Sulfur I. Dioxide (SO2) Permits and the 1990 Clean Air Act
Background:
o Acid rain is caused mainly by sulfur dioxide (SO2) and nitrogen oxides (NOx).
o Comes from burning of fossil fuels.
o Impact of acid rain:
Kills aquatic life (e.g. dead lakes and ponds in Northeast).
Hurts forests, especially at higher elevations.
Detrimental health effects to humans.
Clean Air Act of 1990
o Before the 1990 CAA, SO2 and NOx were only regulated as local pollutants.
o Therefore, utilities could meet regulations by building tall smokestacks that
carried pollution away.
o Moreover, command and control regulation required new plants use best available
scrubber technology
As a result, firms had incentives to extend lives of units.
By 1985, 83% of SO2 emissions came from plants that didnt meet 1971
standards for new units.
Heterogeneity among plants made a market solution useful.
o The 1990 CAA established a permit market for sulfur dioxide (SO2).
Goal by 2000:
Reduce SO2 emissions by 10 million tons.
How the market was implemented.
o Plants given permits (1 ton SO2 per permit) based on current emissions.
Phase I (1995-1999): starts with dirtiest 263 units.
8.7 million tons of permits were allocated in 1995.
By 1999, this was reduced to 6.9 million tons.
Phase II (2000): tightens limits and includes more firms.
o 2.8% not allocated held back and auctioned off to stimulate market activity.
o Firms can make investments to reduce emissions, sell excess permits, or buy
permits to emit more.
o Permits can be banked.
o $2,600 per ton fine for exceeding permits.
The fine is indexed for inflation.
What has happened?
o Projected price of permits: $250-$350 for phase I, $500 - $750 for phase II
Actual price around $100-150 in phase I (see
http://www.epa.gov/airmarkets/progress/alprices.html for details)
o Prices in phase II briefly exceeded $1000. They have typically been in the $300$500 range.
(data available under Quick Facts and Trends at this link)
The 2009 spot auction price was very low ($62/ton), presumably because
of the weak economy.
The 2008 spot auction price was $380.
Estimated cost savings over command and control regulation: $1 billion per year!
o This is a cost savings of 25-34%.
o Firms have learned about the market, resulting in more efficient trading.
When permits first sold in 1993, there was a 10-20% difference between
the top bids and the average bids.
By 1997, there was just a 3.4% difference.
Why have costs fallen?
o Flexible standards made using clean coal, rather than a scrubber, a viable option.
At the same time, deregulation of railroads made cleaner coal cheaper
o Technological innovation.
II. The Political Economy of Tradable Pollution Permits
Although we have shown that market-based environmental policies are more efficient
than command and control (CAC) regulations, the U.S. has historically used command
and control (CAC) policies instead.
Why have CAC policies been favored?
o Environmental groups prefer CAC because:
Firms shouldn't be able to buy the right to pollute.
With CAC, the final amount of pollution is known with certainty.
As a result of this, when market-based policies are used, it is
usually permits that are favored, as they also regulate the final
amount with certainty.
Market-based policies may lead to localized "hot spots."
o Firms prefer CAC because:
Fees require firms to pay both abatement costs and the tax.
This is also why, when market-based policies are used, the policy
is usually permits that are given freely to firms.
CAC may provide a barrier to entry.
CAC treats all firms the same. This may be seen as a fairer option.
o Politicians prefer CAC because:
Many are trained as lawyers.
CAC regulations are more symbolic.
The costs of CAC are less obvious.
Why permits were successful in the case of acid rain?
o Utilities have varying MAC. Thus, beneficial trades are possible.
o The emissions disperse easily, so hot spots are not a problem (although the state
of NY would disagree!).
o Transactions costs are low, so trading is easy.
o Monitoring is straightforward, and enforcement is strong enough to ensure
compliance.
o They were politically feasible because they lowered the total level of pollution.
III. Uncertainty in Environmental Economics
Uncertainty is a problem for all policy decisions.
o dealt Often with using expected values.
Given this, what makes uncertainty different for environmental problems?
o Uncertainty for environmental problems is highly non-linear
Damages may be barely noticeable for low levels, but become severe
above some uncertain threshold, or tipping point.
For policy, this is important because we dont want to go beyond
the tipping point.
However, the tipping point itself is often uncertain.
Uncertainties may interact. For example, the benefits of climate change
reductions depend on:
Expected GHG levels without abatement (BAU)
How rapidly CHG concentrations grow in response to emissions
Effect of concentrations on temperatures
Economic impact of higher temperatures
Similarly, cost of abatement may be low for low levels of abatement, but
be very high for total abatement (e.g. climate change)
While these may be well-known for some pollutants (e.g. SO2,
NOX), for others, costs are uncertain
For climate change, the level of tax needed to meet an emissions
target depends on how responsive energy use is to prices.
There are decent estimates for short-run.
However, for the long-run, this is more challenging.
Our ability to substitute in the long-run depends on
how well alternative energy sources substitute for
fossil fuels.
This is highly dependent on technological change.
It may be that large reductions are very costly.
o Irreversibilities
Two types of irreversibilites:
Environmental damage often irreversible.
Cant undo cutting down a virgin forest or extinction.
Takes many years to remove carbon emissions
Thus, adopting a policy now has a sunk benefit (e.g. a
negative opportunity cost)
Suggests traditional cost-benefit analysis biased
against policy adoption.
Abatement efforts involve sunk costs
Often in the form of capital expenditures
However, may just be lost expenditures
Thus, there is an pportunity cost to adopting a
policy now, rather than waiting for more
information
Long time horizons
Makes results very sensitive to the choice of discount rate.
We will discuss this in the cost-benefit section of the course.
Policy implications (we'll discuss these more next Monday)
o Policy timing
Should we wait until we learn more, or should we act quickly?
When do irreversibilities matter?
Only if there is uncertainty. If we know with certainty how future
generations will value the changes, we can incorporate that into
our cost-benefit analysis.
Only affects current decisions if it would constrain future choices
under plausible conditions.
E.g. if, in the future, we would want negative carbon
emissions to reverse climate change, we might emit less
today, since negative emissions in the future are impossible.
One key here is long-lived effects
In a good news scenario, we can roll back policy
However, in a bad news scenario, we cannot correct the
situation.
Policy intensity
o Choice depends not just on expected values, but on variance
o That is, on the shape of the curves (what Pindyck calls convexity)
Choice of policy instrument
The Role of Uncertainty: Choice of Policy Instruments
The diagrams drawn in class were intended to show how the regulated level of emissions
varies from the optimal level of emissions when taxes or command and control
regulations are used and the marginal abatement costs (MAC) are uncertain. You may
download a copy of the handout by clicking here.
The key points were:
o When the MDF is uncertain, both command and control and taxes result in the
same errors.
Thus, policy makers have to decide how to deal with uncertainty (e.g. base
policy on expected values, try to avoid the worst outcome, etc.), but the
results will not depend on the policy chosen.
o When MAC are uncertain, policy matters:
With regulation, the regulated level of emissions is too high if MAC are
higher than expected (the regulation is too strong), and too low if MAC
are lower than expected (the regulation is too weak).
With fees, the resulting level of emissions is too low if MAC are higher
than expected (because the tax is too low), and too high if MAC are lower
than expected (the tax is too high).
o
IV.
This works in the opposite direction, suggesting that
traditional cost-benefit analysis biased for policy
adoption.
We will continue with this analysis on Wednesday.