Administrative

• Science paper is due 5pm, Friday, March 27– Questions? – Office hours- after class today; Tuesday –till 3

• ES Advising Session– 5pm tonight– Dana 285

Business School

• Businesses seek competitive advantage by reducing costs & product differentiation. M. Porter

• Social License theory– Esty and Winston

Political Economy (Chicago School)

• Corporations seek competitive advantage via public policy. G. Stigler

Baptists Bootleggers

• Companies• Industries• Countries

Command and Control

Regulatory Decision-making

• Decisions by Expert Choice

• High Knowledge Demands

• High Performance Information Demands

• Monitoring & compliance• Enforcement• Bureaucracy Growth

Economists’ Critique

• C & C Regulation is Inefficient

• “One size fits all” rules• Does not recognize that it is

easier and cheaper for• some polluters to reduce

pollution than others• Few incentives for innovation• Few incentives for voluntary

compliance• High transaction costs

Discourses

• “A discourse is a shared way of apprehending the world. Embedded in language, it enables those who subscribe to it to interpret bits of information and put them together into coherent stories or accounts. Each discourse rests on assumptions, judgments, and contentions that provide the basic terms for analysis, debates, agreements, and disagreements”– John Dryzek, The Politics of the Earth, 1997

Economist Discourse

Environmental Degradation

• Causes • Optimal Levels• Pollution as subsidy

Economists Perspective?

Foxconn Factory in Shenzhen 

500 million iPhone uses later....

Implications

• Should only do pollution control if benefits are worth more than values we forgo.

• Means of achieve pollution control targets should minimize costs of meeting targets

Marginal Costs

Air Quality in New DelhiU.S. Embassy Air Quality Monitor

NYC Monitoring of short- and long-term PM2.5 concentrations in ambient (outdoor)

•5 percent above the annual standard in 2003 to 22 percent below in 2013.

•14 percent above the 24-hour standard in 2003 to 26 percent below in 2013

•How - ultra-low diesel fuel, LEV, factory regulations

BUT (2,300 premature deaths, 4,800 emergency room visits for asthma, and 1,500 hospitalizations for respiratory and cardiovascular disease.

Achieves Attainment with U.S. Environmental Protection Agency National Ambient Air Quality Standards for Particulate Matter, http://www.dec.ny.gov/press/96759.html

Should NYC Decrease Pollution

Marginal Costs and Efficiency

• To maximize societal benefits, we should allocate it to where marginal costs of clean are the least.– Ducks vs. Chickens

• If you can spend $100 to remove SO2– Firm A $5 ton– Firm B $10 – Firm C $20

Market Policy Instruments

• provide incentives for businesses and individuals to act in ways that further their own financial goals, but also the environment.

• leave the choice of how to accomplish this up to individuals or companies concerned.

• use economic instruments such as prices, taxes, subsidies, bonds, liability, or markets to align individual incentives with the common good

Examples?

Market Mechanisms

Cons, say political scientists

• Equity• Disproportionate impact• Fairness• Losers more visible

Pros, say economists

• Innovation• Neutral• Efficient

Selling Indulgences

Numerical Example of the Cost Savings Associated with Cap-and-Trade Systems

In the next slide we will evaluate a numerical example of a hypothetical industry that is required to reduce its overall emissions by 50 percent. We will first derive compliance costs for this level of pollution control under a performance-based standard, and then we will derive compliance costs for the same level of pollution control under a cap-and-trade system.

Numerical Example of the Cost Savings Associated with Cap-and-Trade Systems

Case 1: Cut overall industrial emissions by 50 percent using a performance-based standardperformance-based standard, (command and control) which requires that each firm cut its emissions by 50 percent.

Numerical Example of the Cost Savings Associated with Cap-and-Trade Systems

Firms Historical Emissions(Tons/Yr)

Marginal Abatement Cost ($/Ton)

Tons of Emissions to be Reduced

Total Abatement Cost (No Tradable Allowances)

Alkyone 600 50 300

Merope 600 100 300

Kelaino 600 100 300

Elektra 600 150 300

Sterope 800 200 400

Taygete 800 250 400

Maia 800 400 400

Industry Total

4,800 --- 2,400

Fill in this column

Numerical Example of the Cost Savings Associated with Cap-and-Trade Systems

You should have found that the industry wide cost of compliance under the performance-based

standard was $460,000.

Numerical Example of the Cost Savings Associated with Cap-and-Trade Systems

Case 2: Cut overall industrial emissions by 50 percent using a cap-and-trade systemcap-and-trade system. Assume that quota shares are fully tradable and (perhaps unrealistically) that firms can fully eliminate emissions and still produce.

Numerical Example of the Cost Savings Associated with Cap-and-Trade Systems

Firms Historical Emissions(Tons/Yr)

Marginal Abatement Cost ($/Ton)

Allowances (Allowed Emissions)

Alkyone 600 50 300

Merope 600 100 300

Kelaino 600 100 300

Elektra 600 150 300

Sterope 800 200 400

Taygete 800 250 400

Maia 800 400 400

Industry Total 4,800 --- 2,400

Numerical Example of the Cost Savings Associated with Cap-and-Trade Systems

To answer the question of what total industry-wide compliance costs will be in a cap-and-trade system, we must first determine the pattern of trade.

Which firms buybuy allowances and which firms sellsell allowances, and why?

Numerical Example of the Cost Savings Associated with Cap-and-Trade Systems

If a firm has highhigh pollution abatement costs, can it reduce them by purchasing allowances from a firm with low pollution abatement costs?

Note that when a firm buys an allowance, it is allowed to emit an additional 1 ton of pollution for a year, and thus saves on the cost of reducing its emissions by 1 ton.

Numerical Example of the Cost Savings Associated with Cap-and-Trade Systems

Firms Historical Emissions(Tons/Yr)

Marginal Abatement Cost ($/Ton)

Alkyone 600 50

Merope 600 100

Kelaino 600 100

Elektra 600 150

Sterope 800 200

Taygete 800 250

Maia 800 400

Industry Total

4,800 ---

In this example, could Alkyone make a profit by selling an allowance to Maia for $200? How much?

Is this purchase advantageous for Maia? By how much?

Numerical Example of the Cost Savings Associated with Cap-and-Trade Systems

Note: To solve for case 2 (fully tradable allowances), be sure that total allowances bought equals total allowances sold, and that all available gains from trade are realized. You should find that the total cost of compliance with a 50 percent industry-wide emissions reduction is

$240,000$240,000.

Reducing industry wide emissions under the performance-based standard was $460,000. Thus the cost savings here are

$220,000.

Cap and Trade Program Basics

• Set an emissions tonnage limit (cap or budget) for a class of sources in a region.

• Allocate the right to emit tons (allowances or permits) to individual sources.

• At the end of the season, each source must have allowances equal to actual emissions.

• Sources can control, overcontrol, sell, bank, buy allowances to comply.

Elements of a Successful Cap-and-Trade System

• Determine an overall maximum level of emissions (the "cap"). • Assign polluters an individual pollution quota or allowance,

usually based on emissions levels in some baseline year; the sum of these allowances is equal to the desired level of emissions.

• Let these allowances be tradable to some degree.• Require new firms to buy allowances from existing firms.• Create a market institution that minimizes the transaction cost of

trades.• Monitor and enforce sanctions against those that pollute above

and beyond their allowance, so firms have an incentive to buy allowances rather than freely pollute.

• Maintain policy stability over time so, for example, firms are willing to buy permits knowing that standards will not be lifted in the future.

NOX

80006000400020000-2000

MW3000

2000

1000

0

-1000

6000050000400003000020000100000-10000

3000

2000

1000

0

-1000

MW

NOX

MW

SOX

NOX

80006000400020000-2000

CO

AL

1.2

1.0

.8

.6

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.2

0.0

-.2

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1.0

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.2

0.0

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80006000400020000-2000

MW

3000

2000

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COAL

1.00

.99

.98

.96

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.00

SOX

6000050000400003000020000100000-10000

MW

3000

2000

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COAL

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.00

Acid Deposition Process

Source: EPA

Acid Deposition Process

Sulfur dioxide (SO2) and nitrogen oxides (NOx) are the primary causes of acid rain. In the US, About 2/3 of all SO2 and 1/4 of all NOx comes from electric power generation that relies on burning fossil fuels like coal.

Acid rain occurs when these gases react in the atmosphere with water, oxygen, and other chemicals to form various acidic compounds. Sunlight increases the rate of most of these reactions. The result is a solution of sulfuric acid and nitric acid.

Has Acid Rain Cap and Trade Worked?

• Environmental

• Economic

• Political

SO2 Environmental Results: The Cap and Trade Platform

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Ind

ex

: 1

98

7 =

1.0

U.S. Gross Domestic Product

Total net electricity generation

SO2 emissions from electric utilities

(Sources: DOC, DOE and EPA, respectively)

*

* ARP units only

Historical Approach to Cap and Trade

• Fixed levels

• Large, step reductions

• Allocation based on historic heat input

• Participation limited to fossil generators

• New and clean units treated less favorably

Critical Design Elements

• Setting cap levels and timing

• Applicability

• Allocation of Allowances

Historical Problems With Caps• Difficult to find the right cap level.• Allocation favors historic big polluters.• Doesn’t include/support new, efficient

generators.• Under a cap, command and control programs

provide no environmental value since total emissions will remain the same.– Command and control defeats the trading

program benefit of reducing costs.

Traditional Emission Cap Profile

0

1

2

3

4

5

6

7

8

9

10

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Year

MM

Ton

s

Non-Title IV Sources

Example of Declining Cap on SO2

0

1

2

3

4

5

6

7

8

9

10

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

MM

Ton

s

Declining Cap10%/yr

Jeffords

BAU

Non-Title IV Sources

Bush

Declining Cap/Circuit breaker

• Each cap decreases by fixed percent each year. Glide slope defined in advance.

• Decline for each pollutant stops if annual average allowance cost exceeds predetermined cost threshold ($/ton).

• Decline starts again when the annual average cost is below threshold.

Illustration of Declining Cap

0

20

40

60

80

100

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Year of Program

0

100

200

300

400

500

600

Cap Level(Tons/year) Circuit Breaker Value

($/ton)

Allowance Price

Allocation Options

• Grandfathering primarily rewards old, high emitting plants.- Think Maia

• Auction has theoretical benefits but is politically difficult.

• Output-based, reallocating program provides maximum reward for efficiency, low emissions, new plants.

Principles for CO2 Regulation

• Climate change is a long-term problem. We need to look for long-term solutions.

• Short-term massive switching to gas detracts from development of longer term solutions and may not be sustainable.

• More gradual path to the longer-term solutions will be more productive.

– Renewables– Efficiency

– Clean coal– Sequestration

The CO2 Approach Must:

• Limit economic risk• Limit large structural

or lifestyle changes• Not pick winners• Be market-based

• Show a commitment• Be gradual• Promote new

technology• Lead to commitments

from other countries

Proposed Approach

• Replace inefficient command and control regulation with an appropriate cap and trade program.

• Design cap and trade program to:– Better encourage diverse mix of clean

technologies and efficiency.– Promote technology development.– Ensure better environmental performance.

No More Free Dumping

“Since the dawn of the industrial revolution,

the atmosphere has served as a free

dumping ground for carbon gases. If people

and industries are made to pay heavily for

the privilege, they will inevitably be driven to

develop cleaner fuels, cars and factories.”

— Avoiding Calamity on the Cheap, Nov. 3, 2006New York Times editorial

Allocation OptionsFirms Historical

Emissions(Tons/Yr)

Marginal Abatement Cost ($/Ton)

Tons of Emissions to be Reduced

Total Abatement Cost (No Tradable Allowances)

Alkyone 600 50 300

Merope 600 100 300

Kelaino 600 100 300

Elektra 600 150 300

Sterope 800 200 400

Taygete 800 250 400

Maia 800 400 400

Industry Total

4,800 --- 2,400

Fill in this column

Allocation Effects on Companies

Do Better Under Output* Do Worse Under Output

Southern Co. AEP TVA Reliant Cinergy Progress Energy Duke Energy Allegheny Energy DTE Energy Domminion FirstEnergy FPL PPL

Xcel TXU Entergy Edison International Scottish Power Ameren LG&E MidAmerican Energy Pinnacle West

*Within 1%

What are the challenges to reducing carbon emissions?

Principles for CO2 Regulation

• Climate change is a long-term problem. We need to look for long-term solutions.

• Short-term massive switching to gas detracts from development of longer term solutions and may not be sustainable.

• More gradual path to the longer-term solutions will be more productive.

– Renewables– Efficiency

– Clean coal– Sequestration

The CO2 Approach Must:

• Limit economic risk• Limit large structural

or lifestyle changes• Not pick winners• Be market-based

• Show a commitment• Be gradual• Promote new

technology• Lead to commitments

from other countries

Proposed Approach

• Replace inefficient command and control regulation with an appropriate cap and trade program.

• Design cap and trade program to:– Better encourage diverse mix of clean

technologies and efficiency.– Promote technology development.– Ensure better environmental performance.

What are advantage of cap and trade for global warming?

Cap and Trade Programs

• Cap provides greater environmental certainty than command and control.

• Provides greater flexibility and lower compliance cost.

• With proper design, can encourage efficiency and new technology.

Congressional Cap and Trade

• Bingaman-Specter (S 1766)• Udall-Petri (Draft, May 2007)• Lieberman-McCain (S 280)• Kerry-Snowe (S 485)• Waxman (HR 1590)• Sanders-Boxer (S 309)• Feinstein-Carper (S 317)• Alexander-Lieberman (S 1168)• Stark (HR 2069)• Larson (HR 3416)

John Dingell Cap-and-Trade Program

• $50-per-ton tax on carbon

• 50 cents per gallon tax on gasoline and jet fuel

• Indexed to inflation• “No New Taxes”

Regressivity/Rebates

John Dingell (D-MI-Auto)

John Dingell Hybrid Carbon and Petroleum Tax Bill

• $50-per-ton tax on carbon

• 50 cents per gallon tax on gasoline and jet fuel

• Indexed to inflation• “No New Taxes”

Regressivity/Rebates

John Dingell (D-MI-Auto)

Arguments for a Carbon Tax

Effectiveness and Efficiency

Wide Array of Support

• .

Control on Price Not Quantity

• “Specifically, a carbon tax equal to the damage per ton of CO2 will lead to exactly the right balance between the cost of reducing emissions and the resulting benefits of less global warming.” William Pizer

• “Corrective taxes are superior to direct regulation of harmful externalities when the state's information about control costs is incomplete."

AEI, Climate Change: Caps vs. Taxes, 2007

What is the Behavioral Impact on Firms and Consumers?

Why the Changs?

Impact of Carbon Tax on Emissions and Revenue

Equity Implications

• Who gets hit hardest by Carbon Tax?

Reduction in Taxes

Double Dividend

• Mitigate economic costs of tax– Lower capital/corporate taxes– Lower payroll taxes, offset regressive effects– Invest in energy efficiency

Predictability

• No fluctuation in prices

Caveats

• India and China

• US can only impose a national system

• "no regrets" principle

Political Support for Cap and Trade