Regulatory Options & Efficiency

Regulatory Options & Efficiency Goal: Generate regulatory tools to fix environmental problems

Why regulate? • Does free market efficiently provide goods and services? • Market failure (externalities, public goods, etc.) • Market power (monopolies inefficiently restrict production to raise prices) • Information problems (damages uncertain, food safety, env. quality)

Types of questions in regulation • What is the “optimal” amount of pollution? • To reduce by X%, who should reduce and by how much? • What regulatory instrument(s) should be used to achieve that level?

Problem • EPA has regulations to control biological oxygen demand (BOD). EPA would like your advice on how to improve water quality (lower BOD) without increasing costs. • What is your advice?

BOD Removal, Costs of Current US Regulations Source: Magat et al (1986); units: dollars per kilogram BOD removed

Principle of efficiency • Most common approach: uniform burden (e.g., everyone cuts pollution by x%) • Two possible results • Too much pollution for the total amount of pollution control costs • Too much cost for a fixed level of pollution reduction • Burden of pollution control should fall most heavily on firms with low costs of pollution control

More Generally:The efficient amount of pollution Marginal Control Cost $/unit Marginal Damage Cost Total Damage Cost Total Control Cost Q* Units of pollution

Recall example from 1st week • 60 firms, each pollute 100 tons • 30 low abatement cost ($100/ton) • 30 high abatement ($1000/ton) • Everyone reduces 1 ton: Cost=$33,000 • Total reduction = 60 tons. • For same cost how many tons could we have reduced?

With mixed high and low cost firms abating, we could Either: • Reduce more pollution for the same amount of money…or • Reduce the same amount of pollution for less money. So we always want low-cost firm to shoulder abatement.

If costs aren’t constant: two firms, greenhouse emissions of Nitrogen Abatement Cost ($/unit) Who should abate the 1st unit of N? MCA MCB N Reduction

How much abatement from each? $ (A) Loss from equal reduction MCA $ (B) MCB A: 0 40 25 80 80 B: 55 40 0

How did he do that? • Determine how much total abatement you want (e.g. 80) • Draw axis from 0 to 80 (A), 80 to 0 (B) • Sum of abatements always equals 80. • Draw MCA as usual, flip MCB • Lines cross at equilibrium • Price is MC for A and for B.

The “equimarginal principle” • Not an accident that the marginal abatement costs are equal at the most efficient point. • Equimarginal Principle: Efficiency for a homogeneous pollutant requires equating the marginal costs of control across all sources.

Control costs • Should include all other costs of control • monitoring & enforcement • administrative • Equipment • Regulatory uncertainty increases costs. • If you are a polluter, what would be your response to uncertainty in what you have to do? • Does this increase your costs? • Would like to design instruments that provide incentive to innovate

Common Instruments for regulation • Command and Control: Centralized determination of which firms reduce by how much, or technology restrictions. • Taxes: charge $X per unit emitted. This increases the cost of production. Forces firms to internalize externality (what is correct tax?) • Quotas/standards: uniform standard (all firms can emit Y) or non-uniform. • Tradable permits: All firms get Y permits to pollute, can buy & sell on market. Other initial dist’n mechanisms.

Example 1: Taxes in China • China: extremely high air pollution – causes significant health damage. • Instituted wide-ranging system of environmental taxation • 2 tiers • World Bank report estimates that MC of abatement << MB of abatement.

A creative quota: bubble policy • Multiple emissions sources in different locations. • Contained in an imaginary “bubble”. • Regulation only governs amount that leaves the bubble. • May apply to emissions points within same plant or emissions points in plants owned by other firms.

Example 2: Bubble policy in RI • Narraganset Electric Company: • 2 generation facilities in Providence, RI. • Required to use < 2.2% sulfur in oil. • Under bubble policy: • Used 2.2% in one plant, burned natural gas at other plant • Savings: • $3 million/year

Example 3: SO2 Allowances • 1990 CAAA sought to reduce SO2 emissions from 20 million tons/yr to 10 million tons/yr • Set up market in emission allowances • 97% of 10 million tons allocated to polluters • Rest auctioned at CBOT – anyone can buy: see http://www.epa.gov/airmarkets/forms

SO2 Allowance Prices, 1994--2002

How big the tax or how many permits? • We know: • Optimal level of pollution is Q* • Marginal Social Cost at the optimum is P* • Marginal Private Cost at optimum is Pp. • Optimal tax exactly internalizes externality: • t* = P* - Pp • Effectively raises MC of production

Basic Setup: Env Costs, Private Costs, Social Costs $/unit MSC MPC P* MEC Pp D Q* Qc Dirty Good

MPC (with tax) $/unit MSC t* MPC (no tax) P* Pp D Q* Qc Q (pollution)

Problem: How to reduce VOC emissions in LA without increasing costs? • Where do VOC’s come from? • Painting, cleaning in manufacturing, cars • Current regime: command and control • NSPS: “Control Technology Guidelines” (New Source Perf. Stand) • SIP’s: firm by firm rules (state implementation plan) • Example: automobiles • Technology requirements • Emission limits per mile • How could this be done differently? • Alternatives • #1: emmission fees, $1/lb. of VOC • #2: marketable permit – issue permits for 500 tons • Get equimarginal principal in either case (Why?)

Problem: Too many houses being built in SB; want to slow growth. How? • Current regime: command-and-control tools • Zoning • Lengthy permit requirements • Infrastructure fees • Limit critical inputs (eg, water) • Alternative approaches • Fees • Increased property tax • Building permits: $1000/square foot • Land conversion fee • Marketable permits • Issue 100 permits per year (or 200,000 sq. ft.) • Auction permits • Give away permits – what is effect? • What are differences with between fees and marketable permits?

Regulatory Options & Efficiency