Environmental Economics and Policy Final Exam

US climate policy under Obama admin

- 2009: American Clean Energy and Security Act (aka "WaxmanMarkey") narrowly passes House set cap on total US emissions 2012-2050 Senate fails to pass a related measure - 2014: Clean Power Plan proposed After failure of ACES, Obama admin decided to use executive authority to restrict emissions from coal plants Note: Some feel this action was required by Massachusetts vs EPA (2007), where SC ruled EPA required to regulate CO2 under the Clean Air Act - 2016: Obama admin pledges US action in Paris, with CPP as the centerpiece

Taxes

- An alternative approach is to use incentives - This is a "market based" approach → market based because we are going to do something that affects people's marginal incentives. We change the penalty for polluting - For example, rather than prescribing how much every firm must abate, instead make firms pay a tax for every unit of pollution they emit - How does this curb pollution? Curb a behavior when it is easy to avoid it but you will probably still do it when it is hard to avoid it = cost-effectiveness. Reduce cheap pollution but if we are going to allow it, we want it to be in areas where we really can't avoid it

Summary: Taxes vs Cap-and-Trade

- Any target emission level E¯ can be achieved at the exact same (minimum) total cost by either issuing E¯ tradable permits or by setting a tax equal to the marginal cost of abatement at Q¯ = U − E¯ - If permits are auctioned, rather than given away then cap-and-trade is identical to a tax. - Key assumptions: 1 there are no transaction costs 2 polluters are price takers (small) 3 and there is no uncertainty (covering this next)

National Ambient Air Quality Standards (NAAQS)

- CAA requires EPA to set standards for criteria pollutants at levels that protect the public's health with an adequate margin of safety - must consider most sensitive members of population, such as children with asthma, or people who work and exercise outdoors - standards to be set without regard to cost of attainment (court interpretation) - EPA required to revisit these standards frequently and update as the science changes - Where does econ fit in? Health experts pick the NAAQS targets that are safe. We will ask if that target is being met at the lowest possible social cost

The Weitzman Rule

- Coasean logic suggests that defining property rights should be equivalent to Pigouvian taxation - Weitzman (1974) showed that the instruments are no longer equivalent in the face of cost uncertainty - If |Slope MC| > |Slope MB|, a price instrument (tax) will have lower expected DWL - If |Slope MC| < |Slope MB|, a quantity instrument (cap and trade) will have lower expected DWL - Benefit uncertainty does not matter --> When we figured out how much abatement we get in tax vs cap, we did not have marginal benefits anywhere on there. Thus, cap and tax give us the same level of environmental quality and both are the same amount of deadweight loss - Key idea is no matter what happens with costs, cap and trade are always on the green vertical line (q*). No matter what happens with costs, we are always on A horizontal line

Policy options

- Command and control: Technology standards, Uniform emission standards - Market based: Taxes / Subsidies, Cap-and-trade tradeable permits How should we choose between these? - legal constraints / justice / rights - political constraints - economic pros and cons

Social Cost of Carbon Summary

- Conceptually, the efficient Pigouvian tax should be set at marginal social (external) damages - Computing this number for carbon dioxide is incredibly challenging. Mapping each step individually is complex and uncertain, and these interact over decades - 2010 US IAWG presented an important first step in computing this number, and that in turn informed the Obama admin SCC - Since then, the SCC has played a central role in climate policy both domestically and internationally. For example, as of 2017 the federal government had used the SCC to assess the value of over eighty regulations with a combined $1 trillion in estimated gross benefits. - The literature is working to match the climate models more closely to the science. - But there is inherently enormous uncertainty at every stage. Right tailed uncertainty suggests a risk averse population might rationally adopt a much higher number than the average - The biggest determinant remains to be the discount rate. At anything more than 2%, it's hard to justify a price that would match the world's stated emissions goals.

What happens when one actor does more?

- Consider two firms A and B - They are both covered under the same climate policy: a tax T on each unit of CO2 emissions - Let their resulting emissions from this tax be eA(T) and eB(T) - Now imagine that firm B adopts a new emission control technology. It's costs of reducing CO2 are lower than before - How would your answer change under a quantity instrument? → If MC went up and instead done cap and trade → we are locked into Q

Getting to cost-effectiveness in practice

- Controlling pollution in a cost-effective way sounds like a good idea. . . . . . but how do we actually do it? - Historically, most regulation was "command and control" → command and control is centrally planned economy and the Soviet Union the way goods are allocated in a free market is there is no one telling people what to buy and how much to get - Technology standards require all polluters to install a piece of pollution control technology - Performance standards allow the level of pollution to vary across polluters, but require all polluters achieve the same level of pollution per unit - Cars is an example

benefit-cost analysis

- Economic efficiency → Kaldor-Hicks - This provided a clear policy objective: We want to maximize the difference between total benefits and total costs - Practical challenge: May not know the benefit function

MBIs may not be a good idea when the pollutant is highly local

- Efficient point: MB = MC - Cost effective point: MC equal for all polluters. - If some polluters have higher costs than others (which is the motivation for MBIs), then under a cost-effective policy they will pollute more. - This means that the areas around those firms will have more pollution than the areas around firms with low costs. - If pollution is characterized by increasing marginal damages (typical shape), this will not be efficient. - This is the "hot spot" problem

MBIs make sense when a pollutant is uniformly mixing

- Efficient point: MB = MC - MBI's achieve cost effectiveness by allowing some firms to pollute more than others - If the pollutant is uniformly mixing, then it doesn't matter where it's emitted (or which firms pollute): Since the pollution mixes perfectly, MB is the same everywhere. - Will also not be a problem if damages are linear (ie if MB is constant) --> This is the case for greenhouse gases

How good is this "second best" world?

- First-best policy would be to place a price on emissions equal to their social cost → At the national level - How do these "second best" policies compare? Question 1: Is it just as good to subsidize renewables instead of taxing coal? Question 2: If national climate policy is not sufficiently ambitious, can "green" states and localities keep the US on track by doing more?

MBI Benefit #2: Government Revenue

- Has tax bill = T x E = total cost of emissions → this is the government revenue - Total abatement cost is real cost to society that we do need to pay whereas the tax bill is not a real cost

Integrated Assessment Models (IAMs)

- IAMS combine insights from science and economics - Emissions → GHG concentrations →Temperature → Economic Damages - Come at the cost of simplification

Cap-and-trade (tradable permits)

- If a firm's marginal cost is less than the market permit price, then it could make money by reducing its emissions by one unit and selling one of its emissions permits - If its marginal cost is greater than the permit price, then it could reduce its costs by emitting an extra unit and purchasing a permit to cover those emissions - So firm's buy and sell permits until their marginal cost of pollution control is equal to the market price of permits - Since everyone faces the same permit price, the result is cost effectiveness!

How should the government allocate permits (e¯1 and e¯2) to the two firms?

- It doesn't matter for cost effectiveness - as long as we assume zero transaction costs - This is just the Coase Theorem! As long as property rights are clearly defined and there are no transaction costs, the efficient allocation is obtained --> Coase says all you need is property rights and you will get to the efficient point - nothing else matters including how they are assigned, etc - Note that formally we also need the emitters to all be small

Cost-effectiveness of Pigouvian taxes

- Just showed: Each firm responds by reducing its emissions until its marginal cost of pollution control is equal to the tax - If we charge every firm the same tax, this will ensure that the marginal cost of abatement is the same for all firms - Key Result: Any policy that charges firms the same tax will be cost effective - Control policy could be the same environmental benefit by allocating effort to firms who allocate cheaply - Cost-effectiveness = achieves its objective at the lowest possible cost - Condition for cost-effectiveness: If you look at how much they are pollution, marginal cost of abatement should be the same at every firm --> Note that the government does not need to know MC1 and MC2! - If you have a high cost, you will have to reduce pollution by less so everyone will lie and say it is expensive for them

Recap - price vs quantity instruments

- Locked in a price of emissions through T - Tax locks in a marginal price of polluting → Quantity of emissions floats depending on MC - Cap locks in a quantity of pollution → Marginal cost (permit price) floats to ensure cap is met - Thus, under a cap, marginal price of polluting depends on actions of all other polluters → If one polluter's demand for permits changes, this changes all other polluters marginal cost of polluting → A tax does not have this problem → this has important implications for policies which affect some regulated entities but not others - Leakage → international: worried that if the US cuts back on oil supply, then Saudi Arabia will just produce more. It is shown in cap and trade because we have it locked in SHOWN HERE → anything one firm does that marks it cheaper for one firm offsets that it makes it cheaper for another firm to do less

Properties of Cost-Effective Allocations

- Marginal private costs are equal at every firm → Intuition: arbitrage condition - This implies that the marginal social cost of pollution reduction is equal to the marginal private cost of pollution reduction at any firm → Intuition: since they're all equal by construction, we only need to know one firm's marginal cost. As a result, the marginal social cost curve is equal to the horizontal sum of the marginal private cost curves - The total social cost curve is always below (or equal to) the lowest total private cost curve → Intuition: The social planner assigns emissions reductions to the lowest cost firms. So by spreading emissions out, the social cost can't be higher than the lowest cost firm's costs of achieving the same target - Caveat to all of these properties: Some firms (with fixed costs or high marginal costs) might not have any reductions, Remember: firms can't reduce more than baseline emission

Hot spot summary

- Market based instruments reduce costs by allowing low (abatement) cost polluters to reduce pollution by more than high cost polluters. - This makes sense if the benefits of pollution reduction are the same everywhere. - If pollution is non uniformly mixing (local) this will generally not be the case. - Moreover, many global pollutants (like CO2) are produced along with local pollution (like particulate matter). This co-benefits must be considered when deciding if market based policies make sense. - There are a couple solutions to rehabilitate MBIs when pollution is non-uniformly mixing: Tie taxes to marginal damages Use trading ratios for C&T

Where does the permit price come from?

- Permits allow firms to pollute. Imagine you're a polluter, with enough permits to fully cover your baseline emissions (e¯ = u) - Your marginal cost of reducing pollution is zero for the first unit. - And if you reduce, you can sell that permit to another polluter with positive willingness to pay If the market is "competitive" (ie firms are small), trades like this will occur until the marginal abatement costs of all firms is equal. - At that point, the price to buy a permit is equal to the marginal cost of reducing pollution: A = MC(U − E¯ )

Taxes and cap-and-trade are both cost-effective

- Polluters seek to minimize their cost of complying with the regulation - Under a tax, this means they abate until MC = τ ; Under cap-and-trade they abate until MC = A (the permit price) - Since ALL polluters face the same marginal cost of polluting, both policies are cost effective - Under a cost-effective allocation, the aggregate marginal cost of abatement (across all firms) is simply the horizontal sum of all firms marginal costs --> So the aggregate marginal cost curve for both policies is the same - Price instrument = tax - Quantity instrument = cap-and-trade/permits

Intuition for why taxes are cost effective

- Remember that a firm's marginal costs increase as it reduces its emissions - When the firm's marginal cost of is less than the tax, then it is cheaper for the firm to reduce its emissions by one unit than to pay a tax on that unit. - However, when its marginal cost is greater than the tax, then it is cheaper for the firm just to pay the tax and emit the unit of pollution. - Optimal firm response: Abate until MC = tax - If all firms face the same tax, MC1 = tax = MC2 (etc)

Under tradeable permits, government locks in a quantity

- Same graph as tax, just extended QE* to show DWL of quantity - Quantity of allowable emissions set before MC is known U = Q + E, so this is same as setting emissions reductions (QQ) - Firms buy and sell permits based on the realized permit price A = MCR (blue MC) at QQ - Since there is a cap on reductions, permit price A floats to clear the market - If MC is higher than expected, A will be higher than the expected A; If MC is lower than expected, A will be lower - Thus under tradable permits, government locks in quantity of emissions, and let's the price of emission reductions float

What is the economically efficient tax?

- Scientists have identified 1.5 - 2 degrees of warming as important targets, and the UN reports measure progress relative to the target - The economically efficient Pigouvian tax would be set equal to the marginal damages of CO2 pollution - In 2009 the US formed an inter-agency working group (IAWG) to come up with a number for the social cost of carbon (SCC)

Example: Acid Rain Program

- Sulfur dioxide emissions (primarily from coal) projected high into the atmosphere cause acid rain - 1990 Clean Air Act Amendments capped sulfur dioxide emissions from US power plants --> Emissions capped nationally at 50% (10 million tons) below 1980 by 2000 - First large scale cap-and-trade system in the world - Widely regarded as an incredible success --> Acid rain declined by 70%, Net benefits of more than $100 billion

Under a tax, government locks in a price

- T set before MC is known - Always abate until realized MCr = T - Under a tax, government locks in the marginal price of emissions, and let's the quantity of emission reductions float - If MC ends up being higher, then reductions will be lower than expected - If MC ends up being lower, then reductions will end up being higher than expected - Set tax based on expectations, we will buy a lot fewer emission reductions than we thought and fewer than we want even at the higher MC - Always abate based on true cost --> Firms will always abate up until TE*

The Social Cost of Carbon

- The Social Cost of Carbon is an estimate of the sum of marginal costs associated with a unit of carbon dioxide → we want this number/it is useful because we have some policy that will encourage people to switch from gas to electric vehicles. Policy is if it makes us buy more electric vehicles, someone must pay that (it is costly), or we would already be driving electric cars - Need to take into account it has everywhere in the world, not just the US and over a very long time - Climate model = how doe that affect what we care about (like sea levels rising)

Context: Non-Pigouvian taxes create DWL

- The government needs to raise money for a variety of activities (infrastructure, defense, education, etc) - Even if everyone agrees these expenditures are net beneficial, raising revenue to pay for them creates deadweight loss - Conversely, Pigouvian taxation internalizes an environmental externality, and there reduces deadweight loss in the taxed market - Thus we can use the tax revenue or auctioned permit revenue to reduce other distortionary taxes, while keeping government expenditure fixed. - This win-win tax policy is referred to as the "Double Dividend" - Double dividend → even if we think we can get to Q, total abatement cost would be the same. If we did not do that through a tax, we would not get the tax bill so the tax is therefore a "win" --> DD: Reduce labor taxes, Pay down debt

If firms get pollution permits for free, will they pollute more?

- They would sell permits up until MC price = abatement cost to buy them. Polluter Problem: MC(q*) − A = 0. - Firms abate until marginal costs are equal to the permit price --> Note that the firm's first order condition does not depend on the number of permits it is allocated (e¯) - If you have tickets to the Red Sox tonight, your willingness to sell them on Stubhub should not depend on how much you paid for them - This is the independence property of tradable permits: Firms' abatement decisions do not depend on how permits are awarded

Alternatively, the government can auction off the permits

- This sets e¯ = 0 for all firms This is equivalent to a vertical supply curve at Q¯ - While the demand curve for permits is just the reflection of the marginal abatement cost curve - Polluters will bid up to their marginal abatement costs in the auction. The highest bidders get selected until the permits run out - At this point, the price of the auction is the marginal cost of the last bidder, ie A = MC(U − E¯ ) - The benefit is that the government raises A ∗ E¯ dollars in revenue

Summary on policy choice

- Traditional regulation is prescriptive. Market based instruments use incentives instead - If there is no uncertainty (and permits are auctioned), cap-and-trade and taxes are equivalent - If MC is uncertain, Weitzman rule - Primary benefits of MBIs: Cost effectiveness, Raise revenue, Incentives for innovation - Primary limitations: Monitoring / enforcement, Hot-spots

MBI's provide greater incentives for innovation

- Under C&C regulation, firms only care about meeting the regulation (costs just a function of reductions) - Under the tax, a firm also cares about reducing its tax burden - Thus, even if the government has perfect information on cost curves, it will be more cost effective in the long run to use incentive based regulation

When are MBI's NOT a good idea?

- When costs are homogenous across sources (For example if a single control technology is obviously ideal [note gains from revenue and dynamic efficiency] - When monitoring is costly (If number of regulated entities is very high, Example: tailpipe emissions) - When implementation involves costs that undermine the program (Remember the Coase Theorem! Cap and trade may not be cost effective when transaction costs are high and permits are not auctioned)

How does a tax on carbon affect energy consumption?

- this is efficient by construction Now imagine we tax coal at its social cost This shifts it's supply curve up This shifts the aggregate supply curve out Which gives us new prices and quantities Higher MC reduces coal supply → so we get less coal The higher price increases renewable supply But total consumption declines Note this raises tax revenue = q'D * tax Efficient = Less electricity and higher prices → Less total electricity by raising price We know that we got more renewable energy under a tax, which is appealing → but the fundamental problem here is that we should be using less not more

History of US climate policy

-1970s: Federal energy efficiency policy targets appliances, autos and buildings initially motivated by energy price spikes (OPEC), but main motivation today is climate change - 1992: Senate approves U.N. Framework Convention on Climate Change Renewable energy production tax credit (PTC) added to 1992 Energy Policy Act (by Sen. Chuck Grassley (R-IA)) - 1997: Senate preempts Kyoto Protocol (Byrd-Hagel) Clinton admin negotiates anyways Bush admin formally declares non-entry - 2003-2007: Several bipartisan bills in the Senate notable McCain-Lieberman cap-and-trade bill Congress mandates emissions reporting (GHGRP)

Steps for finding a cost-effective allocation

1. Convert total costs to marginal costs 2. Solve a system of equations: Cost-effectiveness, Policy constraint 3. Plug the cost-effective quantities back into the MC equations, make sure they are all equal 4. Integrate or return back to the total cost equation to calculate the total cost paid by each polluter. Note: marginal costs will be equal but total costs generally won't!

let's compare this efficient outcome to trying to achieve the same outcome by subsidizing renewables

At every quantity, supply curve for dirty energy is unchanged gives the same q'R at the old price At every price, we are willing to have more q, so aggregate supply curve shifts down/to the right Some are now willing to sell power that were at the higher prices Some coal that used to produce does not anymore, so this was actually helpful for the environment This is NOT efficient though → we are using too much electricity So total quantity Q must go up (people use more energy) → this means that coal supply is higher than with the tax (but still lower than the baseline) Note that unlike the tax, we also have to spend subsidy cost q'R * subsidy → Opposite of the double dividend

Trump reversed most of these

Clean Power Plan Scrapped New CAFÉ standards suspended US formally exited Paris Agreement

What are the key climate provisions in the Inflation Reduction Act?

Clean electricity Individual clean energy incentives Clean fuel and vehicles Air pollution

MBI Benefit 1: Cost-effectiveness

Does the policy achieve the environmental goal at the lowest possible cost? NEED: The marginal abatement cost of all polluters to be the same Command-and-control might be cost-effective if: 1 The cost of abatement is the same for all polluters (then you can simply tell them all to do the same thing) 2 OR the cost of pollution at every polluter is known to the regulator (can then figure out how much each firm should abate) If either of these is true, MBI's might be less important. But there are two additional reasons to like them

If the cost curve is known with certainty, but marginal benefits are uncertain, why doesn't it matter whether policymakers use taxes or cap-and-trade?

In the previous example, the deadweight loss differences come from the fact that realized reductions (Q) are different under prices vs quantities. Under a tax, emission reductions vary if marginal costs are higher / lower, whereas with a cap, they are fixed. Without MC uncertainty,Q is the same under both instruments (QR = QE = Qcap). There is still DWL (ie QE ̸= Q⋆), but the DWL from both instruments is the same.

Why do economists prefer incentive based regulations (like Pigouvian taxesor tradeable permit programs) to command-and-control regulation?

Incentive based regulations ensure cost effectiveness by design. Under these policies, polluters will reduce pollution up until the point where it is cheaper to buy a permit or pay the tax. Since each polluter is stopping where their private marginal costs equal the same value, these policies satisfy the necessary condition for cost-effectiveness. Command and control regulation can be statically cost effective, but only if the regulator has perfect information about each polluter's marginal cost curves.

What was the difference between Kyoto and Paris?

Kyoto: Only Annex I countries (narrow and deep approach) Paris: Whole world (shallow but broad)

Can't the EPA just set polluter-specific standards at the cost-effective levels?

Problem: The government needs to know the exact marginal cost function of every polluter. This is near-impossible for the regulator to observe. Why? can look at accounting data to observe outlays on environmental compliance but in the relevant economic cost is opportunity cost Why can't the government just ask firms to report their costs? One thing they could do is just ask firms to report their costs, but they will lie to overstate their costs

Example: Regional Greenhouse Gas Initiative (RGGI)

Since 2008, 11 (now 9) states have capped emissions from the electric power sector Cap declines 2.5 percent each year until 2020 100% auctioning (revenue mostly for climate projects) Trading of emissions permits across states

Taxes vs Subsidies

Two sources of electricity, renewable (R), and dirty (D) Horizontal sum to get the aggregate supply curve This intersects with downward sloping demand to determine price P Which in turn determines how much each technology produces

Overlapping policy instruments

We want to get to some smaller amount of emissions which we will do through abatement E (emissions = u (baseline) - q (abatement) With no policy, we have baseline "unconstrained" emissions u Some policy (standard, tax, cap) causes firms to reduce baseline emissions with costly abatement q → Resulting in policy emissions e