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
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
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
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!
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?
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).
3. Efficient Policy Efficient allocation Q* Price Social marginal costs Net benefit Supply = Private marginal costs Demand = Marginal WTP Output Q* cut
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.
3. Efficient Policy Efficient allocation Q*versus market allocation QM Price Social marginal costs Supply = Private marginal costs Demand = Marginal WTP Output Q* QM
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.
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
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).
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
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.
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
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
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.
3. Efficient Policy Marginal damage costs (socialized without any measure) Marginal costs Tax Marginal abatement costs Quantity of emissions Q Q* Emission Cuts
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?
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
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
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
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
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
4. Cost-Effective Policies For example: “equal” obligations to cut emissions - Read article (!)
4. Cost-Effective Policies Marginal costs Firm 1 Firm 2 Emission cuts 3 6 Cuts firm 1 6 Cuts firm 2
4. Cost-Effective Policies See the difference 30
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 !
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.
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!
4. Cost-Effective Policies Marginal costs Firm 1 Firm 2 Tax Emission cuts Total cuts Cuts firm 1 Emission cuts firm 2
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?
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 ?
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.
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
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
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.
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 !
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.
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
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
5. ‘Dynamic’ Incentives Marginal Costs New technology Cost reduction Price Old technology Quantity of Emissions Qnew Q Emission Cuts
5. ‘Dynamic’ Incentives Result: • Firm chooses ‘new’ technology if cost reduction is greater than costs of switching to ‘new’ technology F.
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?
5. ‘Dynamic’ Incentives Marginal Costs New technology Costs of Permits Abatement costs Price Old technology Quantity of Emissions Q Qnew Emission Cuts
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’)