10. Environmental Policy Instruments

4 possible criteria for choosing which instrument is best

1. ecological accuracy 2. static cost-effectiveness 3. dynamic cost-effectiveness 4. political acceptability

Cap and Trade in China

-China plans to launch the world's largest emissions trading program in 2017 -Creating a carbon market for electric power generation, steel, cement and other industries producing most of the country's greenhouse gas emissions

does command and control meet requirements?

-Command and Control does NOT meet requirement of static efficiency -does NOT meet requirement dynamically efficient

EPA's clean power plan

-EPA's new carbon dioxide limits emphasize interstate cooperation -states where more clean energy is being produced than is required by the Clean Power Plan could, in the coming years, sell their surplus achievements to more laggardly states -the new rules create a system in which those trades can be made without any need for special interstate agreements

Pigovian fees: emission taxes

-Pigovian taxation appears a simple solution: a price is set on the externality, a tax is paid equal to the marginal damage -independent of the level of the emission tax, it leads to an equalization of marginal abatement costs across polluters -the resulting total abatement level is therefore achieved at lowest aggregate costs -problem: how to figure out the right level for the tax?

3 important conclusions on Static cost-effectiveness

-a least-cost control regime implies that the marginal cost of abatement is equalized over all firms undertaking pollution control -a least-cost solution will in general not involve equal abatement effort by all polluters -where abatement costs differ, cost efficiency implies that relatively low cost abaters will undertake most of the total abatement effort, but not usually all of it

standard

-a level of quality, achievement, etc., that is considered acceptable or desirable

Pigovian taxation

-a tax on any market activity that generates negative externalities -tax is intended to correct an undesirable or inefficient market outcome, and does so by being set equal to the social cost of the negative externalities

ecological accuracy

-aim is to achieve some emission target, or stock of GHGs in the atmosphere -instrument must make sure that we achieve this target -if there is a trade-off we can quantify, the emission/pollution target should be set such that the aggregate marginal benefit from emissions equals the aggregate marginal damage

EU reduction for 2020

-all 27 states and Iceland agreed to a total aggregate reduction target of −20% (1990 as base year). -emissions are pooled and allocated amongst member states through internal EU reduction assignment

political acceptability

-all policies go via political systems -politicians sensitive for lobbying -policy (target + instrument chosen) must be acceptable for polluters

different options for allocating permits

-all sources get the same number of emission permits for free -all sources get a certain percentage of their original emissions (grandfathering) -emission permits are auctioned off (firms have to bear additional costs) -(political feasibility often achieved by grandfathering of permits)

subsidies

-alternatively to emission taxes, one could subsidize abatement -economists are in favor of market‐based instruments like tax -subsidy is a negative tax -political feasibility: yes! firms love subsidies! -but static inefficiency: •have to be financed through distorting taxes •hard to stop once started

emissions trading vs. taxes

-both permit trading and emissions taxes identified as cost‐effective policy instruments -Problem: neither costs nor benefits are known with certainty -one should choose the policy which minimizes the costs of making a (slightly) wrong choice

are assumptions warranted?

-choice does NOT always follow from valuation -valuation NOT always calculation‐based -NOT without information or capacity constraints

rational choice model assumptions

-choice follows from valuation and comparison of options -valuation is calculation‐based, without information or capacity constraints -valuation maximizes personal material welfare

EU emissions trading prices

-commission has no view on what the price of allowances should be -price is a function of supply and demand as in any other free market -market intermediaries quote prices for allowances offered or bid for -commission will not intervene in the allowance market

merits of tradable pollution permits

-corrects the pollution externality (through the creation of market) -enables control of total emissions (through allocation of permits) -maintains choice of abatement technology -recognizes heterogeneity across industries -allows each firm to equate its own MC of pollution reduction to the traded price of the permit such that economic efficiency is warranted -it is robust to the initial allocation of permits -in sum: Combines advantages of CAC with allocation capacity of a market •standard fixed •scarcity price

4 pros for cap-&-trade

-emissions certainty -can raise revenues through auctioning -can address distributional effects -political feasibility in countries that are "taxation‐averse" (e.g. U.S.)

US cap and trade for GHGs

-failed (in senate 2007/2008): -Cap & Trade with reduction of 63% below 2005 levels by 2050 -initial allocation in 2012 •freely allocated allowances: 73.5% •auction: 26.5% -banking: unlimited banking of allowances -after failure of federal cap & trade initiative, states formed several regional initiatives to introduce cap & trade for GHG reduction

Kahneman automatic thinking system

-fast -effortless -emotionally charged -parallel -associative

motivating green behavior change

-financial/material motivations -natural desire to improve (detailed and timely feedback about energy use and improvements in energy use) -natural desire to compete (relative comparisons to performance of others and friendly competition incentives)

Public Interest Theory of Regulation (normative)

-government should regulate to promote the public interest -scope for government intervention to "make the First Welfare Theorem apply" -imperfect information -imperfect competition -externalities

cognitive deficits

-human attention extremely limited -outcomes processed relative to a reference point ("compared to what?") -loss aversion, i.e., perceived losses hurt more than gains feel -future outcomes not discounted exponentially (steep discounting of future benefits because focus is on "now") -order of processing of choice alternatives matters

motivational deficits

-human needs (material, psychological, social) -goals can conflict -goal activation ("priming") •ex: people vote differently when polling station is a church vs. a public school

dynamic cost-effectiveness

-important way to reduce emissions: new technologies -how do policy instruments affect incentives to develop new technologies? -minimize costs to achieve a target over some time horizon: dynamic efficiency

green growth choices discourage by

-inertia and status‐quo biases -"Egocentric" biases and short time horizons -existing behaviors largely automatic -failure to meet goals does not evoke natural fear

static cost-effectiveness

-instrument is cost-effective if real resource cost of obtaining policy target is no greater than that of any other instrument -sum of damages from emissions and abatement costs should be minimized -marginal abatement costs should equal aggregate marginal damages -for any level of total abatement, marginal abatement costs should be equalized across polluters

green growth choices in calculation-based decisions (3)

-make green‐growth choice option the default -attractive labels for green‐growth -create new goals by new metrics (measures and feedback get attention)

market-based instruments

-market-based instruments affect incentives of agents via a price on the externality •ex: tax on pollution gives incentives to reduce emissions •tradable permits means firm has to buy emission permit when increasing emissions -in theory: efficient outcome as marginal benefits of pollution equalized to marginal costs

defaults work for multiple reasons

-minimize effort -capitalize on people being "passive" -implied endorsement of default -arguments for default option get processed/queried first

4 pros for tax

-no price volatility -revenue allows for "double‐dividend" -can address distributional effects -uncertainty argument

EU Emissions Trading Scheme (EU ETS)

-objective: cost‐efficient implementation of Kyoto Protocol -coverage: •participants (DIR sectors): energy‐intensive installations (electricity, iron and steel, paper and pulp, non‐ferrous metals •not included (NDIR sectors): chemicals, transport, household, small emitters -started with free allocation of emissions allowances

standards: command and control

-past environmental policy largely based upon direct regulation, or command and control (CAC) -input control: ban on certain toxic inputs -output control: each firm not allowed to emit more than X tonnes of pollutant Y -technology control: requirement to use particular method or technology -information requirement: government must know exact marginal costs of emission reduction of every firm

tradable pollution permits

-permits (licenses) can control externalities directly -legislate that externalities can only be generated if a license (e.g. emission permit) is held -licenses up to a given quantity are issued: •initial distribution over agents irrelevant for total costs -trading of licenses ensures equalization of marginal abatement cost over firms

benefits of tradable permits

-pollution level is fixed -multiple options for each firm •reduce emissions to the level covered by the number of awarded permits •reduce emissions less than covered by the number of awarded permits AND buy additional permits •reduce emissions even further than the original award AND sell the permits which are not required to cover emissions

Interest Group Theory of Regulation (descriptive)

-rent seeking is the primary driver of regulation -firms and individuals lobby for regulations that will help their group

Kahneman reflective thinking process

-slower -effortful -consciously controlled -serial -rule-governed

uniform standards

-technology ex: prescribe the use of a certain technology -emissions: require each installation of certain size to emit < e* -abatement: require each installation to cut back emissions by x% -problem: different firms might have different abatement costs

green growth choices in emotion-based decisions

-tempting to scare people into "right" behavior -fear appeals problematic •humans not hard‐wired to worry about distant threats •even if effective, fear appeals work only very briefly

differentiated standards

-to be cost-efficient, equi-marginal principle must hold -huge informational requirements -feasible?

international framework: Kyoto Protocol

-treaty which aims to combat global warming -ratification means that a state is legally bound by the provisions of the treaty -for Annex I parties (e.g. a developed country or one with an 'economy in transition') this means that it has agreed to cap emissions in accordance with the Protocol

political feasibility of taxation

-with taxation, large transfers of money: if target is to reduce emissions by 10%, still taxes are paid over 90% of initial amount -firms are hostile to taxes

flexibility mechanisms

1. emission Trading 2. joint Implementation: Countries can lower the costs of complying with their Kyoto targets by investing in projects that reduce greenhouse gas emissions in an Annex I country where reducing emissions may be cheaper, and then using the resulting Emission Reduction Units (ERUs) towards their commitment goal 3. Annex I countries to meet part of their emission reduction commitments under the Kyoto Protocol by buying Certified Emission Reduction units from CDM emission reduction projects in developing countries

2 implementation issues of tradable permits

1. market needs to be created -licenses need to be clearly defined -property rights need to be guaranteed -search and transaction costs must be low -allowing private markets -market power needs to be taken into account 2. how to determine initial allocation -auction (frequency, market uncertainty, etc.) -granting (by initial pollution, production, each citizen)

2 categories of instruments

1. non-Market instruments (Command And Control, CAC) -standard, technology control, damage control, prohibitions, bans 2. market based instruments -bargaining, tax/subsidy, tradable permits

EU emissions trading issues

1. predicted costs: Kyoto targets at an annual cost of €2.9 to €3.7 billion -without the Emissions Trading Scheme costs could reach € 6.8 billion 2. higher Electricity prices? -changes in electricity prices not a consequence of emissions trading, but of implementation of emission targets (Kyoto Protocol) 3. sectoral coverage of emissions trading -only certain sectors are covered -might not use all the abatement potential effectively (households/transportation) 4. coverage of greenhouse gases

5 steps of practical implementation of tradable pollution permits

1. regulator determines optimal aggregate amount of emissions 2. aggregate amount is parceled into practical units 3. institution of exchange is set up 4. market is initialized through an initial allocation of emission permits 5. trading in permits is opened

EU emission trading

1. trading rules fixed at European level -banking is possible -no banking from phase 1 into phase 2 allowed by member states 2. allocation rules -manufacturing industry will receive 80% of its allowances for free in 2013, a proportion that will decrease in linear fashion each year to 30% in 2020 3. member states can decide: -upon emissions budget (how much to abate in other sectors of the economy, how many allowances to allocate) -the way of allocation (emissions‐based, output‐based...) 4. total supply of emissions allowances only determined after all countries have decided their allocation plans 5. different ways of monitoring, registries for allowances, etc. -penalty of 40€ (Phase 1), 100€ (Phase 2)

2 types of standards

1. uniform standards 2. differentiated standards

why have CAC policies been used so often? (2)

1. very effective: past experience shows successful reduction in emissions of many pollutants -but at higher total costs than with use of an efficient instrument 2. politically attractive: firms may prefer CAC to taxes and permits -because technology standards produce economic rents for firms; -rents can be sustainable if coupled with more stringent requirements

implementation issues of CO2 trading

who should trade? -upstream: where carbon enters the economy (when fuels are imported or produced) -downstream: where carbon is emitted