Economics of the Environment

1. Economics of the Environment 1. The economics of pollution 2. Valuation of externalities 3. The optimal level of pollution 4. Methods of pollution control 5. EU & UK policy

2. Background • Pollution • chemical wastes - rivers • noise pollution • thermal pollution • carbon emissions - air • industrial use • road users • Table 1

3. Fig 1 The interaction between the economy & environment Consumption system Production system Environmental system Wastes Reclaimed materials

4. 1. The economics of pollution • Negative externality • spillover effect of consumption\ production • third party is effected - social costs • Price mechanism? • e.g. air is free • e.g. water - very low price • Over-consumption • consumers\business - private costs • society - social costs

5. Economics of pollution • Private costs  social costs • Policy objective • change consumers\business behaviour • pay full social costs • internalise the externality to reduce pollution • Policies • standards, taxes, permits • … valuation of a negative externality

6. 2. Valuation: A case study • Road traffic congestion • Road use increased dramatically • private (…and freight) • Policy - how to ration a scarce resource? • Road use generates several externalities • e.g. Global warming, e.g. Air pollution • e.g.Congestion • How big are these social costs?

7. Valuation methods • 1. Direct Approaches • Contingent valuation methods • questionnaire & survey • WTP or WTAC • value of externality = mean WTP or WTAC • 2. Indirect Methods • e.g. Hedonic pricing model e.g. house prices, lifetime wages • e.g.Total economic value = use value + option value + existence value

8. Valuation of road transport externalities, 1993 • Externality & cost (£billions) • Global warming = 0.1 • Air pollution = 19.7 • Noise = 2.6-3.1 • Road damage = 1.5 • Accidents = 2.9-9.4 • Congestion = 19.1 • TOTAL = 45.9-52.9 • Revenue from road use = £16.4b

9. Policies to correct road transport externalites • Marginal road user pays about a third of true cost of a journey • Government intervention • build more roads - no! • improve public transport - yes • tax - yes • road pricing - yes • Taxes & pricing depend crucially on value of externalities

10. 3. The optimal level of pollution • How much pollution should Government tolerate? • Not zero pollution. Why? • …because pollution increases with output • …growth of output increases welfare

11. 3. The optimal level of pollution • Quantity of pollution is positively related to output • Social costs increase with output • But, the costs of clean-up rise as pollution falls • What is the socially optimal level of pollution? • See Figure 2

12. Fig 2: The optimal level of pollution Costs of pollution Social costs More untreated waste, the higher the social cost If pollution= 0, output would fall. Welfare? C2 C1 0 Q1 Q2 Quantity of pollution

13. Fig 2: The optimal level of pollution Costs of pollution control Costs of pollution control at each level of discharge B C2 Costs of clean-up rise A C1 0 Q2 Q1 Quantity of pollution

14. Fig 2: The optimal level of pollution Costs Social costs Assume that industry output is fixed Y X Pollution control costs 0 R Quantity of pollution

15. The optimal level of pollution • Thinking marginally, optimality is • “…the cost of an extra unit of pollution is just equal to the cost of reducing pollution by an extra unit.” • Point ‘R’ on figure 2 • pollution is not zero! • How can Government achieve this?

16. 4. Methods of pollution control • No incentive for business & consumers • Government should correct the market failure • Methods • (a) standards & regulations • (b) Pollution tax • (c) Tradeable permits

17. 4. Methods of pollution control • (a) Standards & regulations • Traditional approach • Set emissions target • if targets are too strict - point X • if targets are too lenient - point Y • correct targets - point R • Penalties if business is caught in violation of target

18. (a) Standards & regulations • Disadvantages • (i) Costly • (ii) Information requirements • (iii) Vague & imprecise • (iv) If fines are low, no incentive to comply • (v) Conflict of standards • Advantages • (i) If all businesses comply - very effective • (ii) No alternative in some cases

19. (b) Pollution tax • E.g. fuel tax, effluent taxes • Tax is a fee consumers\producers pay • Control via price • Tax per unit of output • Cleaner production process - lower tax • See Figure 3

20. Fig 3: The pollution tax MSC Costs, Revenue MPC + tax S = MPC Pr Pp Pt D = MSB Qr Qp Output R Y Quantity of pollution

21. (b) Pollution taxes • Advantages • (i) Cheaper than standards • reduce discharge: clean-up cost = pollution tax • (ii) Less information required • meters & charges • (iii) Polluter Pays Principle • price environmental services • sustainable development

22. Advantages • (iv) Raises revenue • (v) Widespread compliance • (vi) Market-based approach • (vii) Producer & consumer share the cost • Disadvantages • (i) Valuation? Tax rate? • (ii) Absence of market failure e.g. monopoly • (iii) Assumes Government knows the firms costs

23. (c) Transferable pollution permits • Second-hand market in pollution • Regulator sets pollution target • Issue pollution permit • license to pollute to a certain level • e.g. emissions • Firms buy & sell permits • Firms have a choice • incur the cost of clean-up • buy a permit & continue polluting

24. (c) Permits • High clean-up costs - buy permits • Outcome • Some pollution is allowed • Remaining pollution is cleaned up at low cost • Control pollution - quantity

25. (c) Permits • Advantages • (I) Market-based approach • (ii) Low cost • (iii) Flexible - regular can buy permits • Disadvantages • (I) Valuation? Number of permits • (ii) Initial allocation is important

26. 5. EU & UK policy • Traditional approach - set standards • EU sets standards on • quality of water - bathing, drinking, emissions • waste management - sewage, toxic substances • atmospheric pollution - agreed to reduce CO2 emissions by 2012 (8%)

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

28. 5. EU policy • How will this be achieved? • ‘…markets [will] be harnessed to generate the most efficient method of achieving desired pollution reuctions.’ • Government set targets • Taxes & permits used to find the best method