ERE ISCTE Lectures13 14 PollutionControl Instruments

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Lectures 13 & 14: Pollution 
Control - Instruments
Environmental and Natural Resource Economics
ISCTE-IUL – Fall 2017 
Mauricio Rodriguez Acosta 
Adapted from Perman, R., Ma, Y., McGilvray, J., & Common, M. 
(2003). Natural Resource and Environmental Economics (3rd 
ed.). Harlow, ESS: Pearson. CHAPTER 7
This course
1. Introduction and Fundamentals of Environmental Economics
2. Environmental Instruments and Policies
2.1 Environmental Valuation
2.2 Pollution control: targets and instruments
2.3 International environmental problems
3. Natural Resource Economics
This lecture: Pollution Control 
Targets
• Part I: Available Instruments
• Part II: Comparative Assessment of 
Instruments
• Advantages and disadvantages
Part I: Available 
Instruments
(Pollution) Policy Questions
• How much pollution should there be?
• Lectures 9 and 10
• What is the best of achieving that target (at the 
national/sub-national level)?
• Lectures 13 and 14
PQ2: What is the best way of 
achieving a target?
• Depends on the objective
• If meeting the target is the only criterion, then go for 
the instrument that is most likely to hit the target
• In practice, policymakers operate in an environment 
with multiple objectives
Criteria
• Cost-effectiveness
• Long-run effects
• Dynamic efficiency
• Ancillary benefits
• Double dividend?
• Equity
• Uncertainty: information requirements, flexibility, cost of 
uncertainty
Cost-effectiveness
• Minimize the cost of pollution control subject to 
attaining a target
• Necessary condition for economic efficiency
• The least cost theorem: Equalization (among pollution 
sources) of marginal costs of abatement is a necessary 
condition for abatement cost to be minimal
෍
𝑖
𝑀𝑖 = 𝑇𝑎𝑟𝑔𝑒𝑡
𝑀𝐶1 𝑍1 = 𝑀𝐶2 𝑍2 = ⋯ = 𝑀𝐶𝐼 𝑍𝐼
Where 𝑀𝑖 (𝑍𝑖) is pollution (abatement) by source 𝑖
Cost-effectiveness
A cost-effective solution implies:
• Marginal cost of abatement equalization
• Generally, unequal abatement efforts
• Polluters with relatively lower marginal cost of abatement will 
undertake most of the pollution effort
We want to abate 40 units
Is it efficient for A (better 
technology) to undertake all the 
abatement effort?
I. Institutional approach
• Institutions: rules of the game
• Create a framework (of rules) that 
reduces/eliminates the need for further 
intervention (e.g., taxes)
• Prevent the emergence of externalities, or help to 
internalize them
Institutional approach 1: Bargaining
• More likely to work when
• Property rights are well defined and enforced (i.e., it is clear 
what agents are bargaining over)
• Few agents are involved (i.e., coordination costs are low)
• These aren’t typically present in environmental 
problems
• Other issues: intertemporal nature of the 
environmental problems (intergenerational 
bargaining?)
• Government’s role: Facilitate bargaining
• Define property rights
• Monitor pollution/environmental quality
• Enforce property rights: access to arbitration mechanisms
Institutional approach 2: Liability
• Make agents liable for the adverse external 
effects of their actions
• Internalize the cost of pollution
• Issues
• Pollution is a public bad. Thus, an agent of the 
public interest (e.g., EPA) should enforce the 
liability
• Redistribution of paid damages
• Costs of tracking down and tracing back damages 
(cradle to grave) 
Institutional approach 3: 
Development of Social Responsibility
• Pollution is often times the consequence of 
thoughtless behavior
• Encourage people to be “good citizens”
• Policy role
• Promote ethical behavior
• Intergenerational transmission of ethical 
preferences
• E.g., Environmental labelling
II. Command and Control
• Set (command) a standard and enforce 
(control) it
• Direct control over polluters
• C&C are (the most) widely used type of 
instruments
C&C 1: Non-transferable permits
• Licenses: individual pollution quotas (i.e., maximum 
emissions that a firm can produce)
• Sum of quotas (allowed by the licenses) is the target level of 
pollution emissions
• Firms cannot trade/exchange these licenses
• This instrument is unlikely to meet cost-efficiency 
• CE requires equalization of marginal costs of abatement between 
firms. The agency emitting the licenses would need to have 
perfect information about firms’ abatement technologies
• The informational asymmetry (firms know their own technologies 
but regulator doesn’t) is unlikely to be resolved simply by firms 
reporting (no incentives to true-telling) 
C&C 2: Minimum technology 
requirements
• Specifies the required characteristics of production 
processes or inputs to be used
• Best practicable means (BPM)/Best available 
technology (BAT)/BAT not entailing excessive cost 
(BATNEEC) 
• Specific techniques may be mandated (use of specific 
equipment)
• Also unlikely to meet CE
• Abatement efforts do not concentrate on firms with better 
abatement possibilities (all are required to do the same)
• The abatement possibilities set is reduced. Firms are unable to 
choose the least-costly way to abate. They’re commanded to 
follow a specific (centrally chosen) method
III. Economic Incentive 
Instruments
• C&C imposes obligations or restrictions
• Incentive-based instruments are designed to “nudge” 
firms to voluntarily change behavior
• How? By altering the structure of payoffs  internalize 
the environmental externality
• E.g., taxes, subsidies, transferable permits markets 
Econ Incentives 1: Emissions Taxes
[emissions M]
Target: Economically efficient level of pollution 𝑀∗
The social optimum: 𝑀𝐵 = 𝑀𝐷𝑀 = 𝑀∗
Econ Incentives 1: Emissions Taxes 
[emissions M]
For the firms:
-MB stands for the benefit of 
polluting one additional unit. 
Which is equivalent to cost saving 
of not abating an additional unit of 
emissions.
-MD is zero (damages are an 
externality)
The firms (markets) choose
𝑀 = ෡𝑀
Econ Incentives 1: Emissions Taxes 
[emissions M]
An emission tax of size 𝜇∗ (social cost of emissions) reduces the firms’ MB by 
𝜇∗ for any 𝑀
MB is the cost saving of not abating an additional unit of emissions net of the 
tax payments of emitting it. 
Thus the firms (markets+tax) choose: 𝑀 = 𝑀∗
Econ Incentives 1: Emissions Taxes 
[emissions M]
Target: Economically efficient level of pollution 𝑀∗
The social optimum: 𝑀𝐵 = 𝑀𝐷𝑀 = 𝑀∗
For the firms:
-MB stands for the benefit of 
polluting one additional unit. 
Which is equivalent to cost saving 
of not abating an additional unit of 
emissions.
-MD is zero (damages are an 
externality)
The firms (markets) choose:
𝑀 = ෡𝑀
An emission tax of size 𝜇∗ (social cost of emissions) reduces the firms’ MB by 
𝜇∗ for any 𝑀
MB is the cost saving of not abating an additional unit of emissions net of the 
tax payments of emitting it. 
Thus the firms (markets+tax) choose: 𝑀 = 𝑀∗
Econ Incentives 1: Emissions Taxes 
[abatement Z]
Target: Economically efficient level of pollution 𝑀∗
The social optimum: 𝑀𝐵 = 𝑀𝐷𝑀 = 𝑀∗; Abatement 𝑍∗ = ෡𝑀 −𝑀
An emission tx of size 𝜇∗
increases the MB of 
abating (per abated unit 
the firms save 𝜇∗ in tax 
payments)
Thus the firms 
(markets+tax) choose
𝑍 = ෡𝑀 −𝑀∗
Without taxes the firms 
gain nothing from 
abatement
The firms (markets) 
choose
𝑍 = 0
Econ Incentives 1: Abatement 
Subsidies [abatement Z]
An abatement subsidy
of size 𝜇∗ increases the MB 
of abating (per abated unit 
the firms gain 𝜇∗ in 
subsidy payments)
Thus the firms 
(markets+subsidy) choose
𝑍 = ෡𝑀 −𝑀∗
Econ Incentives 1: Emissions Taxes 
Vs. Abatement Subsidies
• Looking at an individualfirm, the emissions tax and the 
abatement subsidy of size 𝜇∗ have the same effect (reducing 
emissions from ෡𝑀 to 𝑀∗)
• However the distributional effects are different, and may 
have an impact on the long run evolution of the industry
• Tax: Firm pays 𝜇∗𝑀∗ → 𝜋 = 𝑝𝑦 𝑀∗ − 𝜇∗𝑀∗
• Subsidy: Firm receives 𝜇∗ ෡𝑀 −𝑀∗ → 𝜋 = 𝑝𝑦 𝑀∗ − 𝜇∗𝑀∗ + 𝜇∗ ෡𝑀
• With the subsidy profits are higher (by lump-sum 𝜇∗ ෡𝑀 ). 
• This makes firms more profitable and may thus increase the size 
of the industry in the long-run. With a larger industry the total 
pollution may actually increase as a consequence of the 
subsidy! 
Econ Incentives 2: Tradeable Permits
• Permits on the quantity of emissions
• Principle: Any increase of emissions by a firm A 
needs to be offset by a reduction by a firm B
• Regulator determines the total level of emissions 
allowed. But not how this total is allocated among 
firms/sources (this is the job of the permits market)
• Two main systems
• Cap-and-trade
• Emission reduction credit 
Econ Incentives 2: Tradeable Permits
Cap-and-trade system
• Cap: total level of emissions to be allowed (target level) 
[# of permits issued]
• Rule: Permit ownership determines maximum level of 
emissions per firm
• Enforcement of the Rule: monitoring emissions and 
penalizing excess of emissions 
• Initial permit allocation: Up to the EPA
• Guarantee of a functioning permits market
• As opposed to C&C trade is allowed
• Based on quantities rather that prices (as e.g., taxes)
Econ Incentives 2: Tradeable Permits
Cap-and-trade system – Initial allocation
Actioned permits
• Supply: inelastic (issued 
permits)
• Demand: aggregate marginal 
abatement
Arbitrary allocation
• Supply: firms with initial permits 
willing to sell
• Demand: firms without (enough) 
permits willing to buy
• Price is the same (𝜇∗), which simply depends on the number of issued permits 
𝑀∗
• Traded permits: 𝑀∗ in case of auction, 𝐸𝑃∗ < 𝑀∗ in case of arbitrary allocation
Econ Incentives 2: Tradeable Permits
Cap-and-trade system – Arbitrary 
allocation
Incentives to trade
Econ Incentives 2: Tradeable Permits
Cap-and-trade system – Arbitrary 
allocation
Incentives to trade
Part II: Comparative 
Assessment
Comparative assessment: Cost-
efficiency
• Emissions taxes, abatement subsidies, and tradeable 
permits systems can achieve any emissions target at 
minimum cost
• The same is (generally) not true for C&C instruments
• For a C&C instrument to be efficient the EPA would need to 
have information on the abatement costs of the firms (so that 
the instrument exactly equalizes marginal costs among firms)
• Thus, when it comes to cost-efficiency, among 
quantity-based systems tradeable permits dominate 
over C&C instruments
• These costs may be higher for instruments that 
need to account for the actual emissions level
• Instruments like technology standards will 
have much lower monitoring and enforcement 
costs
• Observing the production methods is much 
easier than quantifying individual emission
Comparative assessment: Monitoring, 
administering, and enforcing 
1. Net income effects
Abatement subsidies (by rising the firms profits) may 
have the undesirable (long run) effect of increasing the 
industry size 
• To avoid this one can design income neutral instruments (e.g., 
firms receiving an abatement subsidy can be charged a lump-
sum tax to ‘partially’ undo the effect of the subsidy on profits, 
while preserving the effect on incentives)
Comparative assessment: Long-run 
effects
2. Technology effects
Under taxes (or subsidies) firms may have incentives to 
improve their technology (i.e., reduce their 𝑀𝐴𝐶). This will 
reduce their tax payments (or increase the subsidies they 
receive)
• This is of course favorable from the environmental stand point
A disadvantage of C&C instruments (vis-à-vis market 
mechanisms) is that once the required standard is fulfilled 
firms have no further incentives to innovate 
Yet, C&C instruments may serve to overcome the innovation 
externalities that typically lead to too little innovation: 
positive externalities in innovation (e.g., due to spillovers) 
cause innovation in the markets to be too low (with respect to 
the social optimum)
Comparative assessment: Long-run 
effects
• Different instruments will have different impacts on the 
distribution of income in the economy
• For instance Carbon taxes will have an indirect impact on final 
consumers through their energy consumption
• If less wealthy households tend to spend a larger fraction of their 
income in energy (which is typically the case), these taxes will 
have a regressive nature
• Tax incidence
• Depending on the nature of the environmental tax, this may have 
differential impacts on labor (intensive sectors/countries) and 
capital (intensive sectors/countries)
• Thus the tax will bring about income redistribution based on 
ownership of production factors 
• This type of arguments are often used (with more or less merit) to 
defend environmental policy inaction (think of US withdrawing 
from Paris)
Comparative assessment: Equity