These slides cover the basic of environmental regulation including taxes, tradable permits, and command and control.

1. Environmental Regulation
Environmental Economics Fall 2013

2. Four General Areas of Regulation to
Protect Environmental Quality
Regulations (Command and Control) (ex. standards, bans, quotas, takeback laws)
Fixing distortions in economic incentives (using markets)
–
–
–
–
Direct subsidies or subsidy reductions
Environmental taxes and user fees
Deposit refund systems
Tradable permits
Creation of markets
– Tradable permits, carbon markets
– Establishing and enforcing property rights
– Public ownership
Engaging the Public
– Eco-labeling
– Education Programs

3. Criteria for Evaluation
• Efficiency
– Maximum net benefits to society
• Cost-effectiveness
– Bang for the buck
• Equity
– Over time, space, income
• Incentives for innovation
• Enforceability
• Moral grounds

4. Command-and-Control
Policies
Standard: a mandated level of performance
enforced in law.
• Ambient Standards
– Water ambient standards
– Air quality ambient standards
• Emission Standards
– Vehicles
• Technology Standards
– BACT

5. Setting the Standard
• A standard is not necessarily set according to
efficiency and/or cost effectiveness
considerations.
• Many times standards are uniform, e.g. the
same nationally.
– This may not be efficient if the damages are different
in different regions.
– Not cost effective if the abatement costs are different
for different firms/regions. The equimarginal
principle will typically be violated.

6. Potential Advantages to Regulatory
Approaches (standards, bans, quotas,
“command and control”)
• More traditional so parties may feel more comfortable
• Lower administrative costs, responsibilities, and easier
enforcement
• Effects are more certain (e.g. amount of pollution reduced)
• Perceived as having less impact on inflation
• Emission standards provide an incentive to innovate
(technology standards not so)

7. Emission Taxes or Charges
Firms are charged for the emission they make on a per ton
or some other basis.
Advantages:
– Cost-effectiveness/ flexibility: Allows firms to chose their
level of abatement:
• Firms with high abatement cost might chose to pay the taxes while
firms with low abatement costs would rather abate.
– Tax structures already in place
– Stimulates development of new technologies continuously
(dynamically efficient).
– Uses “free-market”.
– Raises revenue – ‘double dividend’.
– Can send correct price signal through entire economy.

8. Emission Taxes or Charges
Disadvantages:
• Difficult to assess correct level.
– Based on damage costs?
– Based on marginal abatement costs and desired level
of abatement?
• Unknown emission outcome.
• Need to use right tax.
• Unpopular.

9. How to Set the Right Tax level?
• Base it on the cost of damages associated with an
activity/pollutant/etc. “Pigouvian Tax” – internalizing
the external costs.
This is not always easy to assess. Various impacts need to be
considered:
–
–
–
–
–
–
Loss of life
Loss of work days
Discomfort
Damage to material goods (i.e. acid rain)
Impact on natural world
Aesthetic impact
• Base it on the cost of remediation/ amelioration
• Base it on mandated emission reductions

10. Problems with basing tax on damage:
• Doesn't work well with persistent pollutants like PCBs
which stay in environment. How do you include future
values?
• Uncertainty – how to value uncertain outcomes? ex.
climate change.
• Doesn't include interaction between pollutants.
• Different areas might require different costs – i.e. urban
areas vs. desert
• Marginal cost of each ton emitted is not necessarily the
same. Maybe cost goes up with higher emission levels.

11. How to set the socially optimal tax?
SMC = social marginal cost
PMC = marginal cost
MD= marginal damage costs
Qe = equilibrium quantity
Qs = social equilibrium quantity
P
SMC
PMC
MD
Demand = social benefit
Qs Qe
Quantity

12. How to set the socially optimal tax?
SMC = social marginal cost
PMC = marginal cost
MD= marginal damage costs
Qe = equilibrium quantity
Qs = social equilibrium quantity
P
SMC
PMC
Demand
MD
Qs Qe
Quantity

13. Value per unit
of emissions
or abatement
Illustration of Optimal Tax
Marginal damage
cost (MDC) = MB
from abatement
Marginal
abatement cost
(MAC)
Level w/o
abatement
Tax
Abatement
e*
e* is the socially optimal level.
MAC = least costly way to get a level of abatement
e1 Emissions
(e.g. SOx)

14. Value per unit
of emissions
or abatement
Abatement
Things are not now optimized; it may be
possible to lower emissions and costs.
e1
Emissions

15. 1995 composite figures for cost of damages
from criteria air pollutants in California
Tax values in $/ton
Density
NOx
High
11,584
Medium
5,216
Low
541
CO
2
0
0
SOx
4,768
1,814
1,814
PM10
37,455
4,578
753

16. Tradable Permits
• Firms are allowed a certain quota of emissions. They
can make reductions themselves or trade for
reductions at other facilities.
• Advantages:
– Stimulates new technologies
– Promotes efficiency
– More certainty about amount of pollution reduction compared to
taxes
– More politically accepted than taxes
• Disadvantage:
–
–
–
–
Require more administrative capacity/high costs
Can be gamed more easily than taxes
Can hurt competition
Geographical distortions

17. Permits Can Be Gamed
“Traders for big banks and other financial institutions,
these people say, amassed millions of the credits just as
refiners were looking to buy more of them to meet an
expanding federal requirement”.
“JPMorgan Chase and other financial institutions
…had helped transform an environmental program
into a profit machine, contributing to the market
frenzy this year”.
http://www.nytimes.com/interactive/2013/09/15/business/0915-price-of-an-ethanol-credit.html?ref=business

18. Tax vs. Permits
Unless you know the precise costs of abatement, you
don't know how much pollution reduction will occur.
Costs
Costs
Carbon
Cap
MC
MC
Tax
P?
P
Q*
Abatement
Q?
Abatement

19. Tax vs. Permits
Ideally, abatement occurs where MB = MC
Costs
Costs
Carbon
Cap
MC
MC
Tax
P?
P
MB
Q*
Abatement
MB
Q?
Abatement

20. Tax vs. Permits
With very steeply changing marginal benefits, cap is
better.
Costs
Costs
Carbon
Cap
EMC
P?
EMC
Tax
P
MB
MB
Q*
Abatement
Q?
Abatement

21. Tax vs. Permits
With more horizontal marginal benefits, tax is better.
Costs
Costs
Carbon
Cap
EMC
P?
EMC
Tax
P
MB
Q*
Abatement
MB
Q?
Abatement

22. Variations in Cost Structures
Marginal Damage Costs
Marginal Abatement Costs

23. Mathematical Comparison
• Emission limits (regulation)
• Tax
• Tradable Permit

24. Mathematical Example of Emission
Limits
• Three firms all with different MC of pollution
reduction. Each firm emits 100 tons of
pollution.
• The three firms have MC of abatement as
follows where Q is quantity of emissions
reduced:
MCa = 10 + 0.25Qa
MCb = 20 + Qb
MCc = 10 + 0.5Qc

25. Each firm needs to reduce by 20% which is 20 tons.
MCa = 10 + 0.25Qa
MCb = 20 + Qb
MCc = 10 + 0.5Qc
MC(20) = 10 + 0.25(20) = 15
MC(20) = 20 + 20 = 40
MC(20) = 10 + 0.5(20) = 20
MAC
MAC
MAC
40
20
20
15
10
10
20% Firm A
20% Firm B
20% Firm C

26. If they all reduce by 20 tons, total reduction = 60
tons. The resulting total costs (calculated using
area method) for each firm are:
Firm A: (20 x 10) + (20 x 5)/2 = $250
Firm B: (20 x 20) + (20 x 20)/2 = $600
Firm C: (20 x 10) + (20 x 10)/2 = $300
Total costs = $1150

27. Emission Taxes or Charges
Set tax at $20/ton
MAC
MAC
MAC
20
10
10
40 tons
Firm A
Zip
20 tons
Firm B
Firm C

28. To find out how much each reduces,
set MC = to 20 and solve for Q.
MCa = 10 + .25Qa = 20
Q = 40
MCb = 20 + Qb = 20
Q=0
MCc = 10 + .5Qc = 20
Q = 20
Again we have a reduction of 60 tons.

29. What has been the cost of emission
reduction?
Firm A: (40 x 10) + (40 x 10)/2 = $600
Firm B: 0
Firm C: same as with regulation = $300
Total cost = $900
The cost is lower than with CAC.
However, firms still need to pay the taxes
on the other emissions.

30. Total cost of emission tax
•
•
•
•
Taxes for A = $20 x 60tons = $300
Taxes for B = $20 x 100tons = $2000
Taxes for C = $20 x 80tons = $1600
Total cost to industry = $900 + $3900 in taxes
Compared to CAC, cost of reducing same level of
emissions is less but total cost to industry is more.

31. Tradable Permits:
240 permits given away, 80 tons to each firm.
• Firm B is going to realize that it costs them more to reduce
pollution than firms A and C so it will want to buy permits
from these firms.
• Firm A can sell up to 20 permits for $20 each to Firm B.
• Firm B will pay $20 for permits.
• If sale price is $20, total cost of compliance if permits are
given away:
Firm A: $600 for emission reduction - $400 from Firm B = $200
Firm B = $400 to pay for permits from Firm A
Firm C = $300 for emission reduction
Total = $900

32. Firm C does not trade permits. Firm B buys
20 tons of permits from firm A.
MAC
MAC
MAC
$20
10
10
40 tons
Firm A
20 tons
Firm B
20 tons
Firm C

33. The RECLAIM Experience
(Fowlie et al. 2011)
• NOx and SOx trading program started in
1994.
• REgional CLean Air Incentives Market

38. Industries Are Dynamic
• All this well-developed theory associated with
the benefit and costs of various government
policies for reducing emissions is all based on
static analysis.
• In reality, the world is far more dynamic.
• Well designed regulations can often have
private economic benefits to the firms.

39. Social Value of Regulations
• Often not known in advance.
• 1990 Clean Air Act Amendments (CAAA):
SOx regulation,
– Benefits were $3300 per ton,
– Costs were $270 per ton (1998 dollars).
•

40. Creating Markets/Enforcing
Property Rights
• Tradable permits, carbon markets
• Establishing and enforcing property rights
• Public ownership

41. The Coase Theorem
Economic efficiency will be achieved as
long as:
– property rights are fully allocated and
– completely free trade of all property rights is
possible.
It does not matter who initially owns the
property rights, as long as all rights are
defined.

42. Problems With Coase
Theorem
• Transaction costs can prevent markets from developing
to internalize external costs even with damager liability
rules.
• Agreements can be difficult to enforce.
• Income effects: depending on income of victims, nonmarket damage optima could vary.

43. In Reality
• Well defined property rights unlikely to
solve many environmental problems
• Government intervention necessary
• Intervention more likely with some
environmental problems than others

44. Characteristics of Environmental Problems and Likelihood of Government Control
Democratic Control
Characteristics
Spatial Scale
Level of Complexity/
Uncertainty
Transparency
Less likely
>>>
More likely
>>>
Very Likely
Global/
foreign
High
Regional*
National
Local
Very Local
Moderate
Medium
Low
Very Low
Invisible
Somewhat
Medium Fairly Visible Obvious
Visible
Temporal Scale of Distant future Moderate Near Future Very Soon Immediate
Impacts
Future
Sources
Very many
Many
Moderate
Few
Very Few
Source and Target
Same
Mostly Same
Livelihood Impact
Human Health
Impacts
Level of Health
Impacts
Very Low
Indirect
Low
Somewhat
Indirect
Light
Very Light
Similar or Mostly Differ
Differ
Mixed
Medium
High
Very High
Semi-direct Somewhat
Direct
Direct
Medium
Heavy
Very Heavy
* Depends on country size. For large countries, like the United States or China, "national" might be a larger scale
than "regional".

45. Environmental
Problem
Local - 1 Simple, Transpar- Timing of Sources
Source Livelihood Human Level of
Global - 5 certain - 1
ancy
Effects
Few- 1
and
Impact
Health
Health
Complex, Obvious-1 Present-1 Many - 5
Target
High - 1
Impact
Impact
uncert. - 5 Invisible- Future - 5
Differ - 1 Low - 5 Direct - 1 Heavy - 1
5
Same - 5
Indirect – Light - 5
5
Total
Local water quality
1
1
2
1
4
1
4
1
1
16
Urban air pollution
from industry
2
2
1
1
1
1
5
2
2
17
Toxic dumps
1
2
3
1
1
1
5
1
5
20
Indoor air pollution
1
1
2
1
5
5
4
1
1
21
Local deforestation
2
2
1
1
2
4
2
5
5
24
Acid rain
3
2
3
2
2
2
3
4
4
25
Pesticides
2
3
4
2
2
2
4
2
4
25
Urban air pollution
from mobile sources
2
2
1
1
5
5
5
2
2
25
Soil erosion
2
4
2
2
3
4
1
4
4
26
Ocean pollution
5
3
3
2
2
1
3
4
4
27
Global
deforestation, loss
of biodiversity
Resource depletion
5
2
3
2
4
2
4
5
5
32
4
3
3
4
4
3
1
5
5
32
Ozone depletion
5
4
4
3
4
3
5
4
2
34
Climate change
5
5
4
5
5
3
5
5
3
40

46. Other policy options for reducing
externalities
Engaging the public
• Labeling (e.g. timber certification)
• Education programs
Firm Based
• Voluntary over-compliance
– Pleasing stake-holders, including employees
– Anticipatory compliance
– Saving money
– Indivisibility of pollution abatement technology
• Environmental Accounting

47. Marginal Costs Might Change Abruptly
Example: air pollution emission reduction
$ per unit reduction
Marginal Abatement Cost
Marginal Social Value
Emission Reduction

48. Source: McKinsey and Co. Impact of the financial crisis on carbon economics: Version 2.1 of the global greenhouse gas abatement cost curve
http://www.mckinsey.com/client_service/sustainability/latest_thinking/greenhouse_gas_abatement_cost_curves

49. http://www.mckinsey.com/insights/energy_resources_materials/mobilizing_for_a_resource_revolution

50. Fin