Rethinking the optimal level of environmental quality: justifications for strict environmental policy

Traditional environmental theory suggests that the optimal level of a pollution emission occurs when the marginal damage created by the emissions is equal to the marginal cost of reducing the emissions. We argue that the benefits from reducing pollution should be much more broadly defined to include at least three other sources of benefits. First, we develop a game-theoretic model in which firms may under-invest in cost-saving ‘green technologies’. Second, we demonstrate that consideration of future damages and abatement costs leads to a lower current optimal pollution level than that obtained in traditional models. Finally, we show that ecological complexity creates indirect pathways by which greater pollution increases the likelihood of generating irreversible environmental damage. This broader definition of the benefits of pollution abatement yields an optimal level of pollution that may actually be less than the level at which conventionally-measured marginal damages are equal to marginal abatement costs. Thus, environmental policy should be stricter.     

Environmental taxation,information precision,and information sharing

We analyze how environmental taxes should be optimally levied in a sequential game in which regulators and firms face costs uncertainties. First, the regulator chooses the intensity of emissions taxes to reduce externalities. Then, facing common and private information with noisy signals, firms compete in the marketplace and choose outputs. We show that, under nonuniform quality of signals across firms, the regulator may calibrate differentiated tax policy. We also show that the social impact of more precise private signals hinges largely and fundamentally on the value of the ratio of the slopes of the marginal damage and the marginal consumer surplus. Finally, we investigate information sharing between polluters and its impacts on welfare. We stress that, when there are threats of severe environmental damages under deep uncertainties, collusion is welfare reducing and may jeopardize the regulatory process. Regulators need to set an appropriate precautionary policy. Numerical simulations illustrate the results that the model delivers.     

Uncertainty,Learning and International Environmental Policy Coordination

In this paper we construct a simple model of global warming which captures a number of key features of the global warming problem: (i) environmental damages are related to the stock of greenhouse gases in the atmosphere; (ii) the global commons nature of the problem means that these are strategic interactions between the emissions policies of the governments of individual nation states; (iii) there is uncertainty about the extent of the future damages that will be incurred by each country from any given level of concentration of greenhouse gases but there is the possibility that at a future date better information about the true extent of environmental damages may become available; an important aspect of the problem is the extent to which damages in different countries may be correlated. In the first part of the paper we consider a simple model with two symmetric countries and show that the value of perfect information is an increasing function of the correlation between damages in the two countries in both the cooperative and non-cooperative equilibria. However, while the value of perfect information is always non-negative in the cooperative equilibrium, in the non-cooperative equilibrium there is a critical value of the correlation coefficient below which the value of perfect information will be negative. In the second part of the paper we construct an empirical model of global warming distinguishing between OECD and non-OECD countries and show that in the non-cooperative equilibrium the value of perfect information for OECD countries is negative when the correlation coefficient between environmental damages for OECD and non-OECD countries is negative. The implications of these results for international agreements are discussed.     

Economic criteria for using wetlands as nitrogen sinks under uncertainty

If the environmental damages that are caused by excessive nitrogen load to the sea depend on the timing of emissions, then monitoring the stochastic variation of emissions is crucial for controlling eutrophication damages. A significant problem of nonpoint source (NPS) nitrogen pollution is that emissions are stochastic and difficult to control. The main purpose of this paper is to examine under what criteria wetlands are economically rational to use for controlling stochastic NPS pollution. Three criteria are identified using a simplified stochastic watershed model. It is suggested that wetlands are economically rational to use, especially when monitoring the uncertainty of emissions is a part of the decision problem. The theoretical findings are illustrated with an example from southwestern Sweden.     

The regulatory choice of noncompliance in emissions trading programs

This paper addresses the following question: To achieve a fixed aggregate emissions target cost-effectively, should emissions trading programs be designed and implemented to achieve full compliance, or does allowing a certain amount of noncompliance reduce the costs of reaching the emissions target? The total costs of achieving the target consist of aggregate abatement costs, monitoring costs, and the expected costs of collecting penalties from noncompliant firms. Under common assumptions, I show that allowing noncompliance is cost-effective only if violations are enforced with an increasing marginal penalty. However, one can design a policy that induces full compliance with a constant marginal penalty that meets the aggregate emissions target with lower expected costs. This last result does not depend on setting an arbitrarily high constant marginal penalty. In fact, the marginal penalty need not be higher than the equilibrium marginal penalty under the policy with the increasing marginal penalty, and can actually be lower. Finally, tying the marginal penalty directly to the permit price allows the policy objective to be achieved without any knowledge of firms’ abatement costs.     

Structural Uncertainty and Pollution Control: Optimal Stringency with Unknown Pollution Sources

We relax the common assumption that regulators know the structural relationship between emissions and ambient air quality with certainty. We find that uncertainty over this relationship can manifest as a unique form of multiplicative uncertainty in the marginal damages from emissions. We show how the optimal stringency of environmental regulation depends on this structural uncertainty. We also show how new information, like the discovery of previously unknown emission sources, can counterintuitively lead to increases in both optimal emissions and ambient pollution levels.     

Efficient Environmental Policy with Imperfect Compliance

Discussions of efficient environmental policytend to recommend taxes rather than quotas ongrounds of efficiency; a uniform tax willequalize marginal abatement cost betweenpolluters. When polluters' actions are imperfectly observable, the distinction betweentaxes and quotas becomes less clear. Taxes maybe evaded by underreporting of emissions, whilequota violations will not always be discovered.This paper explores the conditions under whichthe efficiency properties of taxes continue tohold even when evasion is possible, and theextent to which the fine for quota violationsplays the same role as a tax on emissions withsimilar efficiency properties.     

The Welfare Effects of Allowance Banking in Emissions Trading Programs

Permitting allowance banking in emissions trading programs can reduce expected compliance costs by giving capped firms flexibility to adjust the time path of abatement and to hedge against future uncertainty. Recent literature suggests that this compliance cost dividend is significant (Fell and Morgenstern Environ Resour Econ 47:275–297, 2010). Allowance banking may yield an environmental dividend (a) if the growth rate of marginal damages from emissions is less than the discount rate and (b) if emissions are lower in the short run as firms bank permits for use in later periods. A discrete, stochastic dynamic programming model is considered to simulate the two dividends of allowance banking in the context of the most recent Federal United States greenhouse gas cap-and-trade legislation. Simulation results show that under a range of parameter values, the environmental dividend has the same order of magnitude as the compliance cost dividend. Under the central set of parameters, allowance banking increases expected present value of benefits by about $350$ million dollars per year of the program. The environmental dividend, however, is completely eliminated if capped firms can borrow permits from future periods without limit.     

The Timing of Environmental Policy: A Note on the Role of Product Differentiation

We examine the role that product differentiation can play in the design of environmental policy under full commitment and no commitment on the part of the environmental regulator. We consider a setting with two firms selling a differentiated product which generates pollution through emissions. Firms can reduce their emissions by undertaking abatement activities while an environmental regulator taxes emissions. The main results are: (1) When products are highly differentiated, the optimal time-consistent (no commitment) tax is always lower than the optimal pre-commitment tax. As the degree of product differentiation decreases, for relatively efficient abatement technology and high damages, the time-consistent emission tax exceeds the optimal pre-commitment one. (2) Abatement when product differentiation is extensive is higher under the time-consistent regime unless the abatement technology is extremely efficient. The same ranking applies to social welfare. However, as products become more and more similar, these results are (partially) reversed and pre-commitment could lead to both higher levels of abatement and welfare.     

Tradable permit allocations and sequential choice

This paper investigates initial allocation choices in an international tradable pollution permit market. For two sovereign governments, we compare allocation choices that are either simultaneously or sequentially announced. We show sequential allocation announcements result in higher (lower) aggregate emissions when announcements are strategic substitutes (complements). Whether allocation announcements are strategic substitutes or complements depends on the relationship between the follower’s damage function and governments’ abatement costs. When the marginal damage function is relatively steep (flat), allocation announcements are strategic substitutes (complements). For quadratic abatement costs and damages, sequential announcements provide a higher level of aggregate emissions.     

Can Trade Be Good for the Environment?

We analyze the impact of trade in a differentiated good on environmental policy when there is local and transboundary pollution. In autarky, the (equivalent) pollution tax is set equal to the marginal damage from own emissions. If the strategic policy instrument is a tax, leakage occurs under trade and tends to lower the tax. The net terms of trade effect, due to the exportable and importable varieties of the differentiated good, tends to increase the tax. We derive conditions under which pollution taxes under trade are higher than the marginal damage from own emissions, i.e., higher than the Pigouvian tax and than that under autarky. Then, pollution falls under trade relative to autarky. When countries use quotas/permits to regulate pollution, there is no leakage, while the net terms of trade effect tends to make pollution policy stricter. The equivalent tax is always higher than the marginal damage from own emissions, i.e., always higher than the Pigouvian tax and than that under autarky; hence, pollution always falls under trade. Our analysis provides some insight into the findings in the empirical literature that trade might be good for the environment.     

Health effects and optimal environmental taxes

The literature on environmental taxation in the presence of pre-existing distortionary taxes has shown that interactions with these distortions tend to raise the cost of an environmental tax, and thus that the optimal environmental tax is less than marginal environmental damages. A recent paper by Schwartz and Repetto (2000) challenges this finding, arguing that the health benefits from reduced pollution will also interact with pre-existing taxes, and may cause the optimal environmental tax to exceed marginal damages.Schwartz and Repetto’s analysis represented health effects implicitly in the utility function. In contrast, the present paper explicitly represents health effects in an analytically tractable general equilibrium model. This model shows that interactions with health effects from pollution actually will tend to reduce the optimal environmental tax, contradicting, Schwartz and Repetto’s conclusion. This demonstrates the usefulness of explicitly modeling health effects, and it reinforces the general notion that tax-interactions tend to raise the costs of an environmental tax.     

How Effective are Emissions Taxes in an Open Economy?

This paper compares emissions taxes with other taxes from the viewpoint of emissions reduction in an open economy. Using a simple monopoly model, we show that emissions taxes may not be very effective to protect the environment because of the spillover effects between markets stemming from non‐constant marginal costs and transboundary externalities. Other taxes such as production taxes and tariffs are more effective under certain conditions. Thus, an easy application of emissions taxes should be discreet in the open economy framework.     

Mixed Oligopoly and Environmental Policy

We show in this paper that when there are both public and private firms in product markets (a mixed oligopoly) the decision whether to privatize a public firm interacts with the environmental policy of governments. Therefore, the outcome of the decision whether to privatize a public firm may be different if the government internalizes the environmental damage than if the government ignores it. When the government sets a tax to protect the environment, the tax is lower in the mixed oligopoly than in the private one even though the environmental damage is greater. In the mixed oligopoly the marginal cost of the public firm is lower than the market price.     

Environmental participation in the U.S. sulfur allowance auctions

The 1990 Clean Air Act established a sulfur emissions-trading program among utilities. This was the first large scale adoption of this type of emissions-trading program and the program’s success has attracted international attention. An interesting aspect of this program is that in addition to trades among the polluting firms and brokers or investors, individuals and groups have been participants, buying allowances to retire them and reduce sulfur emissions. This provides a relatively unique way to examine the “willingness to pay” for further reductions of sulfur emissions. I examine environmental participation in the sulfur allowances market, focusing on the Environmental Protection Agency (EPA) allowance auctions which have been conducted annually since 1993. The existence of groups purchasing these allowances in order to retire them suggests that the overall cap on sulfur emissions may be higher than the optimal emissions level. The marginal benefits from the first ton of emissions reduction appear to be significantly larger than marginal abatement costs. Total spending to retire sulfur emissions allowances, while small in relation to the total market, is sizeable in terms of the alternate purchases these groups and individuals could have made.      

Regulation of Performance Standards versus Equipment Specification with Asymmetric Information

Economists have greatly criticized regulations that impose uniform environmental standards. Such a critic ignores that the implementation of the standards may vary significantly across plants, thus giving rise in fact to non-uniform standards. The purpose of this paper is to analyze the determinants of the regulator's monitoring activities. We show that greater inspection effort, ceteris paribus, is allocated towards those plants whose emissions are likely to generate a higher level of damages. On the other hand, we show that the behavior of the regulator is also a function of variables that may not be directly related to abatement cost and damages. In particular, we show that variables pertaining to local labor market conditions have an impact on the monitoring strategy adopted by the regulator.     

A Tradable Permit System in an Intertemporal Economy

It is known that in an intertemporal competitive economy, a tradable permit system may not achieve efficiency without setting appropriate permit interest rates (i.e., rewards for holding permits). To find the rates, however, we need to know in advance the path of efficient permit prices, which is difficult to obtain. This study intends to solve this problem in two ways. First, we analyze a special case in which the permit interest rates are given by a simple rule. For example, if the marginal abatement cost of pollution emission is constant, then the appropriate rate is to equal the monetary interest rate. As is the case for global warming, if the damage is caused in the future far beyond the planning period of the environmental program, the appropriate rate coincides with the marginal self-recovery of environmental stock under certain conditions. As a second approach, we propose a tradable permit system with a permit bank, as a mechanism by which the permit interest rates are generated endogenously without governmental intervention other than the issuance of permits. However, we also show that this approach raises the problem of indeterminacy of the equilibrium.     

Who should bear the administrative costs of an emissions tax?

All environmental policies involve costs of implementation and management that are distinct from pollution sources’ abatement costs. In practice, regulators and sources usually share these administrative costs. We examine theoretically an optimal policy consisting of an emissions tax and the distribution of administrative costs between the government and regulated sources of pollution. Our focus is on the optimal distribution of administrative costs between polluters and the government and the optimal level of the emissions tax in relation to marginal pollution damage. We demonstrate how the policy variables affect aggregate equilibrium administrative costs and show that these effects are generally indeterminate, as is the effect of the distribution of administrative costs on aggregate emissions. Consequently, the optimal sharing of administrative costs and whether the optimal emissions tax is higher or lower than marginal damage depend on specific contexts.     

Alternative standards and instruments for air pollution control in Poland

Like other Central European countries, Poland faces the twin challenges of improving environmental quality while also fostering sustainable economic development. In this study we examine the costs of different standards for air pollution control, and the cost savings from using incentive-based policy instruments in lieu of more rigid command-and-control policies. The comparisons are based on the results of a simulation model of energy use and air pollution control for the Polish economy over 1990–2015. The model simulates least-cost energy supply decisions under different environmental policy assumptions, the corresponding emissions, and the cost of achieving the specified policy objectives. The model results suggest that incentive-based policies will have efficiency gains over command policies that are at least worthy of consideration and may be quite substantial. The size of the gains in practice depends in part on how much flexibility is built into the command approach, e.g., capacity for intrafirm trading as well as alack of technology-specific requirements. To achieve these gains, an increase in the current levels of emissions fees is desirable both to strengthen abatement incentives and to improve the capacity of the Polish government to overcome past environmental damages. However, it seems highly unlikely in practice that fees could be raised to the levels necessary to meet current Polish emissions standards. To make further headway, an evolutionary approach to emissions trading patterned after (and profiting from the experience with) emissions trading in the U.S. seems useful. The program could start out relatively modestly and increase in ambitiousness as the Polish economic transition proceeds.     

Optimal Emission Policy under the Risk of Irreversible Pollution

We consider an optimal consumption and pollution problem that has two important features. Environmental damages due to economic activities may be irreversible and the level at which the degradation becomes irreversible is unknown. Particular attention is paid to the situation where agents are relatively impatient and/or do not care a lot about the environment and/or Nature regenerates at low rate. We show that the optimal policy of the uncertain problem drives the economy in the long run toward a steady state while, when ignoring irreversibility, the economy follows a balanced growth path accompanied by a perpetual decrease in environmental quality and consumption, both asymptotically converging toward zero. Therefore, accounting for the risk of irreversibility induces more conservative decisions regarding consumption and polluting emissions. In general, however, we cannot rule out situations where the economy will optimally follow an irreversible path and consequently will also be left, in the long run, with an irreversibly degraded environment.