CONVENTIONAL SOLUTIONS TO ENVIRONMENTAL PROBLEMS:COMMAND-AND-CONTROL APPROACH

PREPARED BYKWABENA NKANSAH DARFOR

Standards in Environmental Policy

n Types of Environmental Standardsn Ambient standard – a standard that designates the quality of

the environment to be achieved, typically expressed as a maximum allowable pollutant concentration

n Technology-based standard – a standard that designates the equipment or method to be used to achieve some abatement level

n Performance-based standard – a standard that specifies a pollution limit to be achieved but does not stipulate the technology

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Implications of Using Standards

n Two key implicationsn Are standards set to achieve allocative efficiency?

p where MSB of abatement equals MSC of abatementn Given some environmental objective, is that objective being

achieved in a manner that is cost-effective?

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EFFICIENT STANDARDS

n MSBAbatement = MSCAbatement

MSB of Abatement

n Additional social gains as pollution abatement increases

n Measured as reduction in damages or costs caused by pollution (i.e., reduction in MEC)

n Represents society’s D for environmental qualityn Implies MSB is negatively sloped

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MSC of Abatement

n Sum of all polluters marginal abatement costs plus government’s marginal cost of enforcement

n Two components: MSC = MACMKT + MCE• MACMKT is the sum of all polluters’ individual

marginal abatement cost (MAC) functionsp SMACi = MACMKT

• MCE is marginal cost of enforcementp Change in government’s cost of monitoring and

enforcing abatementn MSC is positively sloped

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Firm-Level MAC

n Measures the change in cost from reducing pollution, using least-cost method n Equals forgone Mp if the least-cost abatement

method is to reduce outputn Typically positively sloped and increasing at

increasing raten For simplicity, it is usually assumed that MAC is

linear

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Firm’s MAC (typical shape)

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$

Abatement (A)

MAC

MSC of Abatement

9

$

Abatement (A)

MACMKT

MSC = MACMKT + MCE

A1

MCE

Allocatively Efficient Level of A (AE)

n AE occurs at the point where:n MSB of abatement = MSC of abatementn Graphically where the two curves intersect

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Modeling AE

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$

Abatement (A)

MSC

MSB

AE

Why Standards May Not Be Efficient

n Legislative Constraintsn Many standards are benefit-based, i.e., set to

improve society’s well-being with no consideration for the associated cost

n Imperfect informationn Inability to identify MSB and/or MSC

p MSB: due to the problem of nonrevelation of preferences

p MSC: difficulty in identifying each firm’s MAC, including implicit costs

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Why Standards May Not Be Efficient(continued)

n Nonuniformity of pollutantsn Changes in emissions do not have uniform effects on

environmentp e.g., if polluters are at different distances from

populations or ecosystems, MSB would vary

n Regional differencesn Even if AE is identified at the national level, it is not

likely to be efficient at regional level

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Modeling Regional Differences

n Consider two regions, X and Y, with same MSC of abatement

n Suppose their MSB of abatement curves differ, such that MSBX < MSBY

n Result: Allocatively efficient level of abatement for region X (AX) would be lowerthan for region Y (AY)

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Regional Differences

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$ MSCX = MSCY

MSBY

MSBX

MSBY = MSCY

AYAX

MSBX = MSCX

A

A single national abatementstandard would not be optimalfor both regions

Next Step

n If allocatively efficient standards are unlikely, we use cost-effectiveness to evaluate how standards are implemented

n Cost-effectiveness depends on the approachn Command-and-control: using standards or rules to

control pollutionn Market: using incentives and market forces to

motivate or encourage abatement and conservation

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Command-and-Control (CAC)

n Assessing Cost-Effectiveness

Two Standards to Examine

n Technology-based standardn Uniform standard

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CAC and Technology-based Standards

Technology-Based Standards

n Technology-based standards specify the type of abatement equipment or method to be used

n By definition, these standards potentially preventfirms from selecting and using the least-cost abatement method

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Analysis: Use MAC Curve

n Technology-based standardn If prevented from using the least-cost abatement

method, firms would operate above their MAC curven Performance-based standard

n 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

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$

Abatement (A)

MAC

MAC represents least-costmethod of abatementTechnology-based standards can force some firms to operate above MAC

AX

Technology-basedstandard

Performance-basedstandard

CAC and Uniform Standards

Overview

n Uniform standards waste economic resources as long as abatement costs differ among polluting sources

n Cost savings can be obtained if low-cost abaters do more cleaning up than high-cost abatersn Let’s prove this by building a model of 2

hypothetical firms

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Modeln Assumptions

n 2 polluting sources in some regionn Each generates 10 units of pollutionn Government sets emissions limit of 10 units for region, or 5

units per firmn Uniform standard: each firm must abate 5 units

n Cost conditionsPolluter 1: TAC1 = 1.25(A1)2

MAC1 = 2.5(A1)p where A1 is pollution abated by Polluter 1

Polluter 2: TAC2 = 0.3125(A2)2MAC2 = 0.625(A2)

p where A2 pollution abated by Polluter 2

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Modeln Find the total abatement costs using the uniform

standard

n Solution:n The TACs for each firm are

n TAC1 = 1.25(A1)2 = 1.25(5)2 = $31.25TAC2 =0.3125(A2)2 = 0.3125(5)2 = $7.81

n 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

n Use MACs to prove that the uniform standard is not cost-effective

n Solutionn With uniform standards, the MACs are not equal

p MAC1 = 2.5(5) = $12.50p MAC2 = 0.625(5) = $3.125p Shows that Polluter 2 has a cost advantage

n The 5th unit of A (i.e., the marginal unit) costs Polluter 2 $9.37 less than it costs Polluter 1

n It would be cheaper if Polluter 2 did more of the abating, but it lacks an incentive to do so

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Modeln Find the cost-effective abatement, A1 and A2n Solution: uses 3 simple steps

(i) Set MAC1 = MAC2

2.5A1 = 0.625A2An application of the equimarginal principle of optimality

(ii) Set A1 + A2 = Abatement StandardA1 + A2 = 10

(iii) Solve equations (i) and (ii) simultaneously2.5 (10 - A2) = 0.625A225 - 2.5A2 = 0.625A2, so A1 =2 A2 =8

n Prove that this is cost-effectiveMAC1 = 2.5A1 = 2.5(2) = $5.00MAC2 = 0.625A2 = 0.625(8) = $5.00

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Modeln Show that total abatement costs are lower at this

abatement allocation than the costs when a uniform standard is used

n Solutionn TAC1 = 1.25(2)2 = $5.00n TAC2 = 0.3125(8)2 = $20.00n S TACs (cost-effective) = $25.00n S TACs (uniform standard)= $39.06

n Cost Savings= ($39.06 - $25.00) = $14.06

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Graphical Model

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MAC1 MAC2

0

10

10

0

25.00

6.25

Polluter 1’s Abatement

Polluter 2’s Abatement

2

8

5.00 5.00

MAC1

MAC2

Further Observations

n Problem: Public officials will not know where to set firm-specific standards without knowing MAC for every polluter

n Implies that a cost-effective solution is virtually impossible under CAC framework

n Result is possible using market approach

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ECONOMIC SOLUTIONS TO ENVIRONMENTAL PROBLEMS THE MARKET APPROACH

Overview

n Market approach refers to incentive-based policy that encourages conservative practices or pollution reduction strategiesn Difference between market approach and command-and-control

approach is how each approach attempts to achieve its objectives

n Types of Market Instrumentsn Pollution chargen Subsidiesn Deposit/refund systemsn Pollution permit trading systems

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Pollution Charges

Pollution Charge

n Fee that varies with amount of pollutants releasedn Based on “Polluter-Pays Principle”

n Types of pollution charges n Effluent/emission feesn Product chargen User chargen Administrative charge

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Product Charge

n Fee added to price of pollution-generating product, which generates negative externality

n Impose product charge as per unit tax on product, e.g., gas taxn How does the tax on gasoline in Ghana compare with

that of other nations?n If the tax equals the marginal external cost (MEC) at QE,

it is called a Pigouvian tax

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Selected International Gasoline Tax Rates

Nation Tax Rate % of Price (2011)

United States 13.2U.K. 61.6

France 58.1

Germany 60.5Japan 45.8Spain 50.1

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Source: International Energy Agency, January 2011

Modeling a Pigouvian Tax

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$

Q of gasoline

MPB = MSB

MPC

MSC = MPC + MEC

0 QE QC

MPCt

b

a

Amount of tax

Assessing the Model

n In theory, achieves an efficient outcomen In practice, difficult to identify the value of

MEC at QE

n Allows only for an output reduction to reduce pollution

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Emission (Effluent) Charge

n A fee imposed directly on the discharge of pollutionn Assigns a price to pollution

n Typically implemented through a tax

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Model: Single Polluter Case

n Government sets an abatement standard at ASTn Policy options to polluter are:

n Abate up to AST and incur those costs ORn Pay a constant per unit tax, t, on any abatement less than

ASTp Total Tax = t(AST - AO)

n where AO is actual abatement levelp Marginal Tax (MT) = t

n Because t is constant, t = MT

n Firm will choose the least-cost option: the marginal tax (MT) or the marginal abatement cost (MAC)

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Modeling Emission ChargeSingle Polluter

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$

Abatement (A)0

MAC

MTt

AO AST

a b

c

Firm abates up to Ao sinceMAC < MT; firm pays tax between AO and AST, sinceMAC > MT in that range

0aAO = cost to abate AOAOabAST = tax on pollutionnot abated up to AST

Model: Multiple Polluter Case

n To facilitate comparison, we use the same model as in the uniform standard case

n Assumptions n 2 polluting sources in some regionn Each generates 10 units of pollutionn Government sets emissions limit for region as 10

units, which implies AST = 10n Policy: To achieve AST, government imposes an

emission charge as a unit tax (t) of $5

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Model: Multiple Polluter Casen Each firm responds as in the single polluter case

n Abates as long as MAC < MTn Pays emission charge when MAC > MT

n Polluter 1: TAC1 = 1.25(A1)2MAC1 = 2.5(A1)

p where A1 is pollution abated by Polluter 1n Polluter 2: TAC2 = 0.3125(A2)2

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

n 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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Solutionn Polluter 1:

n Abates up to the point where MAC1 = MT,p Set 2.5(A1) = $5, or A1 = 2

n Incurs TAC1 = 1.25(2)2 = $5n Incurs Total Tax = 5(10 - 2) = $40

n Polluter 2:n Abates up to point where MAC2 = MT

p Set 0.625(A2) = $5, or A2 = 8n Incurs TAC2 = 0.3125(8)2 = $20n Incurs Total Tax = 5(10 - 8) = $10

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Modeling An Emission ChargeMultiple Polluter

MAC1 MAC2

0

10

10

0

25.00

6.25

Polluter 1’s Abatement

Polluter 2’s Abatement

2

8

MT = 5.00 MT = 5.00

MAC1

MAC2

Total Abatement Level = 10 = ASTTAC1 + TAC2 = $25 (right triangles)Total Tax Payments = $50 (rectangles)

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Assessing the Model (pros)

n Abatement standard is metn Generates $40 in tax revenues from high-cost

abater and $10 from low-cost abatern Low-cost abaters do most of cleaning upn Cost-effective solution is obtained

n MACs are equal at $5 tax raten 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)n Tax authority will not know where MACs are equal

n Will have to adjust rate until objective achievedn Monitoring costs potentially highern Firms might evade tax by illegally disposing

pollutantsn Distributional implications

n Consumers may pay higher prices due to taxn Job losses may result from polluter paying new taxes

and/or changing technology to abate

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Pollution Charges in Practicen Internationally, the pollution charge is the most

commonly used market-based instrumentn Australia, France, Germany, and Japan use fees or

taxes to control noise pollution generated by aircraftn Canada, France, Mexico, and Poland are among the

nations using effluent charges to protect water resources.

n Others levy charges on products such as batteries, tires, lubricant oil, packaging, paint, paint containers, and gasoline

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Environmental Subsidies

Environmental Subsidies

n Two major types of subsidies:n Abatement equipment subsidiesn Pollution reduction subsidies

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Abatement Equipment Subsidy

n Defined as a payment aimed at lowering the cost of abatement technology

p Goal is to internalize the positive externality associated with the consumption of abatement activities

n If the subsidy (s) equals the marginal external benefit (MEB) at QE, it achieves an efficient equilibrium and is called a Pigouvian subsidy

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Pigouvian SubsidyMarket for Scrubbers

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($ millions)

MSC

MPBMSB

0 QC = 200 QE = 210

PC = 170

PE = 175 Subsidy = $14 million

MPBS

Q of scrubbers

PE – s = 161

K

L

Assessing the Model

n It is difficult to measure the MEBn May bias polluters’ decisions about how best to

abate

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Pollution Reduction Subsidy

n To implement, government pays the polluter a subsidy (s) for every unit of pollution abated below some pre-established level ZST

n Per unit subsidy = s(ZST - ZO), where ZO is the actual level of pollutionn Analogous to an emission charge

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Assessing the Model

n Might be less disruptive than an equipment subsidy

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

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Subsidies in Practicen Environmental subsidies typically are implemented as

grants, low-interest loans, tax credits or exemptions, and rebates

n Many countries around the world use these instruments, including Belgium, Denmark, Finland, Japan, and Turkey

n 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

n 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

n Targets the potential vs. actual pollutern The deposit is intended to capture the MEC of improper

waste disposal (IW) in advancen Preventive vs. ameliorative

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Modeling Deposit/Refund SystemIW disposal market

n MECIW: health damages + aesthetic impairment from litter, trash accumulation, etc.

n MPCIW: costs to disposer (e.g., trash receptacles, collection fees, plus forgone revenue from not recycling)

n MSCIW = MPCIW + MECIW

n MPBIW: demand for improper disposal§ Assume MEBIW = 0, so MPBIW = MSBIW

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Deposit-Refund Model$

Improper Waste Disposal (%)

MPBIW = MSBIW

MPCIW

MSCIW

0QE QIW

MPCIW + Deposit

b

a

Deposit=MEC at Qe

100Proper Waste Disposal (%) 0100

Deposit converts % of overall waste disposal, measured by (QIW - QE), from improper methods to proper

Assessing the Model

n Promotes responsible behaviourn Requires minimal supervision by governmentn Can help slow the use of virgin raw materials

by improving availability of recycled materials

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Deposit/Refund Systems in Practice

n Deposit/refund systems are used worldwiden Many nations use these systems to encourage

proper disposal of beverage containers p In the US, 10 states have bottle billsp Deposits range from 2 cents to 15 cents per

container

n 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

n A pollution permit trading system establishes a market for rights to pollute by issuing tradeable pollution credits or allowancesn Credits are issued for emitting below a standardn Allowances indicate how much can be released

n Two components of the system are1. Fixed number of permits is issued based on an

“acceptable” level of pollution set by government2. The permits are marketable

n Bargaining gives rise to a market for pollution rights

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How Permit Trading Worksn There is an incentive to trade as long as

polluters face different MAC levelsn Suppose a firm has 50 permits but normally

emits 75 units of SO2. What must it do?n Answer

p Abate 25 units of emissions ORp Buy 25 permits from another producer

n Which option will the firm choose?n Answer

p Whichever option is cheaper66

Result

n Low-cost abaters will clean up pollution and sell excess permits to other firmsn They will sell at any P higher than their MAC

n High-cost abaters will buy permits rather than abaten They will buy at any P lower than their MAC

n 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

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Assessing the Model

n Trading establishes the price of a right to pollute without government trying to “search” for a price

n No tax revenues are generatedn Trading system is flexible

n Note that an emissions standard can be adjusted by changing the number of permits issued

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Pollution Trading Systems in Practice

n Most of the evolution of trading is occurring in U.S.n An important example is the allowance-based trading

program to control sulfur dioxide emissions under the Clean Air Act Amendments of 1990

n More innovation has occurred at state and local levelsp Ozone Transport Commission in the Northeastp California Regional Clean Air Incentives Market (RECLAIM)

n Key international examplen Trading of greenhouse gas allowances are part of the

Kyoto Protocol, an international accord aimed at global warming

p Includes the European Union Greenhouse Gas Emission Trading System (EU ETS), launched in 2005

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