class: center, middle, inverse, title-slide # Environmental Economics ## Environmental Regulation ### David Ubilava ### January 2021 --- # Rationale for Regulation Environmental regulation involves the government intervening in the private actions of firms and individuals. <!-- It does so to address the issues of: --> <!-- - *Imperfect competition* - by controlling prices to protect consumers from monopoly pricing, and in some instances - e.g., in the case of a natural monopoly - to restrict the entry of new firms. --> <!-- - *Imperfect information* - by establishing liability rules to ensure the provision of quality (passive/indirect intervention), or by specifying acceptable levels of quality (active/direct intervention). --> <!-- - *Externalities* - by defining institutions/regulations to mitigate the provision of public bads and negative externalities. --> Most environmental regulations fall into two broad categories: *prescriptive regulations* (i.e., *command-and-control*) and *incentive-based regulations*. --- # Prescriptive Regulation Command-and-control is the dominant form of environmental regulation in the world. Its fundamental principle is for a regulator to specify the steps firms must take to mitigate/solve the environmental problem. There are two basic types of prescriptive regulations: *technology standards* and *performance standards*. - Technology standards typically specify a particular type of equipment that must be used. - Performance standards typically stipulate the maximum emissions allowed per unit of economic activity. This is a more flexible method of regulation, which typically leads to improved cost-effectiveness (at least compared to that of a technology standard). --- # Prescriptive Regulation Often, a regulation combines performance standards with technology standards. Prescriptive regulations may, in fact, be present in conjunction with fines and penalties associated with noncompliance. These are different from - and should not be confused with - economic incentives to abate pollution. Two key features that distinguish prescriptive regulations from incentives are: - restricted choice for the polluter as to what means to be used to achieve an appropriate environmental target, and - a lack of mechanisms for equalizing marginal costs of managing emission among several different polluters. --- # Prescriptive Regulation The advantage of prescriptive regulations (over incentive-based regulations) is in greater certainty in achieving the desired pollution levels, as well as in simplifying monitoring of compliance with a regulation. The disadvantages to prescriptive regulations are: - cost (costliness) of administering the regulation; - reduced incentives (for a firm) to find better ways to control pollution; - not accounting for residual damage from the pollution that is still emitted after controls are in place; - difficulty in satisfying the *equimarginal principle*. The equimarginal principle assumes the same marginal costs of emission control from all affected (by a regulation) polluters. --- # Incentive-Based Regulation Economic incentives, in contrast to prescriptive regulations, provide rewards to potential polluters to do what is perceived to be in public interest. Three basic types of economic incentives are: *marketable permits*, *emission fees*, and *liability*. --- # Incentive-Based Regulation Marketable permits allow polluters to buy and sell the right to pollute. This system is often referred as *cap-and-trade*, wherein the regulator sets a cap on overall emissions, and allows trading among polluters to determine who emits what. Trading induces a price or value on a permit to pollute. Emission fees involve the payment of a charge per unit of pollution emitted. It then becomes in a polluter's interest to reduce emissions. Liability is based on a simple concept: if you incur a damage, you must compensate for the damage. Importantly, the regulator does not prescribe a polluter any action, rather it enforces the responsibility for consequences. --- # Incentive-Based Regulation The advantages of incentive-based regulations (over prescriptive regulations) are: - mitigated informational requirements; - enhanced incentives to innovate; - polluter paying for control costs as well as pollution damage; and - equimarginal principle holds for most types of economic incentives. --- # Incentive-Based Regulation The disadvantages to economic incentives are: - difficulty in developing a regulation that efficiently and perfectly address the complexities of environmental transformation; - administrative/bureaucratic difficulties in adjusting the level of incentives in accord with the new information; - political challenges to instituting emission fees, as they, in essence, facilitate the wealth transfer from firms to the government. --- # Marketable Permits The virtue of marketable permits is that no matter how they are initially allocated, after trading, the equimarginal principle automatically holds. The following graph illustrates this. The permits can be allocated for free, or being auctioned, with the revenue going to the government. --- # Marketable Permits <div class="figure" style="text-align: center"> <img src="06-Incentives_files/figure-html/permits-1.png" alt="Marketable Permits" width="90%" /> <p class="caption">Marketable Permits</p> </div> --- # Emission Fees Normally, consumer preferences for goods are communicated to producers through the price system. This system is "broken" in the case of environmental goods (or, rather, bads), because polluters' production function does not account for the damage caused by their emissions. A way to correct this is to establish an *emission fee* paid by a polluter to a regulatory entity for every unit of emission. --- # Emission Fees Consider a firm that produces a market good, and in the process emits pollution, `\(e\)`. Let `\(C(e)\)`, such that `\(C'(e)<0\)`, denote the firm's costs for emission abatement. That is, the firm's costs (or efforts) to reduce pollution increase with the emission abatement. Let `\(\tau\)` be the emission fee - established by a regulator - so that the payment from the polluter to the regulator is `\(\tau e\)`. Total emission-related costs for the firm, then, is given by the sum of the abatement costs and the payment associated with `\(e\)` units of emission: `$$TC(e) = C(e)+\tau e.$$` --- # Emission Fees It then follows that at the optimum: `$$p=-C'(e^*) \equiv MS(e^*),$$` where `\(C'(e^*)\)` is the marginal cost of abating one more unit of pollution, and `\(MS(e)\)` is the marginal savings from emitting one more unit of pollution. The foregoing indicates that when faced with an emission fee, firms will abate pollution up to the point where the marginal savings (or marginal cost of abatement) is equal to the emission fee. Note that in this instance, the equimarginal principle automatically holds: each firm sets their marginal cost of abatement equal to the same emission fee. --- # Pigovian Taxes A special kind of emission fee, which aims to restore Pareto optimality in the case of market failure, is known as the *Pigovian fee* (or *Pigovian tax*), after the English economist Arthur C. Pigou. A Pigovian tax is an emission fee that is exactly equal to the aggregate marginal damage caused by pollution when evaluated at the optimal level of pollution. --- # Pigovian Taxes Suppose a total of `\(n\)` individuals are adversely affected from the pollution emitted by a firm. For person `\(i\)`, the damage from pollution is `\(D_i(e)\)`, and the total damage is given by the vertical sum of individual damage functions: `$$D(e) = \sum_{i=1}^{n}D_i(e).$$` The efficient amount of pollution is the amount that minimizes the sum of costs and damages from pollution. --- # Pigovian Taxes <div class="figure" style="text-align: center"> <img src="06-Incentives_files/figure-html/pigou1-1.png" alt="Optimal Pollution" width="90%" /> <p class="caption">Optimal Pollution</p> </div> --- # Pigovian Taxes At the optimum: `$$MD(e^*) = MS(e^*).$$` The emission fee associated with this optimal level of pollution is the Pigovian tax. That is, the Pigovian tax is not just any emission fee; it is, indeed, the marginal savings from pollution at the optimal level of pollution. --- # Pigovian Taxes With multiple polluters, we typically assume that they are sharing the obligation of emission abatement in an efficient manner. The aggregate marginal savings is the horizontal sum of the individual marginal savings. --- # Pigovian Taxes <div class="figure" style="text-align: center"> <img src="06-Incentives_files/figure-html/pigou2-1.png" alt="Optimal Pollution by Multiple Firms" width="90%" /> <p class="caption">Optimal Pollution by Multiple Firms</p> </div> --- # Pigovian Taxes Thus, for a given emission fee, the aggregate marginal savings tells us how much of pollution will be emitted in total, while the individual marginal savings tell us how much each firm will contribute to that total.