Environmental Economics

Vijaya Raj Sharma, Ph.D.

LECTURE NOTES ON PART III: POLLUTION-CONTROL POLICIES

These notes are not edited. They also do not necessarily cover everything that would be discussed in the class. Students are responsible for any additional materials discussed in the class.

These notes frequently refer to exhibits and tables in the textbook - Environmental Economics, An Introduction by Barry C. Field, Second Edition, Irwin/McGraw Hill, 1997.

VII. ENVIRONMENTAL POLICY APPROACHES

(Chapter 9)

Policy Approaches

• Decentralized
• Centralized

Decentralized Policy Approach

• Least or no direct involvement of government
• Allows individuals involved in an environmental problem to work out solution themselves
• Parties involved (polluters and victims) have strong incentives to find a solution.
• Parties may also have the best knowledge of marginal abatement costs and marginal damages to seek the efficient solution.
• Least involvement of government minimizes possibility of government failure
• Decentralized approaches may have certain limitations.

Centralized Policy Approach

• A central authority to determine, prescribe, and enforce policies
• Implicit assumption
• Public officials always pursue public interest.
• One may question this assumption, especially when there is conflict between good politics and good economics, or between individual interest and public interest.
• Alternative to decentralized approaches

VIII. DECENTRALIZED ENVIRONMENTAL POLICIES

(Chapter 10)

Nonincentive-Based Decentralized Policies

• Liability laws
• Assigning private property rights
• Moral suasion

Liability laws

• Polluters liable for damages they cause
• May encourage would-be polluters to internalize the external effects and thus minimize their exposure to liabilities
• May theoretically achieve efficient solutions
• See Figure 10-1 in the textbook.
• Up to the efficient level (e^*), cost of abating emissions would be lower than total damages for which a polluter is liable
• Past the efficient level, further reduction of emissions cost more than damages saved
• Note that there would be some damages at the efficient level too, but the sum of abatement cost and damages is the lowest possible cost for the polluter, compared to any other level of emissions.
• Liability risk may even encourage polluters to innovate improved methods of pollution control.
• Problems
• Burden of proof to establish direct causal link between pollution and damages lies with the plaintiff (victim).
• A difficult task
• Often the causal link is only statistical, or probabilistic.
• Damages may show up only after long interval of time.
• Must establish that the defendant is the source of the pollution that caused the damage (difficult when many similar polluters).
• Often lengthy and expensive litigation process
• May work best when
• few polluters and few victims
• damages easy to measure damages
• clear causal linkages between pollution and damages
• low transaction costs (legal costs)
• In complicated cases, liability laws may not approach efficient solutions (Exhibit 10-1).
• Damage Assessment
• Determination of the value of damages done to an injured environmental resource
• Example: damages from hazardous wastes dumped on a river
• Estimation procedures prescribed by the U.S. Department of Interior
• Estimate using two procedures and take the lesser of the two as the amount of damages.
• Estimation of resource value
• Estimation of restoration value
• Resource Value
• Lost value of the resource arising from loss of extractive and recreational uses of the resource (such as you can't swim or fish in the river)
• We have discussed techniques of estimating such values.
• Restoration Value
• Cost of restoring the resource to its former state (original quality of the resource)
• Restoration to original state may be impossible in some cases (especially, the uniqueness of a destroyed resource).

Assignment of Private Property Rights

• When a resource has no owner, no one has an incentive to see that it is efficiently utilized
• All environmental problems arise when "well-defined" property rights are lacking.
• Four characteristics of "well-defined" property rights
• Universality
• Private ownership and completely-specified entitlements
• Transferability
• Transferable through a voluntary exchange
• Enforceability
• Secure from involuntary seizure or encroachment
• Exclusivity
• All benefits and costs associated with the use or ownership of the property accrue to the owner and only to the owner, either directly or indirectly by sale to others.
• Coase Theorem
• due to Ronald Coase, Nobel Laureate Economist
• If the property rights over the environmental asset are clearly defined, and bargaining among owners and prospective users is allowed, the efficient level of effluent will result irrespective of who was initially given the property right.
• "clearly-defined" property rights - rights having the above four characteristics
• Example: a lake (common property resource)
• A paper mill and a trout farm operating on the shore of the lake
• Effluents of the paper mill damage fish population and, thus, hurt the trout farm
• Paper mill could dump effluents to the lake because the lake belongs to no one
• Services of lake- a sink for effluents- free of cost to the paper mill
• When a resource is free, it is overused.
• Coase theorem:
• Give property rights over the lake to some one
• The owner and users of the lake would negotiate
• They would agree to the efficient level of effluents
• Consider private property rights to trout farm
• Trout farm will allow no effluents without sufficient compensation
• Paper mill will compensate if cheaper than cost of abating effluents; with no compensation, mill cannot discharge even one ton effluent
• MAC curve - paper mill's costs to reduce effluents
• MAC - maximum rate of compensation mill could pay
• MD curve - losses caused by effluents to trout farm
• MD - minimum rate of compensation farm could accept
• MAC > MD to the left of efficient level and MAC < MD to the right of the efficient level
• Negotiation is likely to lead to the efficient level of effluents; for example, the compensation per ton can be equal to the dollar amount corresponding to the intersection point
• Effluents would not exceed the efficient level because compensation the mill would be willing to offer would be lower than the amount the trout farm would be willing to accept.
• Consider property rights to paper mill
• Trout farm now would have to sufficiently compensate the paper mill to be willing to reduce effluents and allow trout farm to operate.
• With no compensation, the mill would discharge the maximum (uncontrolled) amount of effluents
• Mill may lower effluents if compensation at least exceeds MAC
• Farm may offer compensation at the most equal to MD
• MAC < MD to the right of efficient level; so, negotiation can lead to an agreement to discharge only the efficient level of effluents.
• The deal would not go to the left of the efficient level, because the MAC is too high compared to the MD to the left of the efficient level.
• Problems
• Coase theorem assumes no transaction costs (costs of negotiating and finalizing agreement).
• Likely to be true only when few involved parties
• High transaction costs may discourage negotiation, leading to the possibility of inefficient use of resources
• Nonexclusivity
• Nonmarket benefits of environmental resources are not exclusively realized by the owner
• Example: lake may be providing habitat to a rare species of bird
• No market and therefore no revenue to the owner from nonmarket services of resources
• Owners ignore such benefits (Exhibit 10-2), leading to inefficient utilization of the resource
• A possible solution - allow environmental activist organizations (e.g. Nature Conservancy) to compete for owning property rights over environmental resources, since they put value on nonmarket services of resources
• Generally, such organizations suffer severe limitations of financial resources to buy and own environmental resources.
• Depend on voluntary contributions
• Low level of contributions - free riding on public good nature of many environmental resources
• Talk about successes of elephant protection programs in some African countries
• Talk about tradable discharge permits as a form of ownership of air

Moral suasion

• Appealing to people's sense of moral values to preserve and protect environmental resources
• Examples: recycling and litter control
• Likely to be least effective
• Absence of economic incentives to change behavior
• Free riding (public good nature of most environmental resources)

IX. COMMAND-AND-CONTROL POLICIES

(Chapter 11)

3 Types

• Technology standards
• Emission standards
• Ambient standards

Technology Standards

• A central authority specifies to each polluter a must-use process or technology.
• Examples: height of smoke stacks, catalytic converters or seat belts in cars, stack-gas scrubbers for electric utilities
• May take the form of product standards, input standards, design standards, or engineering standards
• Example: maximum y sulfur content in coals used in power generation
• Note: specifies no limit on quantity of emissions
• Mostly suitable for nonpoint sources
• Sources whose effluents are hard to measure
• Example: golf courses, pollution from return flow of agriculture irrigation, pollution from construction activities, urban storm runoff

Emission Standards

• A cental authority specifies never-exceed quantities of emissions to pollution sources
• Example: x lbs of a pollutant per hour

Ambient Standards

• Ambient standards: never-exceed level of some pollutants in ambient environment
• Examples: x ppm of dissolved oxygen in a river or y µg/m³ of sulfur dioxide in air
• Note: the nature, in particular the meteorological and hydrological phenomena, stands between emissions and ambient environment and determines damages to the ambient quality

Rationale for Standards

• Apparent simplicity and directness of the approach

Issues

• Flexibility of Achieving Emission Reduction at Least Cost
• Technology standards offer no flexibility
• Other technologies - violation of regulation, subject to legal sanctions
• Ambient and emission standards offer flexibility
• However, uniform (the same) standards to all regions and to all polluters may not minimize cost of emission reduction
• Regions differ in population exposed to emissions and polluters differ in technologies to abate pollution
• Methods of Setting Emission Standards
• Ideally, the standards should be the efficient level of emissions
• balance MAC and MD
• Government may not be able to determine efficient standards due to lack of information on MAC (information has to come from polluters)
• Most used methods of setting standards
• Zero-risk approach
• Reasonably small damages approach
• Zero-Risk Approach
• The threshold level of emissions selected as the standard
• Rational: no damage up to this level of emissions (show in a graph)
• Problem
• Very conservative/ too stringent, compared to efficient level
• Some pollutants may have no threshold level - even a small level of emissions causes damages
• Reasonably Small Damages Approach
• Standards set at small level of emissions associated with small damages
• Generally lies between the threshold level and the efficient level
• where the slope of the MD curve becomes steeper
• Less stringent than Zero-Risk Approach, but not efficient
• Efficiency/Cost Effectiveness of Uniform Standards
• Technology standards do not specify allowable level of emissions and do not allow use of other technologies; so, efficiency/cost effectiveness not possible
• Uniform emission standards cannot be efficient
• The same standard cannot balance MAC and MD in both heavily populated cities and sparsely populated rural areas because marginal damages would be different.
• Show graphically, with a higher MD for urban areas and a lower MD for rural areas
• Standards should be more stringent in urban areas
• Uniform emission standards cannot be cost-effective
• Pollution sources differ in MAC
• For minimum cost abatement, most emission reduction should come from sources that can abate it at a lower cost
• Cost-effective emission reduction should equalize MACs across sources (the equimarginal principle)
• Remind students of the principle by again showing the old transparency
• Equity or Fairness of Uniform Standards
• Uniform standards - both technology standards and emission standards - may be considered fair - same for all polluters
• Enforceability of Uniform Standards
• Uniform technology standards - least expensive to enforce
• Uniform emission standards
• cost more than technology standards to enforce, because need to regularly measure actual emission
• but, easier to enforce, compared to many other pollution control methods
• Lower standards that can be enforced may ensure more actual emission reduction than stricter standards that cannot be enforced and hence not complied with.
• Incentives for Long-run Improvement
• Technology standards offer no incentives for improvement, for fear of noncompliance of environmental regulation
• Emission standards offer incentives to improve methods of pollution control
• Potential saving of compliance costs - economic incentive to innovation.
• Draw MAC₁ (the current abatement technology) and MAC₂ (the improved technology, if innovation is successful) - MAC2 below MAC1.
• Draw a vertical line from the horizontal axis to represent the mandated standard; label this standard as e₁.
• Label the area bounded by MAC₁, MAC₂, and e₁ vertical line as a.
• Label the area bounded by MAC₂, and e₁ vertical line as b.
• Polluters would save area a to comply with standard e₁.
• Incentive only when standard perceived stable
• Emission standards may offer perverse incentives if perceived unstable
• Disincentive to innovate if polluters suspect that the mandated standard would be made more stringent after their innovation
• Redraw MAC1, MAC2, and e1 (the current standard) as before.
• Also, label areas a and b as above.
• Draw a vertical line from e2 (a point to the left of e1).
• Suppose: polluters suspect that standard would be changed from e1 to e2 if they develop MAC₂.
• Label the area bounded by MAC₂, e₁ vertical line, and e₂ vertical line as c.
• If the standard changes to e2, the potential cost saving would be (a-c)
• Compliance cost with e1 standard and MAC1: (a+b)
• Compliance cost with e2 standard and MAC2: (b+c)
• Potential saving (a-c) with unstable standard is lower, compared to potential saving (a) with stable standard.
• Perceived instability of standard reduces incentive.
• If (a-c) is negative, there would actually be disincentive - indirect economic penalty on innovation.
• Technology-forcing standards and incentive for innovation
• Pollution-control technology industry may lobby and convince government to set a stringent standard based on a technology that is in the verge of development, but not yet available
• Let MAC₂ be such a technology and e₂ the technology-forcing standard in the above graph.
• In the above graph, label the area bounded by MAC₁, MAC₂, e₁ vertical line, and e₂ vertical line as d.
• Until MAC₂ is available, compliance cost to polluters to achieve e2 is (a+b+c+d).
• Only when MAC₂ becomes available, compliance cost would come down to (b+c).
• In the interim period of development of MAC_2, compliance cost is high.
• Polluters are likely to put political pressure to delay the implementation of standards until MAC₂ is available.

X. EMISSION CHARGES

(Chapter 12)

Rationale

• A kind of user fee: pay for services of environmental resources
• A kind of compensation fee for damages caused
• Charges offer incentive to conserve environmental resources

Economics

• Polluters are charged a fixed $ amount on every unit of effluent emitted
• Polluters free to choose how much emissions they abate and how much they emit by paying applicable emission charges
• Polluters abate if it is cheaper to abate than to pay the charge, but they pay the charge if it is more expensive to abate.
• To minimize cost, polluter abates until MAC balances with the charge.
• Draw MAC curve and a horizontal line from the vertical axis to denote the emission charge ($t per ton).
• Intersection of this horizontal line and the MAC gives the level of pollution emitted by the polluter (say e).
• The difference between e and the uncontrolled level of emissions is the level of emissions abated.
• The area bounded by the MAC and a vertical line at e is the total abatement cost incurred; label this area as a.
• The area of the box to the right of e (bounded by the charge line, e-line, and the two axes) is the amount of total charges paid; label this area as b.
• Total compliance cost to the polluter = (a+b)
• If the polluting industry is not competitive, the competitive pressure of emission charges may be small, as it may be possible to pass on the entire the tax burden of emission charges to consumers (example: a regulated electric power plant).
• If you give a choice to polluters to choose either a charge of $t per ton or an emission standard of e tons, they are likely to prefer emission standards.
• Compliance cost with e emission standard is area a.
• Compliance cost with charge system is (a+b).
• Compliance cost cheaper with emission standard
• Under a charge system, polluter also pays for emitting, besides for abating, whereas environmental services are essentially free under emission standard system.

Level of charge

• The greater the charge, the greater the emission reduction.
• Convince yourself of this by drawing two tax lines in the above graph.
• The level of charge depends on the desired level of emission reduction.
• Charge per ton = MAC at the desired level of emissions (show in a graph)

Efficiency/Cost Effectiveness

• If information on MAC and MD are known, set charge = MAC at the efficient level of emissions (e*). Let this charge be t* per ton.
• This would ensure efficiency.
• Draw MAC and MD.
• Label the area below the MAC to the right of e* as a.
• Label the area below the MD to the left of e* as b.
• Label the area above the MD but below the t* line as c.
• Polluter's abatement cost = a and charges paid = (b+c) at e* level of emissions
• Actual damages inflicted by polluter at e* = b
• Polluter pays charges (b+c) in excess of damages (b); note: c is a transfer payment.
• If charge is seen as a user fee, it is okay.
• If charge is seen as compensation fee, polluter may consider unfair to pay charges in excess of damages.
• To make this fairer, can implement a "two-part charge system."
• Polluters are waved charges up to a certain level and required to pay only for emissions in excess of that level, such that total charges paid = total damages.
• Uniform t* charge for all polluters can lead to e* only when emissions from all sources of pollution cause uniform or equal MD
• If this is not true (for example, MD different in rural and urban areas from the same level of pollution), uniform emission charge cannot be efficient.
• May have to implement zoned emission charges - different charges for different zones; but the same charge for all firms within a zone
• Explain graphically.
• If information on MAC or MD not known, e* and t* cannot be determined.
• If information on MD is lacking, the government first decides the desired level of emission reduction from some technical/scientific criteria and then determines the appropriate charge (graph).
• Note: the emission charge so determined would be cost effective in achieving the desired level of emissions e.
• Draw MAC1 of Firm 1 and MAC2 (above MAC1) of Firm 2.
• It is relatively cheaper for Firm 1 to abate emissions.
• Draw a horizontal charge line ($t per unit) from the vertical axis.
• Intersection of charge line with MAC1 gives e1 on the horizontal axis and with MAC2 gives e2 on the horizontal axis; note e2>e1.
• Firm 1 reduces emission by larger amount (because cheaper) than Firm 2.
• At the individual levels of emissions firms choose under emission charge system, MAC1=MAC2=t.
• Satisfies the equimarginal principle; therefore, cost effective
• Even if information on both MAC and MD are not known, charge system would be cost effective for whatever level of emission reduction is achieved.
• At the time of setting charge, no knowledge of how much emission would be reduced.
• But, by whatever level emission is reduced, it is reduced at the least cost
• because, each polluter equalizes its MAC to the level of charge
• therefore, MACs equalized across all firms (equimarginal principle)
• explain graphically

Equity

• The same charge per ton for each firm
• One which pollutes more pays more.
• Distributional impacts depend on changes in price and quantity of outputs of taxed firms.
• If charges do not affect prices of outputs, and the full tax burden falls on the owners of the firm.
• If charges increase prices of outputs, the tax burden partly falls on consumers too.
• Distribution depends on who mostly consumes outputs: poor or rich.
• With prices up, output declines. Displaced labor may have to incur costs on finding new jobs.
• Distributional impact also depends on whether tax revenues from emission charges are directed mostly to poor or rich.

Incentive to innovate

• Stronger incentive, compared to emission standards
• Reduction in emissions also greater when improved methods are developed.
• Explain graphically
• Draw MAC1 (the current abatement technology) and charge line ($t per unit), resulting into e1 level of emissions.
• Draw potential technology MAC2 (lower than MAC1) and level of emissions e2 (intersection of MAC2 and charge line) with this technology. Note e2<e1.
• Label area between MAC1 and MAC2 to the right of e1 as a.
• Label area below MAC2 to the right of e1 as b.
• Label area bounded by the charge line, MAC2, and e1 line as d.
• Label area bounded by MAC2, e1 line, and e2 line as c.
• Label area bounded by the charge line, e2 line, and the two axes as f.
• Compliance cost with MAC1 technology = (a+b+c+d+f)
• Compliance cost with MAC2 technology = (b+c+f)
• Potential cost saving (incentive to innovate MAC2) = (a+d)
• Potential cost saving with emission standards of e1 = a
• With emission standard, emissions remain at e1 even with MAC2.
• With charges, emissions reduce to e2 with MAC2.

Enforceability

• Enforcement more expensive than standard system
• Measure cumulative discharge over the billing period, bill the polluter, and collect charges.
• Enforceable in point-source emissions, but difficult to measure actual emissions from nonpoint sources.
• Nonpoint sources require a "second-best" approach of taxing inputs that are associated with emissions.
• Examples: taxes on chemical fertilizers, agricultural pesticides, gasoline, etc.

Emission subsidies

• Emission subsidies are rewards for reducing emissions below a base level (the uncontrolled level).
• Emission subsidies are negative emission charges
• Just like emission charges, emission subsidies work as penalty to emission; one unit of effluents emitted is the foregone subsidy.
• Draw a MAC curve and a subsidy line s. The intersection of s-line with MAC gives the level of emissions (say e). Polluters reduce pollution from uncontrolled level to e, because subsidy they can get exceeds abatement cost. Polluters would not abate pollution to the left of e because subsidy is lower than MAC.
• Subsidies are similar to charges in efficiency, cost effectiveness, enforceability, and also on incentive to innovation.
• Problem with subsidy scheme
• Provides perverse incentives to polluters to overstate or raise the base level
• Subsidy increases profit in the polluting industry and invites entry of new firms, increasing the total level of emissions (although emission per firm would go lower).
• Government needs to find necessary fund to meet the subsidy obligation.
• Some may consider it immoral to reward polluters with subsidy.

Deposit-refund system (a combination of emission charges and subsidy)

• Certain goods are taxed at the time of purchase (in the form of a deposit) but subsidized at the time of return of the used goods (by refunding the deposit).
• Examples: beverage containers and car batteries in the U.S., lubricating oil (engine oil) in Germany, and cars in Norway and Sweden. Other possible products for this kind of system can be dry cell batteries and tires.
• Well suited for products that are widely dispersed when they are purchased/used and their disposal is difficult to monitor.

XI. TRANSFERABLE DISCHARGE PERMITS

(Chapter 13)

Rationale

• Permit system offers economic incentives similar to emission charges, but it develops and works through a permit market.

Modus Operandi

• Permits are initially distributed by the pollution-control authority to polluters.
• A permit entitles the permit holder to emit one unit of a specific pollutant.
• Permits are transferable; they can be sold and bought in the permit market at a price mutually agreed by the parties.
• A polluter has three options
• Either emit only the amount of pollutants that is covered by the initial holding of permits.
• Or, purchase additional permits from another permit holder and accordingly emit more.
• Or, emit fewer amount of pollutants and sell surplus permits to interested buyers.
• Obviously, the choice among three options depends on abatement cost and price of permits.

Economics

• Assume two polluters and equal initial allocation of permits to each of them.
• Assume polluters differ in MAC: MAC1 and MAC2 (below MAC1) in a graph.
• At the initial level of allocation of permits, marginal cost of abatement is lower for Firm 2.
• Difference in MAC offers the two firms an opportunity of gains from trade of permits.
• Firm 2 can sell some permits to Firm 1 at a mutually agreed price.
• Price would lie somewhere between the two MACs at the initial levels of allocation of permits.
• Trade of permits would continue until MACs of both firms are equal (graph).
• If we extend this trading possibility among many firms in the industry, it is easy to see that there would develop a market of permits.
• Draw a graph with number of permits (Q) in the horizontal axis and price of permit (P) in the vertical axis.
• Like any other good, demand for permits would be a downward-sloping demand curve (D).
• Supply of permits is decided by the pollution-control authority, according to the total targeted amount of pollutants that can be emitted in aggregate.
• Draw a vertical supply curve (S) to show the number of permits issued by the pollution-control authority.
• Intersection of demand and supply gives the equilibrium price of permits in the market.
• Each polluter would emit at the level where price of permit is equal to its MAC (the point of intersection of price of permit and MAC curve).

Efficiency/Cost Effectiveness

• Each firm emits at the level where P (the price of permit) is equal to its MAC.
• P is fixed for each polluter; therefore, MACs are equalized to P across all polluters in the industry.
• Permits are cost effective in reducing pollution to the targeted level.
• If the number of permits issued is equal to the efficient level of emissions (MAC=MD), the system would as well be efficient.
• Determination of the efficient level, however, depends on availability of information.

Incentive for innovation

• By reducing MACs, polluters can save abatement costs and earn revenue from sale of surplus permits. Draw a graph to explain this.
• Let the current abatement technology be MAC1, so that price of permit (P) results into e1 level of emissions (the intersection of P-line and MAC1).
• Let the potential technology be MAC2 (lower than MAC1).
• when MAC2 is developed, the polluter would actually emit only e2 (the point of intersection of MAC2 and P-line).
• Note that e2<e1, requiring only e2 permits instead of e1.
• Label
• area between MAC1 and MAC2 to the right of e1 as a
• area below MAC2 to the right of e1 as b
• area below MAC2 between e1 and e2 as c
• area below P-line and between the two MAC curves and between e1 and e2 as d

• area below P-line to the left of e2 as f.
• With innovation of MAC2 technology,
• saving of abatement costs equal to (a-c)
• firm needs only e2 number of permits
• (e1-e2) number of permits is now surplus
• surplus permits can be sold at price P, generating a revenue equal to (c+d)
• total incentives to innovation is the amount of abatement cost saved plus the amount of revenue from sales of surplus permits, i.e., (a+d)
• Compare this incentive with the incentive available in case of emission charges
• they would be equal

Enforceability

• Compared to emission charges, enforcement is likely to be less intense with permits, because it primarily relies on market.
• The pollution-control authority, however, must monitor each polluter frequently to ascertain that emissions of the polluter are within limits of its holding of permits.
• The authority would know the initial allocation of permits, but actual holding of permits may be different because they can be bought or sold in the market.

Comparison with Emission Charges

• Compare with the "equivalent" emission charges, equivalent in the sense that both permits and charges lead to the same targeted level of emissions.
• Permits and charges both can be made efficient, when the number of permits and the tax rate correspond to the efficient level of emissions.
• Also, both are equally cost effective for the same targeted level of emissions.
• Both provide similar incentives to innovation of improved method of pollution control.
• Incentives are in the forms of saving of abatement costs and lower taxes in the emission charges system.
• Incentives are in the form of saving of abatement costs and revenue from sale of surplus permits in the permit system.
• Amount of incentives is the area between the current marginal abatement cost curve and the likely improved marginal abatement curve, bounded by the tax-line in the case of charges and bounded by the P-line in the case of permits.
• Determination of the appropriate tax rate requires knowledge of MAC in an emission charge system.
• Tax rate is the marginal abatement cost at the targeted level of emissions.
• In contrast, permit system requires no knowledge of MAC.
• Number of permits to be issued is simply the targeted level of emissions.
• Actual level of emissions is certain (known beforehand) and equal to the targeted level in the permit system.
• In contrast, the actual level may not equal the targeted level in the emission charge system if the information on MAC is hazy at the time of fixing the tax rate.
• If you suspect that marginal damages are likely to be very large (a steep MD curve), you want to choose permit system over emission charges.
• Because the number of permits lock down actual emissions to the targeted level.
• On the other hand, if you suspect that marginal damages are likely to be low (a relatively flat MD curve) but marginal abatement costs are likely to be very high (steep MAC), you want to choose emission charges over permits.
• Because emission charges lock down the level of MAC (equal to the tax rate).
• If the number of firms in the regulated industry is increasing, permit system ensures that total emissions would remain the same (equal to the number of permits issued). On the other hand, emissions would increase under the emission charge system.
• In the permit system, new firms increase demand for permits, raising the price of permits. This provides incentives to the existing firms to reduce pollution so that they can sell surplus permits to take advantage of higher price of permits. Surplus permits would be bought by new firms. Thus, emissions of existing firms would reduce, but total emissions would remain the same.
• In a charge system, existing firms maintain their current levels of emissions at t=MAC. New firms add to emissions. Thus, total emissions would increase.
• If there is an ongoing inflation in the economy, both abatement costs and price of permits increase in the permit system, and there is likely to be no change in emissions of individual firms and also of the entire industry.
• Draw a graph with initial MAC0 and P0.
• Now draw MAC1 (above MAC0) and P1 (above P0) such that the intersection of MAC1 and P1 lies just above the intersection of MAC0 and P0.
• With emission charge system, emissions of each firm and, thus, of the entire industry would increase. Since abatement costs increased with inflation but charges did not increase, taxes would prove cheaper than abatement.
• Draw the initial MAC0 and the new MAC1 (higher than MAC0).
• Show that the tax-line (which has not changed) intersects MAC1 to the right of MAC0, increasing emissions.
• If there is a continuous technological development in the industry, permits system would lead to the same level of emissions (equal to the number of permits), whereas emission charges would lead to lower level of emissions.
• Improved technology reduces abatement costs of firms and, thus, number of permits required. Demand for permits decreases, reducing the price of permits. Both price of permits and abatement costs decrease and emissions remain at the same level.
• Draw a graph with initial MAC0 and initial price P0.
• Draw new MAC1 and price P1 such that their intersection lies just below the intersection of MAC0 and P0.
• Compare this graph to the graph of emission charges.
• Draw MAC0 and MAC1 and draw the tax-line.
• Initial emissions were e0 at the intersection of tax-line and MAC0.
• New emissions would be at e1, the intersection of tax-line and MAC1.
• Note that e1<e0.
• Permits offer greater flexibility to the government to change targeted level of emissions.
• Simply buy permits from the permit market and then destroy or tearing them off to reduce emissions.
• Environmental activist organizations can buy and retire permits to reduce total emissions.
• With emission charges however, emissions can be reduced only by raising taxes, which is a complex legislative and political process.

(Also compare emission standards with charges and permits for efficiency, cost effectiveness, and incentives to innovation.)

XII. SOME FEDERAL WATER POLLUTION CONTROL POLICIES

(Chapter 14)

• Focus on pollution of water bodies (rivers, lakes, etc.)
• 1972 Water Pollution Control Act

• Began a federally-mandated system of pollution control
• Set technology-based effluent standards (TBES) for point sources
• Left control of non-point sources to States
• TBES is an emission standard on inputs tied to a technology
• Implemented in two phases
• Phase I (1972-1983) of 1972 Act
• TBES based on Best Practical Technology (BPT) of abatement
• BPT: reasonably well known, readily available technology, no excessive costs
• TBES: the amount of actual emissions per ton of raw materials processed when using BPT
• Show the example of sugar-beet industry from the textbook
• Set standards by 1977
• Phase II (1983 onwards) of 1972 Act
• TBES tied to Best Available Technology (BAT)
• BAT: more stringent, but economically achievable
• 1977 Clean Water Act
• Amended 1972 Act to revise BAT to BCT (best conventional technology)
• BCT: less stringent and less expensive than BAT
• Method of Enforcing Standards
• Discharge permits to each source
• Specifies allowable emissions per unit of raw material processed
• (discharge permits are not tradable)
• Implications of the Pollution-Control Approach
• Definitions of BPT, BAT, and BCT are open to interpretations
• TBES: perceived more as a technology standard than an emission standard
• Weak incentive for innovation
• Not cost effective (same standard for all firms)
• (standards for 600 subcategories of industries)
• No necessary reduction of total emissions
• TBES specifies only emissions per unit of raw materials
• No incentives for reducing outputs or for improving raw material productivity
• Fox River BOD Discharge Trading Permits
• Problem with ambient water quality in a 22-mile stretch of Fox River in Northern Wisconsin
• Major polluters in this stretch
• 10 pulp and paper mills
• 4 municipalities
• Prior to 1981: BPT-based effluent standards
• Findings of a study to replace TBES with tradable permits
• Potential saving of $6.7 million a year in abatement cost
• Wisconsin Department of Natural Resources implemented permits system in March 1981
• Tradable BOD emission permits
• Free initial distribution of permits, based on historical levels of emission
• Permits valid for 5 years
• Permits had to be reissued after 5 years
• Each permit transaction to be justified and approved
• Problems
• Took 10 months for the first permit to be traded
• Was the only trade for almost next 8 years
• Very few transactions of permits
• Possible reasons
• Uncertain property rights over permits after 5 years
• High transaction costs because of approval process
• Very liberal initial allocation
• Oligopoly permit market
• Waivers on compliance and subsidy on costs to municipalities
• Emission Reduction Credit Program in Dillon Reservoir
• A program in Summit County of Colorado
• Phosphorous pollution in Dillon Reservoir was a major problem
• Major polluters
• 4 municipalities
• many non-point sources, such as golf courses
• Previously relied on control of pollution from municipalities, with little control on non-point sources
• 1984 study on replacing the current efforts by emission reduction credit program
• relatively excessive control on point sources has raised their MAC, as opposed to that of non-point sources
• encourage non-point sources to abate pollution through tradable emission reduction credit (ERC) program
• non-point sources can reduce emissions below their base level, obtain credit, and sell the credit to willing buyers (point sources)
• ERC would equalize MACs (the equimarginal principle)
• potential saving of $1 million a year in abatement cost
• Considered successful and also copied later in Cherry Creek Reservoir in Colorado and another reservoir in North Carolina

XIII. SOME FEDERAL AIR POLLUTION CONTROL POLICIES

(Chapter 15)

• Focus only on six pollutants ("criteria pollutants") from stationary sources of pollution:
• Sulfur dioxide, nitrogen oxides, ozone, particulate matter, carbon monoxide, and lead
• 1967 Air Quality Act
• Dept. of Health, Education, and Welfare to establish criteria for setting ambient air quality standards
• States would then implement the criteria
• 1970 Amendments
• EPA to set uniform national ambient air quality standards

• Guidelines to EPA for setting standards
• no consideration to abatement costs
• consider only protecting human health and improving public welfare
• Implications of the above guidelines?
• Standards cannot be efficient (considered benefits, but ignored costs)
• Implications of uniform national ambient standards?
• Economically unjustified, because marginal damages from the same level of pollution are likely to differ among regions
• 1977 Amendments
• Classified regions into
• Prevention of Significant Deterioration (PSD) Areas
• Current air quality better than standards
• Objective: prevent deterioration of air quality
• Nonattainment (NA) Areas
• Current air quality worse than standards
• Objective: improve quality to the level of standards
• Provided for technology-based emission standards (TBES) for sources of pollution
• TBES for PSD Areas
• Almost none for existing sources
• BAT-based emission standards for new sources
• (new-source bias - stricter standards for new sources)
• TBES for NA Areas
• "Reasonably-Available Control Technology (RACT)" for existing sources
• "Lowest Achievable Emission Rate Technology (LAERT)" for new sources
• (new-source bias - stricter standards for new sources)
• Implication of New-Source Bias?
• Possibly, more cost-effective reduction of emission (assumption: new sources have cheaper abatement technologies!)
• Incentive to hold on to existing (more polluting?) sources
• 1990 Amendments
• Created 2 to 5 subcategories of NA areas for each pollutant
• marginal areas, moderate areas, severe areas, etc.
• More stringent standards for more severe areas
• Policy Reforms
• Emission Reduction Credit program in the 1977 Act
• Transferable Emission Permits plan in the 1990 Act
• Emission Reduction Credit Program (1977)
• Applied to Nonattainment areas
• Polluting sources obtain ERCs for the amounts of emission reduction below their baseline amount
• ERC is tradable if emission reduction is permanent, quantifiable, enforceable, and surplus
• Four types of ERCs:

• Offsets
• Bubbles
• Banking
• Netting

• Offset Program
• A new source or a major modification of an existing source in an nonattainment area allowed only if new emissions offset by an equivalent emission reduction from existing sources
• The new source must use the "lowest achievable emission rate technology (LAERT)"
• Offsets may be intra-firm or inter-firm
• Ratio of offset may be one-to-one or more, depending upon the severity category of the nonattainment area
• (implication: more cost-effective reduction of emission)
• Bubbles Program
• Similar to the offset program, but the trade is allowed only intra-firm
• Considers multiple sources (plants) of a firm as one entity - within one air bubble - for the purpose of compliance with the technology-based emission standards
• (implication: a firm can allocate emission reduction among its plants in a cost-effective manner, following the equimarginal principle)
• Netting Program
• Also an intra-firm program
• Applies to major modifications of existing sources only: added emissions from modifications to be offset by reduction of emissions from other sources in the same firm
• Waves the firm from a time-consuming and costly process of New Source Review (NSR) by the pollution control authority
• (implication: more cost-effective emission reduction)
• Banking Program
• Started by the EPA in 1979
• Objective: to facilitate trading of ERCs
• States to establish "ERC banks"
• Firms can deposit/save ERCs with the bank for future use or trade
• Performance of ERC Programs
• Encouraging, but mostly intra-firm
• Netting - the most popular, as it avoids NSR
• Possible reasons of low inter-firm ERC trading
• High transaction costs (identifying willing sellers and buyers of ERCs)
• Reluctance to use "banking" program, suspicious that deposited ERCs may be confiscated in future
• Uncertainty about the property-right status of ERCs
• Transferable Emission Permit Plan for Power Plants
• Provided by the 1990 Clean Air Act Amendments
• Implemented in two phases
• Phase I : 1995-2000
• Phase II: 2000 onwards
• Objective
• Phase I: 20% reduction of SO₂ emissions from 1980 level
• Phase II: another 20% emission reduction
• General Features of the Plan
• Any one can hold, buy, or sell permits
• Power plants, individuals, environmental groups, pollution-control technology firms, etc.
• Permits are tradable
• Power plants install/maintain emission measuring devices
• Penalty: $2,000 a year per ton of excess emissions
• Phase I Plans
• Implemented in 21 Eastern and Midwestern states
• Covered 110 electric utility plants
• 5.5 million permits issued
• Distribution formula
• number of permits to a plant = 1985-87 average quantity of coal used (in million BTUs)* 2.5 lbs. of SO₂ allowed per million BTU
• Provision of 3.5 million additional permits for delaying the plan or accommodating growth in the power producing sector
• Phase II Plans
• Cover all power plants in the entire country
• Same permits issue formula
• Allowable SO2 emissions per million BTUs: 1.2 lbs., instead of 2.5 lbs. in the first phase
• Overall cap of 8.95 million permits
• Some observations
• Initial allocation of permits: more to larger plants
• Concerns
• Relatively small number of trades
• Low market prices of permits
• Large initial distribution of permits
• Imperfect competition in the utility industry (regulated monopolies)