Price or Quantity Regulation?

Climate Change Policy

 Sept. 9 exam
Sept. 14, 16 No meetings. Scheduled make-up class. Most likely
reports
7 Groups
1. Renewable Energy Law: 30% RE Source
2. Conditional Cash Transfer 4Ps
3. Philippine Competition Commision and Telecom Duopoly
4. Public Transportation: MRT/ LRT
5. Health: Primary health care or specialized hospital?
6. Public Transportation: Uber and Taxi regulation
7. Move to Federalism
Exercise
GHG and global warming: Science (Stern,
2008)
First, people, through their consumption and production decisions, emit
GHGs.
Carbon dioxide accounts for around three-quarters of the human-generated global
warming effect
Second, these flows accumulate into stocks of GHGs in the atmosphere. It
is overall stocks of GHGs that matter, and not their place of origin.
The rate at which stock accumulation occurs depends on the "carbon cycle,"
including the earth's absorptive capabilities and other feedback effects.
Third, the stock of GHGs in the atmosphere traps heat and results in global
warming: how much depends on "climate sensitivity."
Fourth, the process of global warming results in climate change.
Fifth, climate change affects people, species, and plants in a variety of
complex ways, most notably via water in some shape or form: storms,
floods, droughts, sea-level rise.
Greenhouse Effect

Sun
 Earths Atmospheric Gases
Nitrogen (N2)
Non-
Greenhouse
Gases
Oxygen (O2)
99%

Water (H2O)

Greenhouse
Carbon Dioxide (CO2) Gases
1%
Methane (CH4)
 Carbon dioxide stays in the atmosphere for approximately 100 years, methane
lasts about 12 years. Other greenhouse gases last even longer.
Warming triggers more warming
As these gases continue to raise surface temperatures, they trigger the release of
even greater quantities of carbon dioxide and GHG, further increasing
temperatures.
A feedback mechanism ensues
How to evaluate effect of GHG emissions and
global warming?
A lot of uncertainties
Involves time lag
Does not depend origin of emission
Difference from other externalities
Stern, Nicholas. "The Economics of Climate Change." American Economic
Review 98.2 (2008): 1-37. https://www.aeaweb.org/articles?id=10.1257/aer.98.2.1
(a) it is global in its origins and impacts;
(b) some of the effects are very long term and governed by a flow-stock process;
(c) there is a great deal of uncertainty in most steps of the scientific chain;
(d) the effects are potentially very large and many may be irreversible.

Thus, it follows that the economic analysis must place at its core:
(i) the economics of risk and uncertainty;
(ii) the links between economics and ethics (there are major potential policy trade-
offs both within and between generations)
-as well as notions of responsibilities and rights in relation to others and the
environment;
(iii) the role of international economic policy.
Choice of stabilization target and policy
Target has strong implications for the permissible flow of emissions,
and thus for emissions reductions targets
reduction targets shape the pricing and technology policies.
Price or quantity regulation?
A policy that tries to start with a price for marginal GHG damages has two
major problems:
(a) the price estimate is highly sensitive to ethical and structural assumptions on the
future;
(b) there is a risk of major losses from higher stocks than anticipated, since the damages
rise steeply with stocks and many are irreversible.
Stern target: aggregate GHG stabilization targets of below 550 parts
per million (ppm) carbon dioxide equivalent (C02e)
Estimated probabilities for
eventual temperature increases
(which take time to be
established) relative to
preindustrial times (around 1850),
were the world to stabilize at the
given concentration of GHGs in
the atmosphere measured in ppm
(particles per million) C02e

Under BAU (business as usual),

the annual increments to stocks
would average somewhere well
above 3ppm C02e, perhaps 4 or
more, over the next century.
likely to take us to around, or
well beyond, 750ppm C02e by
the end of the century.
Recorded average temperature in Manila for 2016 was at 28.5 which is 1.4 above normal.

Source: http://nyti.ms/1KYBr1c
Uncertainty Costs of Reduction: Tax vs QR Suppose regulator made an error and MC is actually higher?
Tax or QR?
($)
MC2
Cost
Pollution
Reduction DWL Tax DWL QR
MC1

P* t Impose tax t
SMB = MD

PMC
Q1=0 Q2 Q*
Max Pollution Reduction
Pollution Reduction Quantity
Max Pollution 0 Pollution
Uncertainty Costs of Reduction: Tax Suppose regulator made an error and MC is actually higher?
Tax or QR?
($)
MC2
Cost
Pollution Reduction
DWL Tax DWL QR
MC1

P* t Impose tax t
SMB = MD

PMC
Q1=0 Q2 Q*
Max Pollution Reduction
Pollution Reduction Quantity
Max Pollution 0 Pollution
 Kyoto 1997: 35 industrialized nations (but not US) agreed to
reduce their emissions of greenhouse gases to 5% below
(depends on country) 1990 levels by the year 2012
Industrialized countries are allowed to trade emissions rights
among themselves, as long as the total emissions goals are
6.4 billion metric tons
met [=quantity regulation with trading permits] CO2/yr
Developing countries are not in the treaty
Disagreement between rich and developing countries on who
should bear the cost of curbing greenhouse gas emissions
In the US, Obama has directed EPA to regulate CO2 emission
[carbon tax or cap-and-trade requires congress law]

The U.S. emits about 6.4 billion metric

tons of greenhouse gases annually, 25%
of the worlds total.
 EU Emissions Trading System (ETS)
cornerstone of EUs policy to combat
climate change; reduce industrial
greenhouse gas emissions cost-
effectively
first and biggest - international system
for trading greenhouse gas emission
allowances
EU ETS covers more than 11,000
power stations and industrial plants in
31 countries, as well as airlines.
A 'cap', or limit, is set on the total amount of certain
greenhouse gases
The cap is reduced over time so total emissions fall
In 2020, emissions from sectors covered by the EU
ETS will be 21% lower than in 2005. By 2030, the
Commission proposes, they would be 43% lower
Companies receive or buy emission
allowances which they can trade with one
another as needed
After each year a company must surrender enough
allowances to cover all its emissions (or face fine)
If a company reduces its emissions, it can keep the
spare allowances to cover its future needs or else sell
them to another company that is short of allowances.
Flexibility that trading brings ensures that emissions are
cut where it costs least to do so
Pollution abatement technology, cleaner technologies
Los Angeles Air Quality
Southern Californias RECLAIM market started in 1992
Tradeable permits issued to large polluters in L.A. in
proportion to emissions they produce at full capacity
Number of permits issued reduced by 8% per year 1992-
2003.
Large brokerage firms handle trades
Coasian Transaction costs? Commissions: 1-3.5 percent

L.A. air quality has improved drastically

Other Cap-and-trade markets
Acid Rain Sulfur oxide markets in Eastern US States
Water pollution in Wisconsin and Colorado
Fisheries in Australia and New Zealand
Tradable permits to own cars in Singapore
Number increases by 3% per year
New permits auctioned in Walrasian auction
Advantage of Cap-and-Trade
Decentralizes firms decisions about whether to install
abatement devices, change technologies, cut back
output, move away
MB same across firms but different MC
Marginal benefits from polluting are about the same across all
firms and equal to marginal costs of abatement.
Conditional on aggregate level of pollution
Air pollution:
Pigouvain tax or Coasian solution?
Pollution tax (Pigouvian tax)
Tax on per unit of pollution or per unit of production
Determine harm
Enforcement cost
Coasian solution
Who owns the air? Commons problem
Create property rights to air
Right to pollute
Right to clean air
Leads to bargaining create a market for a missing market
Allows flexibility
Private information on private costs and benefits
Achieved with a minimum of government regulation
Reduce politicians chances for corruption and bribery
Climate Change and CO2 Emissions
1) Industrialization has dramatically increased CO2 emissions
2) Atmospheric CO2 generates global warming
3) Atmospheric CO2 has long life (35% remains after 100
years)
- absent any carbon capture tech breakthrough
4) Great uncertainty in costs of global warming
- mitigation or amplifying feedback loops
5) Costs of global warming are decades/centuries away
- How should this be discounted?
How fast should we start reducing emissions?
Stern-Weitzman want a fast reduction
Nordhaus advocates a slower path
Exercises
A competitive rening industry releases one unit of waste into the atmosphere for each unit
of rened product. The inverse demand function for the rened product is Pd = 20Q, which
represents the marginal benet curve where Q is the quantity consumed when consumers pay
price Pd. The inverse supply curve for rening is Ps = 2 + Q, which represents the marginal
private cost curve when the industry produces Q units. The marginal damage is given by
MD = 0.5Q, which describes the cost of pollution when the industry releases Q units of waste.
a) Illustrate the market for the product with a supply/demand graph. Be sure to draw the
curves for demand, supply, marginal damage, and social marginal cost.
b) What are the equilibrium price and quantity for the rened product when there is no
correction for the externality?
c) How much of the chemical should the market supply at the social optimum? d) How large
is the deadweight loss from the externality?
d) Is it possible for the government to achieve the social optimum by imposing a per-unit fee
on emissions? If not, explain why it is not possible. If so, how large must the emission fee
be if the market is to produce the socially ecient amount of the rened product? Also,
draw the rms supply curve with the new emission fee on your graph.
 b) In equilibrium price and quantity when there is no correction for the
externality? Setting Pd = Ps results in Ppriv = 11 and Qpriv = 9.
c) Social optimum? We see that SMC = Ps + MD = 2 + Q + 0.5Q = 2 + 1.5Q
Setting Pd = SMC results in P = 12.8 and Q = 7.2.
d) deadweight loss from the externality?
DWL = (0.5)(Q)(P) = (0.5)(97.2)(15.511) = 4.05
e) Is it possible for the government to achieve the social optimum by
imposing a per-unit fee on emissions?
It is possible: a per-unit tax of $3.6 per unit of product will result in the
social optimum. This tax on the rm raises the cost of production by 3.6
per unit, which is a parallel shift upward of the supply curve. The new
market equilibrium is the same as the social equilibrium result.
Two power plants provide power to all of Manila: Mapayapa plant and Hagonoy plant. Both power
plants burn coal to produce electricity, and consequently produce smog as a by-product. The M power
plant could reduce its smog, but at a total cost:
2
( ) = 5
where indicates the total number of units of smog abated by M.
The H plant is slightly less efficient, and its total cost for cutting down on smog by is:
= 72 +10
The Manila government hires a team of environmentalists who calculate that the total benefit of smog
abatement to the city is 100( + ):
1. Calculate the socially optimal level of abatement for each power plant.
2. The government considers imposing a tax on power production.
a. What tax should it impose to reach the abatement amounts you calculated in part (1)?1
b. Write down each firms optimization problem under the tax, and show that each will privately
choose the socially optimal abatement amount.
3. Suppose that instead of taxation, the Cambridge government tries to regulate quantities. However,
the city of Cambridge cannot write a law for each firm, so it simply declares that all Cambridge power
plants must cut down on smog by xC 1 units each year. Show that this is not efficient with BOTH math
and intuition.
1. Calculate the socially optimal level of abatement for each power plant.
Clue: Social Welfare = Total Benefit - Total Cost
2
= 100( + ) (5 +72 + 10 )

= 0, =0

At the social optimum, marginal cost equates to marginal benefit
90
= 10, =
14
2. The Manila government considers imposing a tax on power production.
(a) What tax should it impose to reach the abatement amounts you calculated in part (1)?
The optimal tax would be the negative of the marginal benefit: = 100 per unit of "non-abatement", or alternatively a
subsidy of 100 for each unit abated.
(b) Write down each firms optimization problem under the tax, and show that each will privately choose the socially
optimal abatement amount.
Each firm, i = H;M, chooses to maximize max 100 ( ) since firm avoids paying tax of 100 per unit of
abatement but has to buy pollution abatement technology (also acts like a subsidy)
2
For M: Max 100 5 F
90
For H: Max 100 (72 +10 ) and = 10, = 14 which is the same levels as the one that maximizes SW in
number 1
3. Intuitively, this is inefficient because the marginal cost (MC) of abatement is different across the plants. The plants
would like to abate at different levels. Mathematically, the MC of abatement at H for one unit is = 14 1 + 10.
But, the MC of abatement at M is = 10. Therefore, if M abated a bit more and H a bit less, there could be more
abatement for less cost.
4. Suddenly, an economist is voted in as Mayor of Manila. She declares that Manila
power plants must cut down on smog by 5 units overall. Additionally, she declares
that firms will be able to competitively trade permits that will allow them NOT to
abate. One of the mayors old classmates from graduate school runs the M power
plant, so the Mayor grants Mapayapa plant 5 permits and Hagonoy 0 permits. As a
result, H is expected to abate by 5 units, and M (since it owns all the permits) is not
expected to abate at all.
(a) H will surely want to buy some of Ms permits. Explain intuitively (no math),
why this trade might happen.
(b) If the new mayor had divided the permits up differently, what outcomes would
have changed and what would have stayed the same?