environmental Policy, if external effects have international impacts

Art. 5 of the Lisbon Treaty:

„Under the principle of subsidiarity, in areas which do not fall within its exclusive competence,
the Union shall act only if and insofar as the objectives of the proposed action cannot be
sufficiently achieved by the Member States, either at central level or at regional and local level,
but can rather, by reason of the scale or effects of the proposed action, be better achieved at
Union level.”

7
3.2 Environmental Policy Instruments
3.2.1 Basics

„Command and control“ instruments: regulate pollution/use of environment directly (e.g.

through production/efficiency standards, bans,…)

Incentive-based instruments: use economic incentives to incentive environmental-friendly

behavior (e.g. environmental taxes, certificates, subsidies,…)

Associated budgetary effects:

− Command and control mostly associated with no direct budgetary impact

− Incentive-based instruments have direct budgetary impacts

8
Criteria for the Comparison of Environmental Policy Instruments

1. Ecological Effectiveness Is an instrument successful in implementing a given pollution target?

2. Cost-efficiency Does an instrument lead to the reduction of pollution at minimal

costs today („static efficiency“)?

3. Dynamic Incentive Effects Does an instrument incentivize investment in eco-friendly

technologicies and innovation („dynamic efficiency“)?

4. Information Requirements What information is required for the efficient implementation of an

instrument?

5. Transaction Costs What are the costs of an instrument (enforcement costs,

implementation costs, …)?

6. Political Feasibility Is an instrument political/social acceptable? What are its distributional

effects?

9
Cost-Efficiency
Cost-Efficiency is given when the marginal abatement costs (𝑈𝑈𝑖𝑖 𝐸𝐸𝐸𝐸 ) are equalized over all firms.

Example: 2 Firms with marginal abatement costs 𝑈𝑈𝑖𝑖𝐸𝐸𝐸𝐸 , 𝑖𝑖 = 1, 2;

emission target: 𝐸𝐸�

Illustration:

Total abatement cost for two alternative emission

allocations 𝐸𝐸�𝑖𝑖 and 𝐸𝐸�𝑖𝑖 (where 𝐸𝐸�1 + 𝐸𝐸�2 = 𝐸𝐸�1 + 𝐸𝐸�2 = 𝐸𝐸)
�

Total abatement cost for 𝐸𝐸�1 , 𝐸𝐸�2: +

→ Transition from 𝐸𝐸�𝑖𝑖 to 𝐸𝐸�𝑖𝑖 :

Cost increase firm 1 < Cost decrease firm 2

10
3.2.2 Command and Control Instruments

a) Quantity control instruments (quantitative regulation), e.g.

• Emission and immission limits

• Examples: Air quality control, water protection

b) Production/product standards (qualitative regulation), e.g.

• Process-oriented norms (prohibition/requirement of particular technologies)

• Input norms (prohibition of the usage of particular substances)

• Examples: BAT = best available technology, lead-free petrol, pollution limits for food products

11
Starting Points of C+C Instruments

Starting Points Instruments

Immissions Immission Limits

Location of Land Use Plan

Emission

Emissions Emission Limits

Outputs Quotas

Production Technology
Technology Standards

Inputs Input Restrictions

12
Command and Control Instruments I
Cost-Efficiency:
If firms have different marginal benefits of emissions 𝑈𝑈𝑖𝑖𝐸𝐸𝐸𝐸 → uniform regulation is inefficient
-

Under uniform regulation, all firms would face the same emission constraint, e.g. 𝐸𝐸 𝑒𝑒 .

With uniform regulation:

→ 𝑼𝑼𝟏𝟏𝑬𝑬𝑬𝑬 (𝑬𝑬𝒆𝒆 ) ≠ 𝑼𝑼𝟐𝟐𝑬𝑬𝑬𝑬 (𝑬𝑬𝒆𝒆 )

→ cost-inefficient

With individual regulation :

→ 𝑼𝑼𝟏𝟏𝑬𝑬𝑬𝑬 𝑬𝑬∗ = 𝑼𝑼𝟐𝟐𝑬𝑬𝑬𝑬 (𝑬𝑬∗ )

→ cost-efficient

13
Command and Control Instruments II
Ecological Effectiveness:

Depends on specific instrument, e.g. specification of maximum emission level per firm vs
introduction of pollution efficiency standards (rebound effects)

Possible to implement the optimal emission level, 𝐸𝐸 ∗ ? Theoretically yes, if marginal abatement
costs and marginal damages are known (in reality there is often uncertainty about curves as well
as technology development, rebound effects,…).

𝑪𝑪𝑬𝑬

14
Command and Control Instruments III
Dynamic Incentive Effects:

Lower incentives for adoption/development of new technologies in comparison to incentive-based

instruments.

What are the incentives to employ an alternative technology? (role of fixed costs)

Example: Firm 𝑖𝑖 faces an absolute limit on pollution. It employs technology 1 with margial
𝑇𝑇𝑇
abatement cost 𝑈𝑈𝑖𝑖𝑖𝑖𝑖𝑖
. It could switch to technology 2 with marginal abatement cost
𝑇𝑇𝑇
𝑈𝑈𝑖𝑖𝐸𝐸𝑖𝑖
.

Is this profitable for the firm?

Yes, it is profitable (in absence of fixed costs).

15
Command and Control Instruments III
Role of fixed costs

What are the incentives to employ an alternative technology with fixed costs?

Example: As before, but now switch to technology 2 leads to additional fixed cost 𝐶𝐶𝑓𝑓𝑓𝑓𝑓𝑓 .

Is switch still profitable for the firm?

Yes, it is profitable if decrease in abatement cost ( ) > additional fixed cost.

16
Command and Control Instruments IV
Information Requirements:

− For uniform regulation: small

− For cost-efficient (differentiated) regulation: high

• To reach specific pollution target: information on abatement cost curve of each firm is
required.

• To implement optimal pollution level: information on marginal damage curve is

additionally required

Political Feasibility:

− Generally, well accepted with society and policy makers (higher for uniform than for
differentiated regulation).

17
3.2.3 Incentive-based Instruments

− Incentive-based instruments operate via economic incentives: scarcity of environmental goods is

captured by their price.

− 2 options: - Price-based instruments: taxes, subsidies

- Quantity-based instruments: certificates (cap and trade)

Price-based instrument: e.g. environmental tax

− Tax rate = price for specific amount of pollution
→ Societal costs of emissions enter the polluter‘s private cost calculation.

Quantity-based instrument: certificates

− Certificates entitle holder to emit a specific amount and are tradable on a market

− Price of certificate = price for specific amount of pollution

→ Societal costs of emissions enter the polluter‘s private cost calculation.

18
Pollution Tax I
Cost-Efficiency:

Fulfilled automatically as marginal abatement costs are equalized across all firms in equilibrium.

19
Pollution Tax II
Ecological Effectiveness:
To implement a given emission target, aggregate marginal abatement costs have to be known.

Possible to implement the optimal pollution level 𝐸𝐸 ∗ ?

Yes: Set tax rate at 𝐶𝐶𝐸𝐸 = 𝑈𝑈𝐸𝐸 = 𝜏𝜏 (Pigouvian tax).

𝑈𝑈𝑖𝑖𝐸𝐸𝐸𝐸 , 𝑈𝑈𝐸𝐸

𝑪𝑪𝑬𝑬

𝜏𝜏 ∗ = 𝑈𝑈𝐸𝐸∗ = 𝐶𝐶𝐸𝐸∗

20
Pollution Tax III
Dynamic Incentive Effects:

Higher incentive to adopt/develop new technologies in comparison to command and control instruments.

What are the incentives to employ an alternative technology?

𝑇𝑇𝑇 𝑇𝑇𝑇
Same example as before: currently employed technology: 𝑈𝑈𝑖𝑖𝐸𝐸𝑖𝑖
, aternative new technology 𝑈𝑈𝑖𝑖𝐸𝐸𝑖𝑖
.

Is it profitable to switch to technology 2?

Yes, even more profitable compared to command and

control as also tax payment is reduced [net reduction:
+ ]

[Role of fixed costs: Profitable to switch to new technology

for even higher fixed costs than under command and control.] 𝑬𝑬𝑻𝑻𝑻𝑻
i

21
Pollution Tax IV
Information Requirements:

− Cost efficiency is automatically reached (no information on marginal abatement costs

required).

− Implementation of optimal emission level requires information on aggregate 𝑈𝑈𝐸𝐸 and 𝐶𝐶𝐸𝐸

Political Feasibility:

− Good, although sometimes lower than for regulatory instruments.

22
Tradable Pollution Certificates I
Regulator issues certificates such that the desired aggregate pollution reduction 𝑉𝑉 is reached:

𝑉𝑉 = ∑𝑖𝑖 𝐸𝐸𝑖𝑖Π − ∑𝑖𝑖 𝑍𝑍𝑖𝑖

with 𝐸𝐸𝑖𝑖Π = pollution in the profit maximum of firm 𝑖𝑖 without regulation

𝑍𝑍𝑖𝑖 = pollution a firm is entitled to according to the number of certificates it

owns (1 certificate entitles to pollution of 1 unit).

Aggregate amount of pollution after regulation: 𝐸𝐸� = ∑𝑖𝑖 𝑍𝑍𝑖𝑖

Firms can trade certificates on a market.

The certificate price 𝑝𝑝𝑍𝑍 results from equilization of supply and demand.

23
Tradable Pollution Certificates II

Emissions Trading and Trade Equilibrium

Profit maximum of individual firm:

max 𝑈𝑈𝑖𝑖 𝐸𝐸𝑖𝑖 − 𝑝𝑝𝑍𝑍 𝐸𝐸𝑖𝑖 → 𝑈𝑈𝑖𝑖 𝐸𝐸𝐸𝐸 = 𝑝𝑝𝑍𝑍

𝐸𝐸𝑖𝑖

→ A firm buys certificates as long as the costs of abating an additional marginal unit of
emissions are higher than the price of a certificate (i.e. as long as 𝑈𝑈𝑖𝑖 𝐸𝐸 > 𝑝𝑝𝑍𝑍).
𝑖𝑖

→ A firm sells certificates as long as the costs of abating an additional marginal unit of
emissions is lower than the price of a certificate (i.e. if 𝑈𝑈𝑖𝑖 𝐸𝐸 < 𝑝𝑝𝑍𝑍 ).
𝑖𝑖

→ Trading continues until all firms hold their desired number of certificates and 𝑈𝑈𝑖𝑖 𝐸𝐸 = 𝑝𝑝𝑍𝑍
𝑖𝑖
holds for all firms.

24
Tradable Pollution Certificates III
Emissions Trading and Trade Equilibrium (II)

Initial allocation: �
𝒁𝒁𝟏𝟏 + 𝒁𝒁𝟐𝟐 = 𝑬𝑬

Allocation after trade: �

𝒁𝒁∗𝟏𝟏 + 𝒁𝒁∗𝟐𝟐 = 𝑬𝑬

Equilibrium price: 𝒑𝒑∗𝒁𝒁

25
Tradable Pollution Certificates IV
Cost-Efficiency: Fulfilled automatically as marginal abatement costs are equalized in
equilibrium.

Ecological Effectiveness: High (pollution level determined by the number of certificates issued)

Dynamic Incentive Effects: Similar to environmental taxes.

Political Feasibility: In general as high as for environmental taxes.

Information Requirements:
− To reach optimal emission level: same as for environmental taxes.
− To reach politically determined emission level cost-efficiently: no information
on abatement costs or damages required.

26
Initial Certificate Allocation and Allocation Mechanism
Different mechanisms to issue certificates are conceivable:

• Free allocation (e.g. proportionate to historic emissions (grandfathering) or according to

best-available-technology)

• Auctioning

Initial allocation and allocation mechanism are irrelevant for the equilibrium allocation of
certificates and the equilibrium of certificates (see next page).

But fiscal effects differ:

• Auctioning: Firms have to pay for (all) certificates (revenues go to the state)

• Free allocation: Firms do not have to pay for initial number certificates and can sell
excessive certificates, resp. only have to buy additional certificates (no
revenues for the state).

27
Equilibrium for Alternative Initial Allocations

Scenario 1 Scenario 2

𝑍𝑍�𝑖𝑖, 𝑍𝑍̌𝑖𝑖 = initial allocation of certificates to firms 𝑖𝑖 = 1, 2.

→ After trading, the allocation of certificates and thus the allocation of emissions as well
as the certificate price are identical for both scenarios.

28
Price Volatility on Certificate Markets

In contrast to pollution taxes, the price of pollution certificates depends on the demand for
certificates and is therefore volatile. Pro or con for certificates?

Pro: In case of recession, the price of certificates falls due to decreasing demand and thus
reduces the burden to firms.

Con: Uncertainty about future prices can lead to suboptimal investment in „green“ technologies.

Reduction of Price Volatility possible by e.g.

− Spatial extension of the certificate market

− Allowing for certificates to be used at a later point in time (‘banking‘)
− Introducing minimum and/or maximum certificate prices

29
European Emissions Trading System (EU ETS)

− Established in 2005.

− Industries included in EU ETS: power generation and 6 other energy-intensive industries

(covers approx. 50% of European CO2-emissions).

− Allocation of certificates partly via auctioning, partly via free allocation.

− Decrease of the volume of certificates by 2.2% per year (leading to – 43% emission reduction
until 2030).

− In order to stabilize prices: Introduction of Market Stability Reserve in 2019.

− Price of certificates: 26.10.2022: 75 €

− Fit for 55 Package of the EU Green Deal:

− increase of linear reduction factor to 4.2%

− introduction of a second EU ETS for transport and buildings
− carbon leakage protection: substitution of free certificate allocation by Carbon border
adjustment mechanism

30
European Emission Trading System (EU ETS)
Price Dynamics (until Oct 26, 2022)

https://tradingeconomics.com/commodity/carbon

31
International CO2 Prices 2022

World Bank 2022

International CO2 Prices 2022

World Bank 2022

International CO2 Prices 2022

2002
2012
2022
10 100

World Bank 2022

Equivalence of Price- and Quantity-based Instruments

Certificates Pigou Tax

𝑼𝑼𝟐𝟐𝑬𝑬𝑬𝑬 𝑼𝑼𝟐𝟐𝑬𝑬𝑬𝑬

𝑝𝑝𝑍𝑍∗ = 𝑈𝑈1𝐸𝐸1 = 𝑈𝑈2𝐸𝐸 𝜏𝜏 = 𝑈𝑈1𝐸𝐸1 = 𝑈𝑈2𝐸𝐸

2
2

𝑈𝑈1𝐸𝐸𝐸 𝑈𝑈1𝐸𝐸𝐸
𝐸𝐸1∗ 𝐸𝐸2∗ 𝐸𝐸 𝐸𝐸1∗ 𝐸𝐸2∗ 𝐸𝐸

Set by regulator: aggreate emission level 𝐸𝐸 ∗ Set by reguator: tax rate 𝜏𝜏

After Trading: emission allocation 𝐸𝐸1∗ + 𝐸𝐸2∗ = 𝐸𝐸 ∗ After firms‘ adjustment to tax: 𝐸𝐸1∗ + 𝐸𝐸2∗ = 𝐸𝐸 ∗

price of certificates 𝑝𝑝𝑍𝑍∗ = 𝜏𝜏

35
3.3 Dynamic Aspects of Environmental Policy

So far in this chapter we have delt with environmental policies without considering the time
dimension explicitly.

But: Considering not only the present but also the future in the analysis often yields new important
insights as…

1. … optimal environmental policies…

a. … might have to be adjusted over time.

b. … have to consider potential long-term effects from today‘s pollution.

2. … environmental policies have long-run impacts on economic development.

36
1a) Adjustment of optimal policies over time

Example: Technological Change decreases marginal abatement costs (𝑈𝑈𝐸𝐸 )

→ Optimal tax rate decreases from 𝜏𝜏1 to 𝜏𝜏2 .

𝑈𝑈𝐸𝐸𝐸 𝐶𝐶𝐸𝐸

𝜏𝜏1
𝜏𝜏2
𝑈𝑈𝐸𝐸𝐸

𝐸𝐸2∗ 𝐸𝐸1∗

37
1b) Long-term effects to today’s pollution

So far, in this lecture we have only considered flow pollution:

• Relevant for pollution that stays in the environment only for a short while (e.g. noise, particulate
matter).

• Determination of optimal pollution level in the case of flow pollution:

max 𝑈𝑈(𝐸𝐸𝑡𝑡 ) – 𝐶𝐶(𝐸𝐸𝑡𝑡 ) → 𝑈𝑈𝐸𝐸𝑡𝑡∗ = 𝐶𝐶𝐸𝐸𝑡𝑡∗ with 𝐸𝐸𝑡𝑡 = pollution at time 𝑡𝑡.
𝐸𝐸𝑡𝑡

• Optimal pollution tax rate: 𝜏𝜏𝑡𝑡 = 𝐶𝐶𝐸𝐸𝑡𝑡∗

→ optimal tax rate is equal to the marginal costs from

pollution at time 𝑡𝑡.

38
Now, consider „stock pollution“
• Pollution that accumulates in the environment results in damages (external costs) not only
in the present but also in the future (e.g. nuclear waste, CO2 in the atmosphere).

• Accumulation of pollution to a stock 𝑆𝑆: 𝑆𝑆𝑡𝑡+1 − 𝑆𝑆𝑡𝑡 = 𝐸𝐸𝑡𝑡+1 − 𝑎𝑎 � 𝑆𝑆𝑡𝑡

→ 𝑆𝑆𝑡𝑡+1 − 𝑆𝑆𝑡𝑡 : change of pollution stock from time 𝑡𝑡 to 𝑡𝑡 + 1

→ emissions 𝐸𝐸 increase the stock
→ natural processes lead to partial absorption/degeneration of the
stock
𝑎𝑎 = absorption/degeneration rate (if 𝑎𝑎 = 0: no absorption, e.g.
heavy metals, dioxin,…)
𝑎𝑎 � 𝑆𝑆𝑡𝑡 = fraction of the stock that degenerates in period 𝑡𝑡 + 1

• Stock: 𝑆𝑆𝑡𝑡+1 = 𝐸𝐸𝑡𝑡+𝟏𝟏 + (1 − 𝑎𝑎) � 𝑆𝑆𝑡𝑡

39
Stock Pollution II

− To derive the optimal environmental policy, the damages caused in the future by today‘s emissions
have to be considered.

− Simple example: the world ends after two periods and there is no pollution at time 0 (𝑆𝑆0 = 0).

− Welfare optimization:

𝟏𝟏
𝐦𝐦𝐦𝐦𝐦𝐦 ∑𝟐𝟐𝒕𝒕=𝟏𝟏[𝑼𝑼 𝑬𝑬𝒕𝒕 − 𝑪𝑪 𝑺𝑺𝒕𝒕 ] � s.t. 𝑺𝑺𝒕𝒕+𝟏𝟏 − 𝑺𝑺𝒕𝒕 = 𝑬𝑬𝒕𝒕+𝟏𝟏 − 𝒂𝒂 � 𝑺𝑺𝒕𝒕
𝑬𝑬𝟏𝟏 ,𝑬𝑬𝟐𝟐 𝟏𝟏+𝝆𝝆 𝒕𝒕−𝟏𝟏

with 𝜌𝜌 = rate of time preference.

− Given 𝑆𝑆0 = 0, we have: 𝑆𝑆1 = 𝐸𝐸1 and 𝑆𝑆2 = 𝐸𝐸2 + (1 − 𝑎𝑎) � 𝐸𝐸1

𝜕𝜕𝑆𝑆 𝜕𝜕𝑆𝑆 1 1−𝑎𝑎

− First-order conditions: 𝑈𝑈𝐸𝐸1 − 𝐶𝐶𝑆𝑆1 𝜕𝜕𝐸𝐸1 − 𝐶𝐶𝑆𝑆2 𝜕𝜕𝐸𝐸2 � 1+𝜌𝜌 = 0 ⇔ 𝑈𝑈𝐸𝐸1 = 𝐶𝐶𝑆𝑆1 + 𝐶𝐶𝑆𝑆2 � 1+𝜌𝜌
�1 �1
=1 =1−𝑎𝑎
𝜕𝜕𝑆𝑆
𝑈𝑈𝐸𝐸2 − 𝐶𝐶𝑆𝑆2 𝜕𝜕𝐸𝐸2 = 0 ⇔ 𝑈𝑈𝐸𝐸2 = 𝐶𝐶𝑆𝑆2
�2
=1

40
Stock Pollution III
𝟏𝟏−𝒂𝒂
So, in the welfare optimum: 𝑼𝑼𝑬𝑬𝟏𝟏 = 𝑪𝑪𝑺𝑺𝟏𝟏 + 𝑪𝑪𝑺𝑺𝟐𝟐 �
𝟏𝟏+𝝆𝝆
𝑼𝑼𝑬𝑬𝟐𝟐 = 𝑪𝑪𝑺𝑺𝟐𝟐

This means, that in the welfare optimum, the marginal utility of emitting a marginal unit has to be
equal to the present value of the damages caused by this marginal unit of emissions.

(If world would not end after two periods: Present value would contain the marginal damages caused
to all future periods as well.)

→ environmental policy today needs to take into account the present value of future damages.

𝟏𝟏−𝒂𝒂
→ optimal environmental tax rate in period 1: 𝝉𝝉𝟏𝟏 = 𝑪𝑪𝑺𝑺𝟏𝟏 + 𝑪𝑪𝑺𝑺𝟐𝟐 � 𝟏𝟏+𝝆𝝆

41
2) Environmental Policy and Economic Growth

Environmental policies induce effects on investment and on incentives to engage in technology

development that have repercussions for growth and future welfare.

In a long-run perspective, investment in environmental protection…

− … reduces negative welfare effects of pollution (as e.g. health problems, decreasing
productivity) which has a positive effect on economic development.

− … reduces the resources available for other types of investment (e.g. in human and physical
capital) which lowers growth.

− … might accelerate technological change and thus foster economic growth.

42
Welfare and Growth Effects of Optimal Environmental Policy
present
value of welfare after internalization of externality
welfare

no internalization of
externality

optimal
growth exemplary growth rates after internalization of externality
rate
no internalization of
externality

While the optimal growth rate can be higher, lower or even (at least temporarily) negative after the
internalization of pollution externalities, the present value of welfare is higher as long as environmental policy
is conducted optimally.

43
Effects of Mitigating Climate Change on Income Development According
to the Stern Report

Stern 2007

“In broad brush terms, spending somewhere in the region of 1% of gross world product on
average forever could prevent the world losing the equivalent of 10% of gross world product
for ever, using the approach to discounting.”
Stern 2007

44
3.4 Environmental Policy under Uncertainty

Assumed so far: Perfect information about damages and abatement cost.

In case of perfect information: Taxes and certificates can be used as perfect substitutes and
thus result, if designed accordingly, in the same allocation, the
same abatement cost and the same pollution price.

Problem: Information is unsually not perfect, e.g. there is uncertainty about

• marginal damages, and/or
• marginal abatement cost.

→ Neither a pollution tax nor emission trading leads to the welfare maximum.

→ Which instrument induces a lower welfare loss?

45
Weitzman (1974) „Prices vs Quantities“

Weitzman, Martin (1974) „Prices vs Quantities“, Review of Economic Studies 61 (4), 477-491.

Weitzman showed that:

If uncertainty arises with respect to the marginal abatement cost:

Which instrument leads to a higher welfare loss depends on the slopes of the
marginal damage curve and the marginal abatement cost curve.

If uncertainty arises with respect to marginal damages:

Both instruments lead to the same welfare loss.

46
1. Uncertainty regarding marginal abatement cost

Assume (for example): Marginal abatement costs are overestimated by the regulator.

Case a): the marginal damage curve is steeper than the marginal abatement cost curve.

𝐸𝐸 ∗ , 𝜏𝜏 ∗ = welfare optimal 𝐸𝐸, 𝜏𝜏

𝐶𝐶𝐸𝐸
𝑈𝑈𝐸𝐸 , 𝐶𝐶𝐸𝐸 𝐸𝐸 𝑠𝑠 = supposingly optimal 𝐸𝐸
𝜏𝜏 𝑆𝑆
= actual emissions in case of emission
trading
𝜏𝜏 ∗
𝑝𝑝 𝑆𝑆 = equilibrium certificate price for 𝐸𝐸 𝑠𝑠
𝑝𝑝 𝑆𝑆
𝑈𝑈𝐸𝐸 (supposed) 𝜏𝜏 𝑆𝑆 = supposingly optimal 𝜏𝜏
𝑈𝑈𝐸𝐸
𝐸𝐸 𝜏𝜏 = actual emissions in case of taxation

𝐸𝐸 𝜏𝜏 𝐸𝐸 ∗ 𝐸𝐸 𝑆𝑆 𝐸𝐸

→ Welfare loss (taxation) > welfare loss (emission trading)

47
Case b): The marginal damage curve is flatter than marginal abatement cost curve.

𝑈𝑈𝐸𝐸 , 𝐶𝐶𝐸𝐸 𝐶𝐶𝐸𝐸

𝜏𝜏 𝑆𝑆
𝜏𝜏 ∗

𝑝𝑝𝑆𝑆 𝑈𝑈𝐸𝐸 (supposed)

𝑈𝑈𝐸𝐸

𝐸𝐸
𝐸𝐸 𝜏𝜏 𝐸𝐸 ∗ 𝐸𝐸 𝑆𝑆

→ Welfare loss (emissions trading) > welfare loss (taxation)

A price instrument is more (less) efficient than a quantity mechanism when marginal damages
are relatively flat (steep) compared to the marginal abatement costs.

48
2. Uncertainty regarding marginal damages
Assume (for example): The marginal damages are overestimated by the regulator.

𝑈𝑈𝐸𝐸 , 𝐶𝐶𝐸𝐸
𝐶𝐶𝐸𝐸 (supposed)

𝐶𝐶𝐸𝐸
Intuition:
𝒑𝒑𝑺𝑺 = 𝜏𝜏 𝑆𝑆
Firms set their level of
𝜏𝜏 ∗ emissions according to their
marginal abatement cost.
𝑈𝑈𝐸𝐸

𝐸𝐸 𝜏𝜏 = 𝐸𝐸 𝑆𝑆 𝐸𝐸 ∗ 𝐸𝐸

Welfare loss (taxation) = welfare loss (emission trading)

A price instrument is as (in)efficient as a quantity mechanism independent of the slopes of

marginal damages and marginal abatement costs.

49
3.5 Additional Benefits of Environmental Policy
In addition to the reduction of the pollutant that environmental policy aims at, it can induce
other desirable (side-)effects – whether of not these arise usually depends on the instrument
employed and the type of pollution targeted:

1. „Double dividend“
A so-called double dividend arises if the revenue generated by pollution taxes/auctioning of
certificates is used to lower the rates of other distorting taxes (e.g. reduction of VAT, wage or
income taxes)

Dividend 1: Increase in welfare due to internalization of external costs.

Dividend 2: Increase in welfare due to reduction of excess burden from other taxes.

50
Example: Using revenues from pollution taxes to reduce the excess burden of a VAT

1 + 𝝉𝝉𝟏𝟏 𝒑𝒑𝑨𝑨 (𝒙𝒙)

(1 + 𝝉𝝉𝟐𝟐 )𝑝𝑝𝐴𝐴 (𝑥𝑥)

𝒑𝒑∗𝝉𝝉𝟏𝟏 (𝒙𝒙)
𝒑𝒑∗𝝉𝝉𝟐𝟐 (𝒙𝒙) 𝒑𝒑𝑨𝑨 (𝒙𝒙)
If the tax revenue generated by the
pollution tax is used to reduce the
VAT rate (from 𝝉𝝉𝟏𝟏 to 𝝉𝝉𝟐𝟐 ) , this
lowers the excess burden caused by
the VAT.

Tax revenue (𝝉𝝉𝟏𝟏 ): Tax revenue (𝝉𝝉𝟐𝟐 ):

Excess burden (𝝉𝝉𝟏𝟏 ): Excess burden (𝝉𝝉𝟐𝟐 ):

Pollution tax revenue: -

51
2. “Secondary“ environmental benefits

• Arise if the reduction of one type of pollution reduces emissions of other pollutants at the same
time.

• Example: Climate Policy

 Primary goal: Reduction of CO2-emissions from the burning of fossil fuels.

 Less fossil fuels being burnt reduces emissions of SO2, PM, NOx… as well
→ positive health effects, e.g., constitute additional benefits from climate policy (see next
slide)

• Considering secondary benefits that often arise closer in time can increase incentive to reduce
the use of fossil fuels considerably – especially in regions where, e.g., air pollution is high.

52
Benefits of from Reduced Non-CO2-Emissions

Examples for pollutants that are emitted together with CO2:

Pollutant Sources Health Effects

Carbon fuel combustion; industrial processes; reduction of oxygen delivery to the body's organs and
Monoxide natural sources like wildfires tissues; visual impairment; reduced work capacity….
(CO)
Nitrogen combustion processes in automobiles irrigation of lungs and causing lower resistance to
Oxide (NOx) and power plants; home heaters and respiratory infections; increased incidence of acute
gas stoves also produce substantial respiratory diseases in children
amounts
Particulate emission directly by a source or premature death; increased hospital admissions and
Matter (PM) formation by the transformation of emergency room visits; increased respiratory
gaseous emissions; combustion symptoms and disease; decreased lung function;
processes cause direct emissions alterations in lung tissue and structure and in
respiratory tract defense mechanisms; lung cancer
Sulfur burning of coal and oil; metal smelting effects on breathing; respiratory illness; alterations in
Dioxide and other industrial processes the lungs' defenses, and aggravation of existing
(SO2) cardiovascular disease

53
3. Reduction of existing technical and economic inefficiencies
Incentives to switch production processes to modern, more efficient technologies.

4. Induced technological change

Incentives to develop new more efficient (and less polluting) technologies.

5. Promotion of technology transfers to developing countries

Example: Clean Development Mechanism (CDM) of Kyoto Protocol
− CDM allowed emission reductions to be carried out in developing countries (usually at lower
cost than in industrial countries) and be counted towards emission reduction obligations of
industrial countries.
− Emission reduction had to be in addition to status quo.
− Aim: To foster sustainable development in developing countries, e.g., through technology
transfer in the course of emission reduction.

54
3.6 CGE-Models: Macroeconomic Impacts of
Environmental Policy

− Environmental policies (e.g. environmental taxes) change relative prices between polluting and
non-polluting goods/services and therefore affect decisions of economic agents outside of the
regulated sector as well.

− Challenge: Estimation of general equilibrium effects and heterogeneous impacts on different

economic variables (e.g. on trade, employment, industrial output, …) often
requires highly complex models.

− Problem: These models can usually not be solved in closed form analytically but only
numerically.

− Purpose of these models: Ex ante estimation of, e.g., allocative, distributive, fiscal an/or
environmental effects of alternative policies and shocks.

55
CGE-Models
CGE-Models = Computable General Equilibrium Models

1. „Computable": Closed-form analytical solutions not attainable due to high

complexity of models.

Instead: Calibration of models based on empirical data and numercial

approximation of the effects of policies/shocks (via computer-based
simulations).

2. „General": General equilibrium (in contrast to partial equilibrium) analysis

3. „Equilibrium models": Prices coordinate individual decisions of economic agents such that
in equilibrium all markets clear (supply = demand).

56
Model structure
• Specification of equations describing demand and supply on all markets.

• Assumptions on behavior of households and firms (utility/profit maximization).

• Derivation of equilibrium conditions for all markets; prices as coordinating mechanism.

Data base
• "Social Accounting Matrix" containing data from

• Input-output tables
• Statistics on income use, generation and distribution
• Balance of payments
• International statistics
….

57
Exemplary modelling of supply

• Production of final products 𝑋𝑋𝑖𝑖 , 𝑖𝑖 = 1, . . . , 𝑛𝑛, from capital (𝐾𝐾𝑖𝑖 ), labor (𝐿𝐿𝑖𝑖 ), energy (𝐸𝐸𝑖𝑖 ), materials (𝑀𝑀𝑖𝑖 )

• „Nested" production functions:

Production of 𝑋𝑋𝑖𝑖
from 𝑀𝑀𝑖𝑖 and 𝐾𝐾𝐿𝐿𝐸𝐸𝑖𝑖 -aggregate

Production of 𝐾𝐾𝐾𝐾𝐸𝐸𝑖𝑖 Production of 𝑀𝑀𝑖𝑖

from 𝐿𝐿𝑖𝑖 and 𝐾𝐾𝐸𝐸𝑖𝑖 from different material Inputs

Production of 𝐾𝐾𝐸𝐸𝑖𝑖
Input of 𝐿𝐿𝑖𝑖
from 𝐾𝐾𝑖𝑖 and 𝐸𝐸𝑖𝑖

Production of 𝐸𝐸𝑖𝑖 Input of 𝐾𝐾𝑖𝑖 Modelling of the production functions

from different energy sources on the different levels can differ, e.g.
with respect to substituability of the
… production factors (Leontiev, Cobb-
Oil Wind Solar
Douglas, CES,…)

58
Exemplary modelling of demand side
• Consumption of energy-related and non energy-related goods:

Utility 𝑈𝑈(𝐸𝐸, 𝑁𝑁𝑁𝑁, 𝐿𝐿)

Energy-related (𝐸𝐸) + non-

Leisure (𝐿𝐿)
energy related (𝑁𝑁𝑁𝑁) goods

𝑁𝑁𝑁𝑁-goods (aggregate) ... 𝐸𝐸-goods (aggregate)

𝑁𝑁𝑁𝑁 - 𝑁𝑁𝑁𝑁 - 𝑁𝑁𝑁𝑁 - 𝑁𝑁𝑁𝑁 -good

… electricity gas oil products
good 1 good 2 good 3 𝑛𝑛

59
Model calibration
− Choice of a base year.

− Calibrating the economy for this base year:

− Using empirical estimates for parameters where possible.

− Model parameters for which no empirical estimates exist are calibrated such that the
economy is in equilibrium given the data of the base year.

Computing the effects of a policy measure

– Integrate policy measure into baseline scenario.

– Run numerical simulation to obtain new equilibrium of the economy and assess the effects of
the policy measure by comparison with baseline scenario.

60