TK7 Policy Instruments for Pollution Control (III)

Question 1

Tradable Permits (Cap and Trade)

Answer 1

• Regulator issues emission permits (allowances).
• Each permit entitles one unit of pollution emissions (ex. 1 ton of
  CO2).
• Number of all permits in the economy = ‘cap’
• Each firm obtains an initial allocation of tradable permit though
  grandfathering or auctioning.
• Each firm’s initial allocation adds up to the aggregate ‘cap’.

Question 2

Permit Market

Answer 2

• Permits are tradable in a permit market.
• If a firm wants to emit more than its initial allocation, buy permits in the
  market.
• If a firm chooses to emit less than its initial allocation, can sell permits in
  the market

Question 3

Tradable Permits – Important Observations

Answer 3

• The regulator can achieve the aggregate emissions target with certainty, assuming full compliance.
• A competitive permit market achieves the target cost-effectively.
• The regulator doesn’t need to know firms’ marginal abatement cost (MAC) curves for cost-effective allocation.
• Cost-effective allocation is independent of the initial permit distribution (per Coase Theorem).
• Initial permit allocation represents a valuable asset for firms.

Question 4

Liabillity Defined

Answer 4

The regulator makes potential polluters responsible for any consequences but does not dictate actions, incentivising them to internalise risks and take socially optimal precautions

Question 5

Liabillity Example

Answer 5

hazardous waste storage facility, offshore oil drilling rig

Question 6

Liabillity Graph

Answer 6

Question 7

effect of Liability

Answer 7

• The potential polluter wants to minimise the total social costs
  because of liability
• Liability makes the society’s objective agree with the polluter’s objective. That is, external costs are internalised
• Total social costs: TD(x) + TC(x)
• TD(x) is Total expected damages
• (x) is precaution
• TC(x) is total cost of production

Question 8

Price-based regulations

Answer 8

• tax on emissions (or subsidy on abatement)

Question 9

quantity-based regulations

Answer 9

• cap and trade

Question 10

Price vs Quantity under certainty

Answer 10

• Price- and quantity-based regulations yield the same abatement levels if MAC and MB curves are certain
• both individual and aggregate

Question 11

Price vs Quantity under certainty

Answer 11

• Price- and quantity-based regulations differ when uncertainty exists on the location of the MAC
  curve.

Question 12

Proposition (Weitzman) marginal benefits are more steeply curved

Answer 12

• quantity regulations are preferred if marginal benefits are more steeply sloped than marginal abatement costs

Question 13

Proposition (Weitzman) marginal abatement cost curve is steep

Answer 13

• if the marginal abatement cost curve is steep then a price instrument like an emission tax is preferable

Question 14

When should a quantity-based or price-based instrument be preferred in environmental policy under uncertainty?

Answer 14

• A steep marginal benefit curve implies a threshold effect, meaning small changes in emissions cause large changes in damage.
• For health-related regulations (e.g. local air pollutants), a quantity-based approach (e.g. cap-and-trade) is preferred.
• For global pollutants like carbon emissions, where marginal damages are smoother, a price-based approach (e.g. emission tax) is preferred for social efficiency.

Question 15

Advantages of Economic Incentives over
Command and Control

Answer 15

• The equi-marginal principle automatically holds through
  polluters’ individual decisions. As a result, the overall environmental goal is achieved at the lowest possible total cost to society
• Information requirements are less significant.
• Provide an incentive for a polluter to innovate and/or find cheaper
  ways of controlling pollution.

Question 16

Disadvantages of Economic Incentives over
Command and Control

Answer 16

• Difficult to design economic incentives that can accommodate the
  complexities of environmental transformation without being too
  complex and impractical.
• Ex. Urban air pollution: damage from a unit of emissions can vary in both
  space and time.
• On emission taxes: it is politically difficult to introduce an emission
  tax as it involves massive transfers from polluters to the regulator.
• Cap and trade may be able to avoid this difficulty as permits can be
  initially given away freely to the polluter.

Question 17

Pollution hot spots

Answer 17

• Pollution hot spots occur when the uniform mixing assumption fails, meaning pollutants do not disperse evenly.
• In such cases, emissions cause more harm in some locations than others.
• Simple emission taxes or cap-and-trade systems can lead to hot spots.
• This happens when firms in high-damage areas also face high abatement costs and opt to pollute more

Question 18

how to address Pollution hot spots

Answer 18

• Using command-and-control regulations that directly restrict emissions in vulnerable areas.
• Adjusting market-based tools by setting location-specific tax rates, differentiated permit prices, or applying trade ratios that make it more expensive for firms in sensitive regions to emit.