Conventional Solutions to Environmental

Problems
Command-and-Control Approach
 Standards in Environmental Policy

 Types of Environmental Standards

 Ambient standard – a standard that designates the quality of the
environment to be achieved, typically expressed as a maximum allowable
pollutant concentration
 Technology-based standard – a standard that designates the equipment or
method to be used to achieve some abatement level
 Performance-based standard – a standard that specifies a pollution limit to
be achieved but does not stipulate the technology

2
 Implications of Using Standards
 Two key implications
 Are standards set to achieve allocative efficiency?
 where MSB of abatement equals MSC of abatement
 Given some environmental objective, is that objective being achieved in a
manner that is cost-effective?

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Efficient Standards

MSBAbatement = MSCAbatement
 MSB of Abatement

 Additional social gains as pollution abatement increases

 Measured as reduction in damages or costs caused by pollution
(i.e., reduction in MEC)
 Represents society’s D for environmental quality
 Implies MSB is negatively sloped

5
 MSC of Abatement
 Sum of all polluters marginal abatement costs plus
government’s marginal cost of enforcement
 Two components: MSC = MACMKT + MCE
• MACMKT is the sum of all polluters’ individual marginal abatement
cost (MAC) functions
 (SMACi = MACMKT)
• MCE is marginal cost of enforcement
 Change in government’s cost of monitoring and enforcing abatement

 MSC is positively sloped

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 Allocatively Efficient Level of A (AE)
 AE occurs at the point where:
 MSB of abatement = MSC of abatement
 Graphically where the two curves intersect

7
 Modeling AE
$
MSC

MSB

AE Abatement (A)
8
 Why Standards May Not Be Efficient
 Legislative Constraints
 Many standards are benefit-based, i.e., set to improve society’s
well-being with no consideration for the associated cost
 Imperfect information
 Inability to identify MSB and/or MSC
 MSB: due to the problem of nonrevelation of preferences
 MSC: difficulty in identifying each firm’s MAC, including implicit costs

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 Why Standards May Not Be Efficient
(continued)

 Nonuniformity of pollutants
 Changes in emissions do not have uniform effects on environment
 e.g., if polluters are at different distances from populations or ecosystems, MSB
would vary
 Regional differences
 Even if AE is identified at the national level, it is not likely to be
efficient at regional level

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CAC and Technology-Based
Standards
 Technology-Based Standards

 Technology-based standards specify the type of

abatement equipment or method to be used
 By definition, these standards potentially prevent firms from
selecting and using the least-cost abatement method

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 Analysis: Use MAC Curve

 Technology-based standard
 If prevented from using the least-cost abatement method, firms would
operate above their MAC curve
 Performance-based standard
 If allowed to select an abatement method to achieve some performance
level, p-maximizing firms will choose the least-cost method and operate
on the MAC curve

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 Modeling Cost-Ineffectiveness
$ MAC
Technology-based
standard

MAC represents least-cost

method of abatement
Performance-based Technology-based standards
standard can force some firms to operate
above MAC

14 AX Abatement (A)
CAC and Uniform Standards
 Overview

 Uniform standards waste economic resources as long as

abatement costs differ among polluting sources
 Cost savings can be obtained if low-cost abaters do more
cleaning up than high-cost abaters

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 Model

 Assumptions
 2 polluting sources in some region
 Each generates 10 units of pollution
 Government sets emissions limit of 10 units for region or 5 units per firm
 Uniform standard: each firm must abate 5 units
 Cost conditions
Polluter 1: TAC1 = 1.25(A1)2
MAC1 = 2.5(A1)
 where A1 is pollution abated by Polluter 1

Polluter 2: TAC2 = 0.3125(A2)2

MAC2 = 0.625(A2)
 where A2 pollution abated by Polluter 2

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 Model
 Find the total abatement costs using the uniform standard

 Solution:
 The TACs for each firm are
 TAC1 = 1.25(A1)2 = 1.25(5)2 = $31.25
TAC2 =0.3125(A2)2 = 0.3125(5)2 = $7.81
 Sum of TACs = $39.06, which represents the value of resources
given up by society to clean up the pollution

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 Model
 Use MACs to prove that the uniform standard is not cost-effective
 Solution
 With uniform standards, the MACs are not equal
 MAC1 = 2.5(5) = $12.50
 MAC2 = 0.625(5) = $3.125
 Shows that Polluter 2 has a cost advantage
 The 5th unit of A (i.e., the marginal unit) costs Polluter 2 $9.37 less than it costs
Polluter 1
 It would be cheaper if Polluter 2 did more of the abating, but it lacks an
incentive to do so

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 Model

 Find the cost-effective abatement, A1 and A2

 Solution: uses 3 simple steps
 (i) Set MAC1 = MAC2
2.5A1 = 0.625A2
An application of the equimarginal principle of optimality
 (ii) Set A1 + A2 = Abatement Standard
A1 + A2 = 10
 (iii) Solve equations (i) and (ii) simultaneously
2.5 (10 - A2) = 0.625A2
25 - 2.5A2 = 0.625A2, so A1 =2 A2 =8
 Prove that this is cost-effective
MAC1 = 2.5A1 = 2.5(2) = $5.00
MAC2 = 0.625A2 = 0.625(8) = $5.00
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 Model

 Show that total abatement costs are lower at this abatement allocation
than the costs when a uniform standard is used
 Solution
 TAC1 = 1.25(2)2 = $5.00
 TAC2 = 0.3125(8)2 = $20.00
 S TACs (cost-effective) = $25.00
 S TACs (uniform standard)= $39.06
 Cost Savings= ($39.06 - $25.00) = $14.06

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 Graphical Model
MAC1 MAC2
25.00

6.25
5.00 5.00

0 2 10
Polluter 1’s Abatement
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10 8 Polluter 2’s Abatement 0
 Further Observations

 Problem: Public officials will not know where to set firm-specific

standards without knowing MAC for every polluter
 Implies that a cost-effective solution is virtually impossible under
CAC framework
 Result is possible using market approach

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Economic Solutions to Environmental
Problems The Market Approach
 Overview
 Market approach refers to incentive-based policy that encourages
conservative practices or pollution reduction strategies
 Difference between market approach and command-and-control approach is
how each approach attempts to achieve its objectives
 Types of Market Instruments
 Pollution charge
 Subsidies
 Deposit/refund systems
 Pollution permit trading systems

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Pollution Charges
 Pollution Charge
 Fee that varies with amount of pollutants released
 Based on “Polluter-Pays Principle”
 Types of pollution charges
 Effluent/emission fees
 Product charge
 User charge
 Administrative charge

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 Product Charge
 Fee added to price of pollution-generating product, which
generates negative externality
 Impose product charge as per unit tax on product, e.g., gas tax
 How does the tax on petrol in Malaysia compare with that of other
nations?
 If the tax equals the marginal external cost (MEC) at QE, it is called a
Pigouvian tax

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 Modeling a Pigouvian Tax

MSC = MPC + MEC

MPCt
MPC
a

Amount of tax
b

MPB = MSB
0 QE QC Q of gasoline
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 Assessing the Model
 In theory, achieves an efficient outcome
 In practice, difficult to identify the value of MEC at QE
 Allows only for an output reduction to reduce pollution

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 Emission (Effluent) Charge
 A fee imposed directly on the discharge of pollution
 Assigns a price to pollution
 Typically implemented through a tax

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 Model: Single Polluter Case
 Government sets an abatement standard at AST
 Policy options to polluter are:
 Abate up to AST and incur those costs OR
 Pay a constant per unit tax, t, on any abatement less than AST
 Total Tax = t(AST - AO)
 where AO is actual abatement level
 Marginal Tax (MT) = t
 Because t is constant, t = MT
 Firm will choose the least-cost option: the marginal tax (MT) or
the marginal abatement cost (MAC)

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 Modeling Emission Charge
Single Polluter
$ Firm abates up to Ao since
MAC < MT; firm pays tax
MAC
between AO and AST, since
MAC > MT in that range
0aAO = cost to abate AO
AOabAST = tax on pollution
c
not abated up to AST
a b MT
t

0 AO AST Abatement (A)

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 Model: Multiple Polluter Case
 To facilitate comparison, we use the same model as in the
uniform standard case
 Assumptions
 2 polluting sources in some region
 Each generates 10 units of pollution
 Government sets emissions limit for region as 10 units, which
implies AST = 10
 Policy: To achieve AST, government imposes an emission charge as a
unit tax (t) of $5

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 Model: Multiple Polluter Case

 Each firm responds as in the single polluter case

 Abates as long as MAC < MT
 Pays emission charge when MAC > MT
 Polluter 1: TAC1 = 1.25(A1)2
MAC1 = 2.5(A1)
 where A1 is pollution abated by Polluter 1
 Polluter 2: TAC2 = 0.3125(A2)2
MAC2 = 0.625(A2)
 where A2 is pollution abated by Polluter 2
 Find each firm’s abatement level. Then, find each firm’s total
abatement costs (TAC) and tax payment at that level. Support with a
graph.
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 Solution
 Polluter 1:
 Abates up to the point where MAC1 = MT,
 Set 2.5(A1) = $5, or A1 = 2
 Incurs TAC1 = 1.25(2)2 = $5
 Incurs Total Tax = 5(10 - 2) = $40
 Polluter 2:
 Abates up to point where MAC2 = MT
 Set 0.625(A2) = $5, or A2 = 8
 Incurs TAC2 = 0.3125(8)2 = $20
 Incurs Total Tax = 5(10 - 8) = $10

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 Modeling An Emission Charge
Multiple Polluter

MAC1 MAC2
Total Abatement Level = 10 = As
25.00
TAC1 + TAC2 = $25 (right triangles)
Total Tax Payments = $50 (rectangles)

6.25
MT = 5.00 MT = 5.00

0 2 10
Polluter 1’s Abatement

10 8 Polluter 2’s Abatement 0

 Assessing the Model (pros)
 Abatement standard is met
 Generates $40 in tax revenues from high-cost abater and $10
from low-cost abater
 Low-cost abaters do most of cleaning up
 Cost-effective solution is obtained
 MACs are equal at $5 tax rate
 Combined TAC of $25 is lower than $39.06 under command-and-
control with a uniform standard

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 Assessing the Model (cons)

 Tax authority will not know where MACs are equal

 Will have to adjust rate until objective achieved
 Monitoring costs potentially higher
 Firms might evade tax by illegally disposing pollutants
 Distributional implications
 Consumers may pay higher prices due to tax
 Job losses may result from polluter paying new taxes and/or changing
technology to abate

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 Pollution Charges in Practice

 Internationally, the pollution charge is the most commonly used

market-based instrument
 Some countries use effluent charges to control the noise pollution
generated by aircraft
 Others levy charges on products such as motor vehicles, pesticides,
fertilizers, batteries and gasoline

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Environmental Subsidies
 Environmental Subsidies

 Two major types of subsidies:

 Abatement equipment subsidies
 Pollution reduction subsidies

42
 Abatement Equipment Subsidy

 Defined as a payment aimed at lowering the cost of abatement

technology
 Goal is to internalize the positive externality associated with the
consumption of abatement activities
 If the subsidy (s) equals the marginal external benefit (MEB)
at QE, it achieves an efficient equilibrium and is called a
Pigouvian subsidy

43
 Assessing the Model
 It is difficult to measure the MEB
 May bias polluters’ decisions about how best to abate

44
 Pollution Reduction Subsidy

 To implement, government pays the polluter a subsidy (s) for

every unit of pollution abated below some pre-established level
ZST
 Per unit subsidy = s(ZST - ZO), where ZO is the actual
level of pollution
 Analogous to an emission charge

45
 Assessing the Model

 Might be less disruptive than an equipment subsidy

 Can have the perverse effect of elevating pollution levels in
the aggregate since the subsidy lowers unit costs and raises
profit, encouraging entry

46
 Subsidies in Practice

 Environmental subsidies typically are implemented as grants, low-

interest loans, tax credits or exemptions, and rebates
 Many countries around the world use these instruments, including
Austria, Finland, Japan, and Turkey
 In the U.S., common uses include federal funding to build publicly-
owned treatment works and subsidies to encourage the
development of cleaner fuels and low-emission vehicles

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Deposit-Refund Systems
 Deposit/Refund Systems

 A deposit/refund system is a market instrument that

imposes an up-front charge to pay for potential damages
and refunds it for returning a product for proper disposal
or recycling
 Targets the potential vs. actual polluter
 The deposit is intended to capture the MEC of
improper waste disposal in advance

49
 Assessing the Model
 Promotes responsible behavior
 Requires minimal supervision by government
 Can help slow the use of virgin raw materials by improving
availability of recycled materials

50
 Deposit/Refund Systems in Practice

 Deposit/refund systems are used worldwide

 Many nations use these systems to encourage proper
disposal of beverage containers
 In the US, 11 states have bottle bills
 Other applications include systems used to promote
responsible disposal of used tires, car hulks, and lead-acid
batteries

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Pollution Permit Trading Systems
 Pollution Permit Trading Systems

 A pollution permit trading system establishes a market for rights

to pollute by issuing tradeable pollution credits or allowances
 Credits are issued for emitting below a standard
 Allowances indicate how much can be released
 Two components of the system are
1. Fixed number of permits is issued based on an “acceptable” level of
pollution set by government
2. The permits are marketable
 Bargaining gives rise to a market for pollution rights

53
 How Permit Trading Works
 There is an incentive to trade as long as polluters face
different MAC levels
 Suppose a firm has 50 permits but normally emits 75 units of
SO2. What must it do?
 Answer
 Abate 25 units of emissions OR
 Buy 25 permits from another producer
 Which option will the firm choose?
 Answer
 Whichever option is cheaper

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 Result
 Low-cost abaters will clean up pollution and sell excess permits to
other firms
 They will sell at any P higher than their MAC
 High-cost abaters will buy permits rather than abate
 They will buy at any P lower than their MAC
 Trading will continue until the incentive to do so no longer exists,
at which point, the cost-effective solution is obtained, i.e., the
MACs across firms are equal

55
 Assessing the Model

 Trading establishes the price of a right to pollute without

government trying to “search” for a price
 No tax revenues are generated
 Trading system is flexible
 Note that an emissions standard can be adjusted by changing the
number of permits issued

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 Pollution Trading Systems in Practice

 International examples
 Trading of greenhouse gas allowances are part of the Kyoto
Protocol, an international accord aimed at global warming
 Canada has a trading program for ozone-depleters
 Denmark has one for carbon dioxide emissions
 Most of the evolution of trading is occurring in the U.S.
 An important example is the establishment of an allowance-based
trading program to control sulfur dioxide emissions under the
Clean Air Act Amendments of 1990

57
Research Issues in Tradeable Permit Market

 Problems associated with the markets

 Trading rules and permit system designs
 Imperfectly competitive permit markets
 Auctions
 Extensions to the basic model
 Innovation and TPPs
Trading rules and permit system designs

 Two designs of permit system:

 Emissions permit system (EPS)
 Ambient permit system (APS)
Emissions permit system (EPS)

 Permits are denominated in units of pollutant emitted

 Trade of permits between firms take place at a one-to-
one rate, for example:
 If A sells one permit, it must reduce the emission covered by the
permit. When B buys the permit, it can increase the emissions
by the same amount
 Total emissions do not increase
 EPS system works well for uniformly mixed pollutant
Problems with EPS

 Could result in violations of ambient quality targets, for

example:
 If B is located at a more sensitive part (for e.g. a river), then its
increase in x tonnes of pollution is more damaging than A’s
reduction in x tonnes of pollution.
 To solve this Ambient Permit System (APS) is proposed
EPS Problem: B causes more damage than A,
although the amount of pollution is the same
Firm B Firm A

River

Note that Firm B should have a higher damage transfer coefficient than Firm A
Ambient permit system (APS)

 Permits are denominated in units of damage at receptors

 There is a separate market in permits at each receptor
Problems with APS

 High transaction costs and low number of traders in each

markets leading to imperfect competition
 Total emissions can rise, for example:
 If A sells permits which allow an certain amount of dissolved
oxygen at receptor point Q, and if B’s emissions have small
impact on dissolved oxygen, then B could emit more pollutant
than A could have done
 Could result in an increase in long-range transport of
pollutants
APS Problem: B Could emit more pollutant than A can
because of its distance to the receptor

Wind Direction

Firm B Firm A
Solutions

 Permits denominated in units of emissions but with rules on

trades to avoid ambient quality targets violations:
 Pollution offset : non-violation of ambient quality target at
receptor
 Non-degradation offset: no increase in total emissions as a result
of trade
 Modified offset: allows trade as long as pre-trade quality level or
target level not violated
Imperfectly competitive permit markets

 Least cost property of tradeable pollution permit (TPP) may

not hold if firms are small in numbers, or a firm is large
enough to influence price
 Firms seek to influence the permit price to minimize the sum
of control costs plus net expenditures on permit purchases
Imperfectly competitive permit markets

 Monopoly case: the market power firm will spend too little
on abatement, as it sells fewer permit than it would do in a
competitive case. Other firms will spend too much
 Monopsony case: the market power firm will spend too
much on abatement and buys too few permits relative to the
competitive case
 Firms may also seek to raise permit price to increase total
cost by rivals and deter potential entrants
Auctions

 A way of instituting TPP system is to initially auction off

stock of permits
 However, there is a transaction cost problem – the initial
payment firms have to make for the permits
 This decreases the attractiveness of auctions
Innovations and TPPs

 TPP system offer superior incentives to firms relative to

incentives available under a design or performance standard
Innovations and TPPs: Illustration

 MAC1 – MAC under dirty technology

 MAC2 – MAC under clean technology
MAC1
$/unit  When firms face performance standard q1, the
MAC cost savings by adopting clean technology is area
MAC2 abc
 Under marketable permits (price p), dirty tech
firms will reduce emissions at q1, clean tech
b d
p firms will reduce emissions at q2
c  Here, the cost of adopting clean tech is q1, c, d,
a q2
 But the firm will earn by selling permits with
value q1, b, d, q2 as well as cost savings abc
 The overall gain is abd
q1 q2 Emission reduction  Thus, firms save more under TPP than
performance standard and is more likely to
invest in a cleaner technology