Business in a Modern World

1. Business in a Modern World • Markets, Firms, and the Role of Governments • Legal systems; externalities and public goods; social security and distribution; imperfect competition. • Firms and Governments: The Case of Environmental Policy • Pollution; emission standards, taxes and permits; EU emissions trading scheme. • The Global Economy I: Trade and Location • International trade; comparative versus competitive advantage; location and MNEs. • The Global Economy II: Capital and Currencies • Capital mobility and market integration, exchange rates. • The Global Economy III: Policy and Organisations • Trade policy and capital restrictions; the future of nations and organisations • Concluding Remarks on Business in a Modern World

2. Firms and Governments: Environmental Policy • Part 1: Policy Approaches to Controlling Pollution • 1. Introduction • 2. Main Objectives • 3. Efficient Policy • 4. Cost-Effective Policies • 5. ‘Dynamic’ Incentives • 6. Other Criteria • 7. Conclusions

3. 1. Introduction • Today’s topic: Policy approaches to control pollution • Main issues: • government objectives • efficient & cost-effective policies • incentives to use/invent eco-friendly technologies • policy instruments and information requirement

4. 2. Main Objectives Now: Focus on pollution, i.e., flow of waste products from the economy back to the environment. Pollution causes damage (externality) and benefits. Damage includes loss of • use value • option value • existence value.  Take 15 minutes and give me examples! Is it possible to quantify that? Research it!

5. 2. Main Objectives • Cuts in pollution can be achieved by means of • less output/consumption  check on EUROSTAT GDP in 2008 and 2009 and CO2 emissions! http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/themes • abatement • Main objectives of environmental policy: • efficiency • cost-effectiveness • incentives to use/invent eco-friendly technologies  Can you think of other objectives?

6. 3. Efficient Policy Efficient policy : cuts in polluting output • Determining efficient pollution levels means balancing the trade-off between costs of & benefits from pollution. • Efficiency condition: Marginal WTP for a product equals marginal social costs (marginal private plus external costs).

7. 3. Efficient Policy Efficient allocation Q* Price Social marginal costs Net benefit Supply = Private marginal costs Demand = Marginal WTP Output Q* cut

8. 3. Efficient Policy But: Environmental costs are ‘external’ costs.  No prices for pollution reflecting environmental scarcity.  Agents do not take environmental damage into account.  Inefficient high pollution levels in market equilibrium.

9. 3. Efficient Policy Efficient allocation Q*versus market allocation QM Price Social marginal costs Supply = Private marginal costs Demand = Marginal WTP Output Q* QM

10. 3. Efficient Policy Possible efficient policy 1: “Creating” a substitute for a market price by implementing an emission tax (or charge): resulting tax payment per output unit = marginal damage at Q* • Agents internalise environmental damage. • “Modified” market outcome is efficient.

11. 3. Efficient Policy Efficient policy Supply = Private marginal production costs + Tax Price Social marginal costs Net benefit Supply = Private marginal costs Demand = Marginal WTP Output Q*= QP QM

12. 3. Efficient Policy Efficient policy 2: increase in ‘abatement’ • Efficient pollution level (which we don’t know!) minimises the sum of • damage costs of pollution & • abatement (or control) costs of pollution. • Marginal damage costs increase with the quantity of emissions. • Marginal abatement costs increase with the quantity of emissions reduced (i.e., decrease with the quantity of emissions).

13. 3. Efficient Policy Marginal costs Marginal damage costs Remember a damage has a certain benefit (cause) Marginal abatement costs Quantity of emissions Q Q* Emission Cuts

14. 3 Assignments • Damage includes loss Give examples! Is it possible to quantify that? Research it! • Cuts in pollution can be achieved by means of less output/consumption  check on EUROSTAT GDP in 2008 and 2009 and CO2 emissions! • Summarize different positions regarding pollution (proof!) from different stakeholders e.g.specific industries, parties,interest groups, NGOs etc.

15. Example: Socially optimal outcome

16. Example: Socially optimal outcome Cost to reduce the 6th unit of emissions Reduction costs of 5 emissions units Additional damage caused by the 3rd emission unit Cumulated damage

17. Example: Socially optimal outcome

18. 3. Efficient Policy Efficiency condition: If pollution is efficiently allocated, then the marginal damage costs of pollution equal the marginal abatement costs. Market allocation: • Damage costs are externalities, firms’ abatement costs are private.  Firms do not abate  REALITY if no policy applied

19. 3. Efficient Policy Possible efficient policy  Pigouvian Tax: Implementing an emissions tax which is equal to the marginal damage at the point where the marginal damage and abatement costs are identical.  Firms cut emissions as long as the marginal abatement costs are below the emissions tax.  Damage costs are internalised.

20. 3. Efficient Policy Marginal damage costs (socialized without any measure) Marginal costs Tax Marginal abatement costs Quantity of emissions Q Q* Emission Cuts

21. 3. Efficient Policy Major Problem: • lack of information about marginal damage costs (despite of a wide range of valuation methods) • lack of information about abatement costs & differences in abatement costs between emission sources • Difficulties in evaluating the efficient intertemporal use of resources • Less ambitious policy assessment criterion: • cost-effectiveness  But what could be there reason for implementing it?

22. 4. Cost-Effective Policies “Exogenous” environmental targets determined in the political process. Cost-effectiveness: An allocation is cost-effective if it meets a given environmental target in a manner that minimises total abatement costs. Simple case (Example): • 2 emission sources • abatement costs differ between emission sources • given pollution target

23. Question: Cost-effective outcome if total cuts = 6? The case with 2 firms To cut 6 emission units is necessary to minimize sum of total costs (1+2) To cut the sixth unit of emission costs 12 Units of money Cut in emission of firm 2 Cut in emission of firm 1

24. 4. Cost-Effective Policies Marginal costs Firm 1 Initial situation without cuts Firm 2 Initial situation without cuts Emission cuts 6 Cuts firm 1 6 Emission cuts firm 2

25. 4. Cost-Effective Policies Optimality condition: If an allocation is cost-effective (i.e., if it minimises total costs of pollution cuts), then the marginal abatement costs will be identical for all emission sources (here: polluting companies).  This principle can be applied to a case with countless companies e.g. the European trading scheme

26. 4. Overview of instruments 26

27. 4. Cost-Effective Policies Command-and-control policy: Emission standards • Emission standard: • legal limit on the quantity of emissions • allocation between different emission sources/firms? • Any arbitrary allocation between sources/firms does • usually not equalise marginal abatement costs • not lead to cost-effective outcomes. • For example: “equal” obligations to cut emissions

28. 4. Cost-Effective Policies For example: “equal” obligations to cut emissions - Read article (!)

29. 4. Cost-Effective Policies Marginal costs Firm 1 Firm 2 Emission cuts 3 6 Cuts firm 1 6 Cuts firm 2

30. 4. Cost-Effective Policies See the difference 30

31. 4. Cost-Effective Policies Non-market based instrument: See example above (Emission standards): An “equal" cut of three emission units is not cost-effective. • Problem: • Cost-effective standards require knowledge of abatement costs that governments do not have. And even if they had, these costs are, due to dynamics, constantly changing !

32. 4. Cost-Effective Policies Market-Based Instruments I: Emission Tax (Pigou) • A tax on each unit of pollutant emitted, imposed by the government. • Emission tax serves as a substitute for the missing market price of the environment. Response of firms: • Firms cut emissions as long as marginal the abatement costs are below the emissions tax.

33. 4. Cost-Effective Policies Result: • If firms face an identical emission tax, they face identical incentives to cut emissions.  Marginal abatement costs are equalised across firms. • Abatement costs are “automatically” minimised; • emission taxes are cost-effective. • Note: Knowledge of abatement costs is not needed!

34. 4. Cost-Effective Policies Marginal costs Firm 1 Firm 2 Tax Emission cuts Total cuts Cuts firm 1 Emission cuts firm 2

35. 4. Cost-Effective Policies: Tax Problems: • Iterative trial-&-error process is necessary to achieve environmental targets (Was the tax imposement successful). • Costs of legislative adjustments can be substantial. Discussion: • What about using subsidies to install new technology instead of taxes?

37. 4. Cost-Effective Policies Market-Based Instruments II: Emission Permits • Transferable emission permits: • Permits that allow a firm to emit a specific amount of pollutant over a specific time period; freely tradable. Basic idea: • Generate a market for the environment by setting aggregate “supply” of pollution • setting indirectly the price of the environment. • What does the “price” depend on ?

38. 4. Cost-Effective Policies Response of firms: • Firms cut emissions & sell permits not needed as long as the marginal abatement costs are below the permit price. • Firms buy permits and emit more as long as the marginal abatement costs exceed the permit price. Result: • Trade takes place until all firms’ marginal abatement costs are equalised, and are equal to the permit price. • All firms face identical incentives to cut emissions.

39. 4. Cost-Effective Policies: Permits Marginal costs Initial distribution of permits: Incentives to trade emission permits when marginal abatement costs differ Firm 2 Firm 1 Emission cuts Total cuts

40. 4. Cost-Effective Policies: Permits Marginal costs Market equilibrium after trade in permit market Firm 2 Firm 1 Price Emission cuts Total cuts Equilibrium Cuts firm 1 Equilibrium cuts firm 2

41. 4. Cost-Effective Policies • Abatement costs are ‘automatically’ minimised; • emission permits are cost-effective. Note: • Knowledge of abatement costs is not needed! • Cost-effectiveness is independent of initial permit allocation. • No (costly) iterative trial-&-error process to meet environmental targets.

42. 4. Cost-Effective Policies Permits put into practice: How does this work? • initial allocation of permits: • auctions • free allocation (grandfathering) • Problems: • imperfect competition for permits • new market entries • transaction costs of trade We will discuss this further !

43. 4. Cost-Effective Policies Conclusion: Both market-based approaches, emission taxes & permits, are suitable to achieve cost-effectiveness. Permits enable the government to achieve directly pollution targets; taxes require a (costly) trial-&-error process.

44. 5. ‘Dynamic’ Incentives • ‘Dynamic’ incentives to use (and invent) eco-friendlier technologies in the case of emission taxes: • lower (marginal) abatement costs • lower tax payment • But: costs of switching to ‘new’ technology • Example: • two technologies – ‘old’ and ‘new’ – available to a firm • new technology: lower (marginal) abatement costs • switching to new technology: fixed costs F Example: Carbon Capture & Storage

45. 5. ‘Dynamic’ Incentives Marginal Costs Dynamic incentives : Example with tax New technology Tax payment Abatement costs Tax Old technology Quantity of Emissions Q Qold Emission Cuts

46. 5. ‘Dynamic’ Incentives Marginal Costs New technology Cost reduction Price Old technology Quantity of Emissions Qnew Q Emission Cuts

47. 5. ‘Dynamic’ Incentives Result: • Firm chooses ‘new’ technology if cost reduction is greater than costs of switching to ‘new’ technology F.

48. 5. ‘Dynamic’ Incentives 48 Dynamic incentives to use (and invent) use eco-friendlier technologies in the case of emission permits: • lower (marginal) abatement costs • revenues from selling permits (!) Discussion: • Is there any difference between taxes and permits? • Why? Why not? • What about the dynamic incentives of emission standards?

49. 5. ‘Dynamic’ Incentives Marginal Costs New technology Costs of Permits Abatement costs Price Old technology Quantity of Emissions Q Qnew Emission Cuts

50. 6. Other Criterias argument for market-based approaches • Response to economic cycles & growth • E.g. see following example of CO2 prices during the economic crisis • Distributional issues • Ancillary benefits (‘double dividend’)