Environmental economics

Jean-Jacques PAUL February 29, 2012

Outline
Economic considerations: definitions, theoretical background How the society tackles environmental issues? The cost-benefits approach of pollution control The global concern for environment

Definition of Environmental Economics

Theoretical or empirical studies of the elaboration of environmental policies and of their effects, from an economic point of view. Particular issues include the costs and benefits of alternative environmental policies to deal with air pollution, water quality, toxic substances, solid waste, and global warming

Environmental issues as market failures

Reminder: a market failure exists when there is a gap between the behaviour of somebody based on the existing system of prices and the the benefit of the society. Three examples of market failures
Externality: pollution by a firm Non rivalry: common goods Non excludability: protection against climate change

Two basic economic approaches of pollution: Pigou and Coase

In 1920, British economist Pigou wrote The Economics of Welfare:
The producer creating the social harm does not pay for it. Because non-pecuniary externalities are not taken into account into the price, there is an over-production of the polluting good. Pigou recommends a tax placed on the offending producer.

 Coase (1960) argument is that in the absence of transactions costs, the distortions associated with externalities will be resolved through bargaining. That will lead to an efficient outcome regardless of the initial allocation of property rights. Since most cases of air and water pollution, for example, involve a large number of polluting agents and/or victims, transaction costs are too large to permit a Coasian resolution of most major environmental problems.

Role of various environment-related measures

Command and control instruments (CAC)
also referred to as standards or regulations, are the most common forms of environmental policies in both the advanced and developing countries. As the name implies, the CAC approach consists of a 'command', which sets a standard - the maximum level of permissible pollution, and a 'control', which monitors and enforces the standard.

Market-based instruments (MBIs)

Unlike the Command and Control (CAC) approach, MBIs use price or other economic variables to provide incentives for polluters to reduce harmful emissions.

Command and control instruments

In general, there are two types of standards - ambient standards and emissions standards.
Ambient standards set the minimum desired level of air or water quality, or the maximum level of a pollutant, that must be maintained. Emissions standard specify the maximum level of permitted emissions.

Emissions standards can be performance-based standards or technology-based standards.

Performance-based standards are the most common type: They stipulate emissions limits that each firm is allowed. Technology-based standards not only specify emissions limits, but also the "best" technology that must be used.

 Advantages of Standards
Standards are a more widely understood form of environmental policy. Standards are a pragmatic approach when there is uncertainty about the effects of pollution on the environment. Political costs of standards are lower compared to market based instruments.

Disadvantages of Standards
An 'optimum' standard is difficult to determine, especially with non-marketable goods, such as water and air. Under a CAC approach, firms have no incentives to reduce pollution beyond the standard. Penalties for violating standards tend to be too low and enforcement tends to be weak. To be effective, standards need to be revised frequently but in practice legislation tends not to keep up with the change. Standards tend to be less cost-effective than MBIs. The financial costs of standards may be high. There could also be political costs if the standards are stringent and businesses are adversely affected.

Example: The Malaysian Oil Palm Industry

Promulgation of the Malaysian Environmental Quality Act in 1974 brought the palm oil industry to revolutionize their effluent treatment in order to comply with the mandatory discharge standard. During the initial year of the enforcement of the regulations, the palm oil industry regarded effluent treatment as an additional cost of production. Compliance with discharge standard of 5,000mg/l BOD (Biochemical oxygen demand) was not mandatory during the first year. Many mills chose to pay the fees rather than treat their effluent to meet the standard. As a result, 67.8% reduction in BOD level was reduced. During the second year of enforcement, it was mandatory for mills to reduce their BOD discharge to 2,000mg/l and the license fee was charged RM 10 per ton BOD. In two years of mandatory enforcement, the total BOD load discharged was reduced by 94.2% despite the increase in the number of mills. It appeared that the motivation to comply with the standard was not the fee, but rather the risk of being shut down.

Market-based instruments (MBIs)

MBIs use price or other economic variables to provide incentives for polluters to reduce harmful emissions. MBIs include charges, subsidies, marketable (or tradable) permits and other MBIs including deposit/refund systems, eco-labelling, licenses, and property rights. In general, MBIs may have the following advantages and disadvantages:

 Advantages of MBIs
Cost effective as it offers a possible lowest cost to society to control pollution Provides incentives for technology innovation and diffusion Generate revenues for the government

Disadvantages of MBIs
Institutional constraints - such as underfunding, inexperience unclear jurisdiction and lack of political will - limit the effective implementation of MBIs. Administrative intensity (i.e., monitoring requirements, legal design requirements, public consultation needs and enforcement of collection needs) remains high and thus MBIs cannot substitute for weak institutions or command and control policies. Have the potential to be regressive, as they make cost of goods and services higher. If not designed properly, have the potential to have perverse effects (e.g., water pollution charge may cause more pollution if based on effluent concentrations and not on total pollution load)

Charges
A charge or a tax is a fee that is imposed on a pollutant in proportion to the amount of the pollutant released into the environment. Charges are based on the 'Polluter Pays Principle (PPP)', which requires that a polluter must bear the cost of any pollution abatement necessary to maintain environmental quality.

Charges may be classified into the following categories :

Emission (or effluent) charges is based on the actual amount of the pollutant discharged. Product charges or levies is a mark-up on the price of a pollution-generating product that is based on the amount responsible for pollution. An example of a product charge is a carbon (fuel) tax. User charges is a fee levied on the user of an environmental resource based on the costs of treating emissions (or effluents) that affect the resource. Administrative charge is a service fee for implementing or monitoring regulation. Betterment charge is a fee levied for private properties benefiting from public projects

 Advantages of charges
Charges give consumers and firms an economic incentive to reduce pollution. Unlike standards, which are applied uniformly to all polluters, charges enable firms to adopt a cost-effective solution to pollution abatement. Compared to standards, there is a stronger incentive for firms to adopt new technology in order to lower the charges they have to pay.

Disadvantages of charges
An 'optimum' standard is often difficult to set for certain non-market environmental commodities. Firms could pass on a portion of the tax or charge to consumers in the form of higher product prices. Imposing a tax could also lead to job losses as firms minimise their costs in order to increase pollution abatement. Costs of monitoring the compliance may be high if charges are based on the emission.

Example: The Republic of Korea's Effluent Charge System

The effluent charge system was introduced in 1983 in the Republic of Korea as a penalty for violations of the regulatory standard. The charge rate was low. Unlike command and control with penalties such as closure, relocation of firms or imprisonment, payment of the penalty was not a threat to industries. Ineffective monitoring induced polluters to attempt to avoid penalties through bribery or cheating. Computation of charges based on toxicity rather than on total volume discharged, led some polluters to dilute the wastewater to acceptable level.

Subsidies
A subsidy is a payment or tax concession that assists firms to reduce pollution. In that sense a subsidy is the opposite of taxes. The subsidy could be offered in proportion to the per unit reduction in pollution, or it could be offered for the purchase of pollution abatement equipment or technology

Comparison of charges and subsidies In theory, both taxes and subsidies should result in the same optimum level of environmental quality. However, there could be the following differences:
where there is unrestricted entry into the industry, subsidies could attract more firms and therefore aggregate pollution could increase in the long-run subsidising polluters may be seen as socially unjust because some may see this as taking income away from the society

Marketable (or tradeable) permits

Under this system, the government issues a fixed number of permits or "rights to pollute" equal to the permissible total emissions and distributes them among polluting firms in a given area. A market for permits is established and permits are traded among firms. Firms that maintain their emission levels below their allotted level can sell or lease their surplus allotments to other firms or use them to offset emissions in other parts of their own facilities.

 The concept of marketable permits may also be used to manage natural resources such as fisheries. This system is referred to as Individual Transferable Quotas (ITQs). Under this system, property rights to a specified quantity of fish harvest are distributed among firms or auctioned off to the highest bidders. The holders of ITQs may use, sell or lease them to other firms. Over time, the ITQ systems leads to an efficient use of effort and harvest.

Advantages of permits Allocation of permits is determined by market forces The ability to sell permits is an incentive for firms The system makes allowance for industrial development. The system can generate income for the government. Disadvantages of permits The market for permits may not be perfectly competitive. Well-developed markets may constraint the permits' system. Administrative, monitoring and enforcement costs may be high.

Example: Individual transferable quotas (ITQs) for the fishery industry in Australia
The Australian government introduced an ITQ for the Australian fishery in 1984. Each individual holding a quota was entitled to a proportion of the total allowable catch (TAC) set by the government each year. The TACs have been reduced each year since 1984, owing to concern about the biological viability of the tuna stocks. With the introduction of the ITQ, the number of vessels operating in the Australian fleet declined by over 50 percent by 1991. At the same time, the harvests have remained roughly constant at 10,000 metric tons. The ITQ would seem to have achieved the objective of promoting efficiency in the fishery without affecting harvests.

Other MBIs
Deposit-refund systems Ecolabelling and ISO standards Licenses, concessions and quotas Traditional property rights Performance bond/environmental guarantee fund

Deposit-refund systems
A deposit-refund system consists of a 'deposit', which a front-end payment for potential pollution, and a 'refund' which is a guarantee of a return of the deposit upon proving that the pollution did not take place. Deposit-refund schemes have built-in economic incentives similar to charges. For example, the 'deposit' is an attempt to force the consumer to account for the cost of improper waste disposal by making an upfront payment. On the other hand, the 'refund ' serves as a reward for proper waste disposal.

 Advantages of deposit-refund systems:

It is a voluntary scheme that attempts to change environmental behaviour at least cost to the government. Monitoring and enforcement costs are minimal because it requires limited supervision. The system can be used to encourage recycling and more efficient use of raw materials. For example, the 'deposit' can be considered as a tax to encourage firms to use raw materials more efficiently, while the 'refund' encourages them to properly dispose of their waste products.

Disadvantages of deposit-refund systems:

If refunds are too low, the public may not have an incentive to participate in the scheme.

Bottle reuse and drink can recycling in Port Moresby

Refunds for returned bottle paid by PNG Bottle Industry Pty Ltd. is K1.50 for a 285ml Coke bottle, K1.70 for a 285ml Pepsi bottle and K1.20 for an SP beer bottle.
The use of returnable bottles is cheaper in economic and energy terms than non-returnable bottles or cans. Therefore PNG Bottle Industry Pty Ltd has an incentive to offer refunds. The average returnable rate for bottles is 85% within the country, while in Port Moresby, it can be as high as 90%, i.e. the same bottle is reused about 9 times.

Aluminum cans cannot be re-used but the raw material, aluminum, is valuable.
The strength of the overseas aluminum market allows the recycling companies to offer reasonable refunds. PNG Recycling exported 13,000 tonnes of cans in 1997. Given a price of US$1,050 per tonne for packed cans, the company could have earned over US$13 million in foreign exchange. The high level of reuse and recycling means that resources are conserved and the waste stream reduced. Recycling also has social benefits in the form of income redistribution of sections of the population with no formal employment.

Ecolabelling and ISO standards

In the ecolabelling or performance rating approach, firms are required to provide information on the final end-use product. Firms are performance rated based on ISO 14000 voluntary guidelines that include the following: zero discharge of pollutants, adoption of pollution abatement technology, submission of mitigation plans. The 'ecolabels' are attached to products that are determined to be 'environmentally friendly'

Licenses, concessions and quotas

Licenses, concessions and quotas have traditionally been used for the management of environmental resources such as forests and fisheries. For example, many Pacific island countries use licenses and access fees to manage their exclusive economic zones . However, due to lack of knowledge about the financial performance of foreign fishing fleets, and inadequate monitoring and enforcement capacity, most PICs are unable to capture a fair proportion of the rents from fishing. Example : Foreign fisheries vessels in PNG The PNG Government receives about K15 million per annum in license fees from foreign fishing vessels. Due to PNG's limitation to monitor fishing activities, many of the vessels avoid paying resource rent to the State.

Traditional property rights

In recent years, there has been a realization that traditional or customary communal rights systems can provide insights into the design of modern systems of natural resource management. In most developing, as well as developed countries, resource managers have concentrated their management efforts on licenses and quotas in order to prevent overexploitation of natural resources such as fisheries and forests. In many cases, these efforts have been unsuccessful. Customary communal rights systems, whereby local people manage their own resources through the establishment of private or communal ownership over common property resources, have better chances of success. This is because the "owners" of the resource have an interest in its current and future productivity and would be inclined to control exploitation so as to maximise the net benefits.

Example: Sri Lankan Coastal Fisheries System

Sri Lankan coastal fisheries have a history of traditional property rights in the form of rights of access and closed communities. In earlier times, beach seine owners controlled access to coastal waters and had associated rights that were obtained through inheritance or marriage. While there was no limit to the number of nets that anyone holding rights to access could have constructed, the fishermen on a given beach refrained from constructing additional nets unless they could bring in a catch whose value would have been higher than the cost of the net.

Measuring the Benefits and Costs of Pollution Control

Does the marginal cost of achieving the ozone standard in the Los Angeles basin exceed the marginal benefits? Methodologies to measure the benefits of goodssuch as clean air or water fall into two categories:
indirect market methods, which attempt to infer from actual choices, such as choosing where to live, the value people place on environmental goods; and direct questioning approaches, which ask people to make tradeoffs between environmental and other goods in a survey context.

The Averting Behavior Approach

The averting behavior approach relies on the fact that in some cases purchased inputs can be used to mitigate the effects of pollution. For example, residents of smoggy areas can take medicine to relieve itchy eyes and runny noses. The value of a small change in pollution can be measured by the value of the inputs used to compensate for the change in pollution. If, for example, a reduction in one-hour maximum ozone levels from 0.16 parts per million (ppm) to 0.11 ppm reduces the number of days of respiratory symptoms from 6 to 5, and if an expenditure on medication of $20 has the same effect, then the value of the ozone reduction is $20

Hedonic Market Methods

Air quality and other environmental amenities can be valued in an urban setting by virtue of being tied to residential location: they are part of the bundle of amenities-public schools, police protection, proximity to parks-that a household purchases when buying a house. The essence of the hedonic approach is to try to decompose the price of a house (or of residential land) into the prices of individual attributes, including air quality.

The Contingent Valuation Method

Non use values refer to the benefits received from knowing that a good exists, even though the individual may never experience the good directly. Examples include preserving an endangered species or improving visibility at the Grand Canyon for persons who never plan to visit the Grand Canyon. Typically, direct questioning or contingent valuation studies ask respondents to value an output, such as a day spent hunting or fishing, rather than a change in pollution concentrations per se. Perhaps the most serious criticism is that responses to contingent valuation questions are hypothetical-they represent professed, rather than actual, willingness to pay

Measuring the Costs of PollutionControl

Risk of overstating the cost of environmental regulations. Abatement expenditures overstate the loss in firms' profits if firms can pass on part of their cost increase to consumers. Consumers in turn can avoid some of the welfare effects of price increases of "dirty" goods by substituting "clean" goods for "dirty" ones.

The Use of Benefit-Cost Analysis in Setting Environmental Standards

In the USA, benefits could legally be compared with costs in the case of lead in gasoline. In this case, the benefits in terms of engine maintenance alone were judged to exceed the costs by $6.7 billion over the period 1985-92, and the regulation was issued.

The global concern for environment

Club of Rome STERN Review KYOTO Protocol

Club of Rome
The Club of Rome is a global think tank that deals with a variety of international political issues. Founded in 1968 at in Rome, the CoR describes itself as "a group of world citizens, sharing a common concern for the future of humanity." It consists of current and former Heads of State, UN bureaucrats, high-level politicians and government officials, diplomats, scientists, economists, and business leaders from around the globe. It raised considerable public attention in 1972 with its report The Limits to Growth. It predicted that economic growth could not continue indefinitely because of the limited availability of natural resources, particularly oil. The 1973 oil crisis increased public concern about this problem.

STERN Review
The Stern Review on the Economics of Climate Change is a report released for the British government on 30 October 2006 by economist Nicholas Stern, The report discusses the effect of global warming on the world economy. The Review provides prescriptions including environmental taxes to minimize the economic and social disruptions. The Stern Review's main conclusion is that the benefits of strong, early action on climate change far outweigh the costs of not acting. The Review points to the potential impacts of climate change on water resources, food production, health, and the environment. According to the Review, without action, the overall costs of climate change will be equivalent to losing at least 5% of global gross domestic product (GDP) each year, now and forever. Including a wider range of risks and impacts could increase this to 20% of GDP or more.

 The Review proposes that one percent of global GDP per annum is required to be invested in order to avoid the worst effects of climate change. In June 2008, Stern increased the estimate for the annual cost of achieving stabilisation to 2% of GDP to account for faster than expected climate change Critics: how to discount the future?

KYOTO Protocol
The Kyoto Protocol is a protocol to the United Nations Framework Convention on Climate Change (UNFCCC or FCCC), aimed at fighting global warming. The Protocol was initially adopted on 11 December 1997 in Kyoto, Japan, and entered into force on 16 February 2005. As of September 2011, 191 states have signed and ratified the protocol. The only remaining signatory not to have ratified the protocol is the United States. Other United Nations member states which did not ratify the protocol are Afghanistan, Andorra and South Sudan. In 2011, Canada denounced the Protocol.

Carbon credit
Under the Kyoto Protocol, the 'caps' or quotas for Greenhouse gases for the developed countries are known as Assigned Amounts . The quantity of the initial assigned amount is denominated in individual units, called Assigned amount units (AAUs), each of which represents an allowance to emit one metric tonne of carbon dioxide equivalent, and these are entered into the country's national registry.

 These countries set quotas on the emissions of installations run by local business and other organizations, generically termed 'operators'. Countries (or Regional entities such as EU) manage this through their national registries, which are required to be validated and monitored for compliance by the UNFCCC. Each operator has an allowance of credits, where each unit gives the owner the right to emit one metric tonne of carbon dioxide or other equivalent greenhouse gas. Operators that have not used up their quotas can sell their unused allowances as carbon credits, while businesses that are about to exceed their quotas can buy the extra allowances as credits, privately or on the open market. As demand for energy grows over time, the total emissions must still stay within the cap, but it allows industry some flexibility and predictability in its planning to accommodate this.