Economics of the EnvironmentEconomics of the Environment

1. The economics of pollution1. The economics of pollution

2. Valuation of externalities2. Valuation of externalities

3. The optimal level of pollution3. The optimal level of pollution

4. Methods of pollution control4. Methods of pollution control

5. EU & UK policy5. EU & UK policy

BackgroundBackground

Pollution Pollution chemical wastes - riverschemical wastes - rivers noise pollutionnoise pollution thermal pollutionthermal pollution carbon emissions - air carbon emissions - air

industrial useindustrial use road usersroad users Table 1Table 1

Fig 1 The interaction between the Fig 1 The interaction between the economy & environmenteconomy & environment

WastesWastes

Environmentalsystem

Productionsystem

Consumptionsystem

Reclaimedmaterials

1. The economics of pollution1. The economics of pollution Negative externalityNegative externality

spillover effect of consumption\ spillover effect of consumption\ productionproduction

third party is effected - social coststhird party is effected - social costs Price mechanism?Price mechanism?

e.g. air is freee.g. air is free e.g. water - very low pricee.g. water - very low price

Over-consumption Over-consumption consumers\business - private costsconsumers\business - private costs society - social costssociety - social costs

Economics of pollutionEconomics of pollution

Private costs Private costs social costs social costs Policy objective Policy objective

change consumers\business behaviourchange consumers\business behaviour pay full social costspay full social costs

internalise the externality to reduce internalise the externality to reduce pollutionpollution

PoliciesPolicies standards, taxes, permitsstandards, taxes, permits … … valuation of a negative externalityvaluation of a negative externality

2. Valuation: A case study2. Valuation: A case study

Road traffic congestionRoad traffic congestion Road use increased dramaticallyRoad use increased dramatically

private (…and freight)private (…and freight) Policy - how to ration a scarce Policy - how to ration a scarce

resource? resource? Road use generates several Road use generates several

externalitiesexternalities e.g. Global warming, e.g. Air pollutione.g. Global warming, e.g. Air pollution e.g.Congestione.g.Congestion

How big are these social costs?How big are these social costs?

Valuation methodsValuation methods

1. Direct Approaches1. Direct Approaches Contingent valuation methodsContingent valuation methods

questionnaire & surveyquestionnaire & survey WTP or WTACWTP or WTAC value of externality = mean WTP or WTACvalue of externality = mean WTP or WTAC

2. Indirect Methods2. Indirect Methods e.g. Hedonic pricing model e.g. house e.g. Hedonic pricing model e.g. house

prices, lifetime wagesprices, lifetime wages e.g.Total economic value = use value e.g.Total economic value = use value

+ option value + existence value+ option value + existence value

Valuation of road transport Valuation of road transport externalities, 1993externalities, 1993

Externality & cost Externality & cost (£billions)(£billions) Global warming Global warming = = 0.10.1 Air pollutionAir pollution == 19.719.7 NoiseNoise == 2.6-3.12.6-3.1 Road damage Road damage == 1.51.5 AccidentsAccidents == 2.9-9.42.9-9.4 CongestionCongestion == 19.119.1 TOTALTOTAL == 45.9-52.945.9-52.9

Revenue from road use = £16.4bRevenue from road use = £16.4b

Policies to correct road transport Policies to correct road transport externalitesexternalites

Marginal road user pays about a third Marginal road user pays about a third of true cost of a journeyof true cost of a journey

Government interventionGovernment intervention build more roads - no!build more roads - no! improve public transport - yesimprove public transport - yes tax - yestax - yes road pricing - yesroad pricing - yes

Taxes & pricing depend crucially on Taxes & pricing depend crucially on value of externalities value of externalities

3. The optimal level of pollution3. The optimal level of pollution

How much pollution should How much pollution should Government tolerate?Government tolerate?

NotNot zero pollution. Why? zero pollution. Why? ……because pollution increases with because pollution increases with

outputoutput ……growth of output increases welfare growth of output increases welfare

3. The optimal level of pollution3. The optimal level of pollution

Quantity of pollution is positively Quantity of pollution is positively related to outputrelated to output

Social costs increase with outputSocial costs increase with output But, the costs of clean-up rise as But, the costs of clean-up rise as

pollution fallspollution falls What is the socially optimal level of What is the socially optimal level of

pollution?pollution? See Figure 2 See Figure 2

Fig 2: The optimal level of Fig 2: The optimal level of pollutionpollution

Costs ofpollution

Quantity ofpollution

Social costs

C2C1

Q2Q1

More untreatedwaste, the higherthe social cost

0

If pollution= 0,output would fall. Welfare?

Fig 2: The optimal level of Fig 2: The optimal level of pollutionpollution

Costs ofpollutioncontrol

Quantity ofpollution

C2C1

0 Q2 Q1

AB

Costs of pollutioncontrol at each level ofdischarge

Costs ofclean-uprise

Fig 2: The optimal level of Fig 2: The optimal level of pollutionpollution

Costs

Quantity ofpollution

0

Pollution control costs

Social costs

R

Assume thatindustry output isfixed

X Y

The optimal level of pollutionThe optimal level of pollution

Thinking marginally, optimality isThinking marginally, optimality is “…“…the cost of an extra unit of pollution the cost of an extra unit of pollution

is just equal to the cost of reducing is just equal to the cost of reducing pollution by an extra unit.”pollution by an extra unit.”

Point ‘R’ on figure 2Point ‘R’ on figure 2 pollution is not zero!pollution is not zero!

How can Government achieve this? How can Government achieve this?

4. Methods of pollution control4. Methods of pollution control

No incentive for business & No incentive for business & consumersconsumers

Government should correct the Government should correct the market failuremarket failure

MethodsMethods (a) standards & regulations(a) standards & regulations (b) Pollution tax(b) Pollution tax (c) Tradeable permits(c) Tradeable permits

4. Methods of pollution control4. Methods of pollution control

(a) Standards & regulations(a) Standards & regulations Traditional approachTraditional approach Set emissions targetSet emissions target

if targets are too strict - point Xif targets are too strict - point X if targets are too lenient - point Yif targets are too lenient - point Y correct targets - point R correct targets - point R

Penalties if business is caught in Penalties if business is caught in violation of targetviolation of target

(a) Standards & regulations(a) Standards & regulations

DisadvantagesDisadvantages (i) Costly(i) Costly (ii) Information requirements(ii) Information requirements (iii) Vague & imprecise(iii) Vague & imprecise (iv) If fines are low, no incentive to comply(iv) If fines are low, no incentive to comply (v) Conflict of standards(v) Conflict of standards

Advantages Advantages (i) If all businesses comply - very effective(i) If all businesses comply - very effective (ii) No alternative in some cases(ii) No alternative in some cases

(b) Pollution tax(b) Pollution tax

E.g. fuel tax, effluent taxesE.g. fuel tax, effluent taxes Tax is a fee consumers\producers payTax is a fee consumers\producers pay Control via priceControl via price Tax per unit of outputTax per unit of output Cleaner production process - lower taxCleaner production process - lower tax See Figure 3See Figure 3

Fig 3: The pollution taxFig 3: The pollution tax

Output

Quantity of pollution

Costs,Revenue

D = MSB

S = MPC

Qp

Y

Pp

MSC

Qr

Pr

R

MPC + tax

Pt

(b) Pollution taxes(b) Pollution taxes

AdvantagesAdvantages (i) Cheaper than standards(i) Cheaper than standards

reduce discharge: clean-up cost = pollution reduce discharge: clean-up cost = pollution taxtax

(ii) Less information required(ii) Less information required meters & chargesmeters & charges

(iii) (iii) Polluter Pays PrinciplePolluter Pays Principle price environmental servicesprice environmental services sustainable developmentsustainable development

AdvantagesAdvantages (iv) Raises revenue(iv) Raises revenue (v) Widespread compliance(v) Widespread compliance (vi) Market-based approach(vi) Market-based approach (vii) Producer & consumer share the (vii) Producer & consumer share the

costcost DisadvantagesDisadvantages

(i) Valuation? Tax rate?(i) Valuation? Tax rate? (ii) Absence of market failure e.g. (ii) Absence of market failure e.g.

monopolymonopoly (iii) Assumes Government knows the (iii) Assumes Government knows the

firms costsfirms costs

(c) Transferable pollution (c) Transferable pollution permitspermits

Second-hand market in pollutionSecond-hand market in pollution Regulator sets pollution targetRegulator sets pollution target Issue pollution permitIssue pollution permit

license to pollute to a certain levellicense to pollute to a certain level e.g. emissions e.g. emissions

Firms buy & sell permitsFirms buy & sell permits Firms have a choiceFirms have a choice

incur the cost of clean-upincur the cost of clean-up buy a permit & continue pollutingbuy a permit & continue polluting

(c) Permits(c) Permits

High clean-up costs - buy permitsHigh clean-up costs - buy permits

OutcomeOutcome

Some pollution is allowedSome pollution is allowed Remaining pollution is cleaned up at low Remaining pollution is cleaned up at low

costcost Control pollution - quantityControl pollution - quantity

(c) Permits(c) Permits

AdvantagesAdvantages (I) Market-based approach(I) Market-based approach (ii) Low cost(ii) Low cost (iii) Flexible - regular can buy permits(iii) Flexible - regular can buy permits

DisadvantagesDisadvantages (I) Valuation? Number of permits(I) Valuation? Number of permits (ii) Initial allocation is important(ii) Initial allocation is important

5. EU & UK policy5. EU & UK policy

Traditional approach - set standardsTraditional approach - set standards EU sets standards onEU sets standards on

quality of water - bathing, drinking, quality of water - bathing, drinking, emissionsemissions

waste management - sewage, toxic waste management - sewage, toxic substancessubstances

atmospheric pollution - agreed to reduce atmospheric pollution - agreed to reduce COCO22 emissions by 2012 (8%) emissions by 2012 (8%)

EU reduction targets for EU reduction targets for greenhouse gases (% change)greenhouse gases (% change)

-30

-20

-10

0

10

20

30

40

Country

Belgium

Denmark

Germany

Greece

Spain

France

Ireland

Italy

Luxembourg

Netherlands

Austria

Portugal

Finland

5. EU policy5. EU policy

How will this be achieved?How will this be achieved? ‘…‘…markets [will] be harnessed to markets [will] be harnessed to

generate the most efficient method of generate the most efficient method of achieving desired pollution reuctions.’achieving desired pollution reuctions.’

Government set targetsGovernment set targets Taxes & permits used to find the best Taxes & permits used to find the best

method method