ECON 311: Lecture Notes 7
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ECON 311 Lecture Notes 7
Metropolitan State University
Allen Bellas
Emission Charges and Subsidies – FF Chapter 12
Transferable Discharge Permits – FF Chapter 13
Market-Based Environmental Policies – PS Chapter 3
FF Chapter 12: Emission Charges and Subsidies
In an earlier version of the textbook, FF give this chapter a great start by saying:
“Until recently people have been able to use the waste-disposal services of the
environment virtually without cost, so there has been little incentive for them
to think about the environmental consequences of their actions and to
economize on the use of these environmental resources. The incentive
approach seeks to change this situation.”
The two approaches discussed here are emissions charges and abatement subsidies,
which are basically opposite approaches to the same thing.
Emission Charges
Basically, an emission charge system tells emitter that they can put out any level of
emissions they like, but they will be charged a certain amount for each unit put out.
This gives emitters an incentive to reduce emissions while also allowing them complete
flexibility in how they do it. Possibilities mentioned in the book include:
 waste treatment
 internal process changes
 changes in inputs
 recycling
 shifts to less polluting outputs
 phase change of emissions (they’ll still need to be put somewhere)
This is in sharp contrast to command and control approaches that typically specify
exactly how a particular pollution issue should be dealt with.
The one potential concern is that if an emitter is charged for emissions of one polluting
chemical but not another, they might substitute the uncharged for the charged one or
transform the charged pollutant into the uncharged pollutant.
For example, U.S. coal burning power plants are charged for their SO2 emissions.1 If
there was a chemical process that changed SO2 into a different chemical before it was
1
Actually, these emissions were governed by a permit system, but the effect is the same.
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emitted, they might be able to avoid the charges as long as the different chemical isn’t
subject to an emission charge.
A good general rule is to beware of unintended consequences.
Emitter Behavior
The behavior of emitters under a system of emission charges is fairly straightforward.
They will reduce emissions as long as the marginal abatement cost (MAC) is less than the
per unit emission charge and then will emit all remaining units.
A Numerical Example with One Firm
Emissions in
tons
10
9
8
7
6
5
4
3
2
1
0
2
MAC
$0
$15
$30
$50
$70
$90
$115
$135
$175
$230
$290
Total
Abatement Cost
$0
$15
$45
$95
$165
$255
$370
$505
$680
$910
$1200
Total Emission
Fee @ $120/ton
$1,200
$1,080
$960
$840
$720
$600
$480
$360
$240
$120
$0
Total Cost2
$1,200
$1,095
$1,005
$935
$885
$855
$850
$865
$920
$1,030
$1,200
Of course, the emission fee is only a cost if the pollution control authority is not given standing.
Otherwise it is merely a transfer.
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This firm will continue to reduce its emissions as long as MAC is less than the fee of
$120/ton. They will abate six tons. This will minimize their combined abatement and
emission fee cost.
A Numerical Example with Two Firms
Emissions in
tons
10
9
8
7
6
5
4
3
2
1
0
MACA
$0
$15
$30
$50
$70
$90
$115
$135
$175
$230
$290
MACB
$0
$20
$40
$75
$120
$155
$180
$210
$240
$290
$325
If the goal of a policy was to reduce pollution by ten tons, the lowest cost way to do it is
to have A do six units of abatement and to have B do four units of abatement.
A fee will achieve this goal at minimum cost because each firm will abate until their
marginal abatement costs are roughly equal to the emission fee, so their marginal
abatement costs will be equal, satisfying the equimarginal principle. Costs are minimized
even though the regulator knows nothing about the firms’ abatement cost functions.
The fee that would achieve this goal at minimum cost is anything between $120 and
$135.
If the firms are both initially emitting ten tons, firm A would pay the fee on four tons and
firm B would pay the fee on six tons.
For example, if the emission fee is $125/ton, A would do six tons of abatement and pay
for four tons of emissions while B would do four tons of abatement and pay for six tons
of emissions.
The total cost to A would be $15 + $30 + $50 + $70 + $90 + $115 + (4 x $125)
The total cost to B would be $20 + $40 + $75 + $120 + (6 x $125)
The previous examples demonstrated how polluters behave under some exogenously
determined emission fee. We turn our attention now to the question of what an optimal
fee might be, or at least the theory behind an optimal emission fee.
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The optimal fee to set is where the marginal damage function equals the marginal
abatement cost function:
These curves are, of course, not really practical devices. The likely outcome is some sort
of convergence to a fee that generates an ambient level of quality that people find
acceptable. As the books points out, however, firms that make investments expecting one
fee only to find that the fee has changed after a short period of time may be upset. From
a different point of view, changing the rules of a policy after it has been implemented
may not be fair.
It is worth noting that the total amount of emission fees paid by the firm is greater than
the pollution damages.
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It is also worth noting that while emission charges will minimize the cost of any level of
emissions reductions, charges will not necessarily minimize the cost of any level of
pollution damage reduction.
For example, if two plants are emitting the same amount of some chemical, but the
emissions from one plant do much damage than the emissions from the other plant, then
simply equating the marginal costs of abatement between the plants is not enough to
minimize the cost of a reduction in pollution damage. A higher emission fee might be
used in areas where emissions do more damage per unit and a lower emission fee might
be used in areas where emissions do less damage per unit.
Emissions Charges and Incentives for Innovation
Emissions charges offer relatively good incentives for firms to pursue improvements in
innovation technology. These incentives can be thought of as being equal to the cost
savings that will be gained when MAC falls.
In contrast, command and control policies tend to freeze the development of new control
technologies.
As a baseline, let’s consider the cost savings from a technological innovation offered by
an emission standard. The left hand diagram shows the cost savings enjoyed by a firm
that lowers its MAC when an emission standard is held constant. The right hand side
shows the cost savings enjoyed by a firm that lowers its MAC, but finds itself subject to a
stricter emissions standard as a result. They gain some savings, but must incur additional
costs to meet the new, stricter standard.
It is worth thinking about two situations along these lines.
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First, what if the per unit emission fee will not change if technology improves? The firm
will save money on the abatement it would have done anyway. It will also choose to do
some additional abatement (moving from E to E’) for which it will incur additional costs,
but will also enjoy reduced fee payments.
Now, what if the emission fee changes to reflect the social optimum as the technology
improves? The firm not only enjoys cost savings on units of abatement it would have
done anyway, it also does more abatement *and* also enjoys cost savings on units of
emissions that it chooses to emit.
Question
What area in the above graphs represents the social gain from a reduction in marginal
abatement cost? That is, what is the socially optimal level of incentives for innovation?
Question
Imagine that a revenue-maximizing pollution control agency is free to set per unit
emissions fees. Under what conditions would a reduction in the per-unit fee increase the
agency’s emission fee revenues? What sort of marginal abatement cost function would
be consistent with this?
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Other Types of Charges
Sometimes it isn’t practical to measure and charge for emissions.
An example would be agricultural runoff containing fertilizer or pesticides. This isn’t
really measurable, but we might like to try and charge for the emission of these
chemicals.
One approach to doing this would be to impose a tax on the use of these goods. This
would serve to decrease the quantities used and promote the development of untaxed
alternatives, which may, of course, be worse. However, it would not reward users of the
chemicals that find ways to minimize the emissions associated with using a certain
quantity of the chemicals.
It is worth noting that in Washington State, the usual state sales tax is not applied to
agricultural chemicals, so there is what would seem to be an easy way to both reduce
runoff of agricultural chemicals *and* increase revenues for the state government that is
going unexploited.
An alternative approach might be just to have the landowners along a stream take a nice
big drink from that stream once or twice a week. Yum!
Abatement Subsidies
These are payments made to people for reducing the amount that they pollute. The basis
might be per unit or per percentage.
This hasn’t ever really been done, probably because it would be politically unpopular to
spend taxpayer money to bribe polluters to reduce their polluting. Two exceptions are
beverage container deposits, which are subsidies for reducing littering, and one aspect of
the Kyoto protocols that effectively provide for subsidies for reductions of greenhouse
gas emissions in developing countries.
A problem specific to abatement subsidies is establishment of a baseline level of
emissions from which abatement will begin.
Also, the incentives for innovation offered by abatement subsidies are rather poor.
Finally, such subsidies will encourage entry of new polluters in to the market, and has the
potential to increase the total amount of emissions.
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FF Chapter 13: Transferable Discharge Permits
A transferable discharge permit (TDP) or pollution permit system creates the right to emit
some type of pollutant, allocates these rights through some method and then allows these
rights to be traded among eligible participants.
Each firm essentially faces an emission standard equal to the number of permits it holds,
but is free to meet that standard by whatever means it chooses, including ceasing
production or purchasing additional permits.
To the extent that firms see purchasing or selling permits as an option, each firm also
faces an emission fee and, because the fee is the market price of a permit and is the same
for all participants, total emissions reductions should be achieved at minimum cost
through the equimarginal principle.
The market basically looks like this:
with the supply curve equal to the quantity of permits that the regulatory authority chose
to make available.
From the point of view of an individual firm, however, the market looks like this:
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with a downward sloping demand curve and a constant price for permits, assuming that
the emitter is small relative to the market.
How to Allocate Rights Initially?
Golly, this is a tough question.
Should rights be given away, sold at auction, distributed through a lottery?
Should rights be evenly distributed among emitters, or should they be allocated on the
basis of historical emissions or some other historical basis?
The SO2 tradable permits system, created by the Clean Air Act Amendments of 1990,
allocated generating units permits for free on the basis of their energy consumption over
the period 1985-87.
Political considerations may well dictate free distribution of emissions permits to firms
currently operating in the industry because they would otherwise be well organized and
effective in fighting the imposition of a permit system.
On the other hand, in the 2008 election, Senator Obama talked about the benefits of
selling greenhouse gas emissions permits, suggesting that only taxpayers/government had
standing in the analysis and that emitters and their shareholders were excluded.
Trading Rules
Who should be allowed to trade? Anyone, or just people originally allocated permits?
Should there be regional restrictions, especially if the pollutant to be traded creates
problems that are regional or local in nature?
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The smaller the trading area is, the greater incentive local environmental groups will have
to purchase and retire some emissions rights. There are relatively few purchases of SO2
permits, which are distributed nationally. If groups think globally and act locally, permit
systems covering smaller areas might attract more environmental purchases.
Will you allow emissions to be transferred to places where they will do greater amounts
of pollution damage? For example, a transfer of mercury emissions permits from a rural
area to an urban area might significantly increase the damage done by those emissions.
Should there be limits on the total holdings allowed in order to prevent permits being
used as a barrier to entry into the market for whatever good these emissions are related
to?
Incentives For Technological Innovation in Pollution Control Technology
These differ, and it really depends on whether innovations are developed by individual
firms independently or by research consortia composed of firms within an industry.
From the point of view of an individual firm, tradable permits are like a fee system and
the incentives offered for an individual firm to reduce its costs are similar to those offered
by an emission fee that won’t be adjusted for technological changes.
From the point of view of the entire industry, tradable permits are like an emission
standard and the incentives offered for cost reducing technology are similar to those
offered by a standard.
Fees vs. Permits: A Comparison
Portney offers the following comparisons of emissions fees and permits
1. Permit systems set aggregate levels of pollutants while emissions fees set the fees for
those emissions and the marginal cost of abatement at emitting sources. Limiting
aggregate emissions might be a macroeconomic limit to growth.
2. If there is technological advance, a fee system will result in fewer emissions while a
permit system won't result in fewer emissions.
3. Emissions fees transfer wealth from emitters to the government.
4. Charges make the cost of the system more obvious than do permits. Under permits,
abatement costs might be somewhat hidden.
5. Permit prices automatically adjust for inflation, which won't necessarily happen with
fees.
6. Permit systems might be subject to strategic manipulation by groups of polluters.
7. A permit system is politically self-sustaining in that permit holders have an asset
whose value depends on the survival of the permit system. They will defend that policy
regime.
8. If there is uncertainty about costs or benefits of abatement then either one system or
the other might be preferable.3
3
Prices vs. Quantities, Martin L. Weitzman, The Review of Economic Studies, Vol. 41, No. 4 (Oct., 1974),
pp. 477-491.