ECON 575

Intro to Energy Markets, Policies,

and Regulations
Semester 222
 Outline
• Externalities
• Pigouvian tax to correct externalities
• Abatement Policy
– Cap and trade or permit system

2
 Energy & Environment (1)
• Energy consumption has a strong relation with
the environment
• Most countries have power plants that are
fossil-fuel generated, it involves burning fossil
fuel and air pollution
– Coal power plants
– Natural gas power plants
– Oil/diesel power plants

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 Energy & Environment (2)
• Some countries do not have regulation
regarding air pollution. Even if they do, the
effect is negligible

4
 Externalities (1)
• What we learned from previous models, firms
decide based on MR and MC
• Air pollution is costly for the environment and
also the community. However, if firms are not
forced to pay for emitting pollution, then firms
would not put air pollution into business
decision consideration
– There is an extra cost to society, but they can
ignore it
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 Externalities (2)
• Externalities: an extra cost or benefit that neither
firms nor consumers put into consideration in their
decision-making
– Extra cost = Negative externalities
– Extra benefit = Positive externalities
• Externalities results in an inefficient market
– Positive externalities -> under-consumption compared
to the efficient quantity
– Negative externalities -> over-consumption compared
to the efficient quantity
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Negative Externalities
P
MCSociety

MCPrivate

P*

Pprivate

Q* Qprivate Q
7
Positive Externalities
P

MC

P*

Pprivate

DSociety
DPrivate

Q*
Qprivate Q
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 Correcting Externalities (1)
• In order to correct the market, the externalities have
to be internalized (the ignored benefit or cost has to
be included in the decision-making of either
producers or the consumers)
• A very common approach is:
– Introduce a tax for negative externalities (extra cost)
– Introduce a subsidy for positive externalities (extra
benefit)
• A tax to correct inefficient market is called Pigouvian
Tax (named after Arthur Cecil Pigou)
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 Correcting Externalities (2)
• Notice that the externalities may cause a
parallel shift (that looks similar to unit tax) or
more of a rotation (similar to ad-valorem tax)
• Hence, in order to correct the market, the
government has to be:
– precise on which kind of externalities
– accurate regarding the value of externalities

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 Correcting Externalities (3)
• In theory, correcting the externalities through
Pigouvian Tax is straightforward
• In practice, it is very difficult to be precise and
accurate
• In the case of negative externalities of pollution,
the Pigouvian Tax will reduce the consumption
of the fossil fuel and simultaneously:
– Less electricity generated
– Higher price for electricity
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 Another Approach
• A different way of thinking is to look at cleaning up
the pollution (for the case of negative
externalities)
• We want the fossil fuel power plants to emit less
pollutants. Therefore,
– If the power plants have to clean up their pollutants,
the externalities have already internalized through the
cleaning up process
– In order to be efficient, the quantity of pollutants
cleaned up has to be the optimal quantity
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 Abatement (1)
• We want to look at the cost and benefit
analysis of pollution abatement (cleaning up
pollutants)
• There is a benefit of cleaning up
– As the quantity of pollutants abated increases, the
benefit is less (if the air is very dirty, even a small
clean up would be noticeable. On the other hand,
if the air is already very clean, cleaning up even
more would be hard to distinguish)

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 Abatement (2)
• There is a cost of cleaning up
– As the quantity of pollutants abated increases, the
cost is higher (cleaning up the first few pollutants
would be easy, but the very last pollutants would
require sophisticated equipments)
• In order to be efficient, we want the highest
net benefit (total benefit – total cost). The
highest net benefit is when MB = MC

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 Abatement (3)
$

MC

NB
$*

TC
MB

Q* Q
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 Abatement (4)
• In theory, it is very straightforward
• In practice, there are problems:
– Valuing the benefit of cleaning up the pollutants
(what is the benefit of having 1 kg less of CO2?)
– Different power plants uses different fuels and
different technology. They don’t have the same
cost of cleaning up

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 Abatement Policy (1)
• Command and control
– The government forces the firms to clean up
without regarding each firms different cost of
cleaning up
– For example, every firms have to clean up a quantity
of 10 pollutants
– This is inefficient because firms that have a high cost
of cleaning up would face a big cost. This increase in
cost would affect their competitiveness and profit in
the electricity market
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Abatement Policy (2)
P
MC2
MC1

$ 2* MCcomb

$ 1*

MB
Q* Q
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 Abatement Policy (3)
• Cap and trade (Permit)
– Cap -> putting a quota on the number of pollutants
– Trade -> allow firms to trade the permits
– Each firm will value a permit (a license to emit pollution) based on the
cost of cleaning up that pollutant if they do not have that permit
• “If I don’t have that permit, I will have to clean up one pollutant, and it will
cost me X. Therefore, I am willing to pay for a permit up to the price of X. If
price of the permit is higher than the cleaning up cost, then I would rather do
clean up and maybe sell the permit for profits”
– Different firms that have different cost of abatement will value each
permit differently based on their marginal cost of abatement
– Transaction can happen if there is a firm who is willing to sell (because
abatement cost is less than the permit price) and another firm who is
willing to buy (because the abatement cost is higher than the permit
price) 19
 Abatement Policy (4)
• Eventually, permit trading will end when each
firms valued a permit at the same price
• If the government provides the “correct”
amount of permit, the price of the permit will
be equal to the equilibrium value when we
combine the MC of each firms
– Otherwise, one firm would bear the significant
burden of cleaning up the pollutants

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Abatement Policy (5)
P
MC2
MC1

MCcomb

$*

MB

Q2 * Q1 * Q* Q
Q1* + Q2*
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 Limitations (1)
• However, if it very hard to be precise and
accurate on the optimal quantity of
abatement that has to be done
• Inaccuracy would produce DWL

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 Limitations (2)
P
MC2
MC1

MCcomb

$*

MB

Q2 * Q1* Q* Q
Q1* + Q2*
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 Limitations (3)
P
MC2
MC1

MCcomb

$*

MB
Q2 * Q1 * Q* Q
Q1* + Q2*
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 Abatement Policy (6)
• In conclusion
– Firms that have a lower cost of cleaning up should
clean up more
– Firms that have a higher cost of cleaning up should
clean up less
– In practice, there is an issue of transaction cost
(the cost to make the transaction actually
happens)

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 Conclusion
• There is 2 different school of thoughts in
tackling air pollution (especially carbon
emission from fossil fuel generated power
plants)
– Carbon tax (Pigouvian tax approach)
– Carbon emission trading (cap and trade approach)

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