ECONS3013
Environmental Economics
Lecture 4: Regulation
Dr Kelly Neill
School of Economics
University of Sydney
22 August 2022
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Overview
Question:
How do we achieve the ‘right’ balance between environmental
protection and use?
1. Regulation
2. Equimarginal Principle
3. Cost Benefit Analysis
4. Discount factors
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Housekeeping
Reading
• Kolstad Chapters 6, 11, 4(Part C), Box p80
Assessments
• Quiz 2 due at the end if this week
• Multiple choice and short answer
• Question 4 requires handwritten response to be uploaded
• 35 minutes duration from when you start, includes upload time
• Content from lectures 3 and 4, and tutorial 2 and 3
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Regulation
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Rationale for regulation
Environmental regulation involves the government intervening in the
private actions of firms and individuals.
Two basic theories of regulation
• Public interest theory
• Interest group theory
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Rationale for regulation
Public interest theory
Views the purpose of regulation as the promotion of public interest.
That is, the government should intervene in cases when markets fail
to deliver the optimal outcome.
General reasons for regulation to exist
• Imperfect competition
• Imperfect information
• Externalities or lack of property rights
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Rationale for regulation
Interest group theory
Views the purpose of regulation as the promotion of the narrow
interests of particular groups in society.
Maintains that rent seeking is the primary driver of regulation.
Rent seeking:
• when individuals or firms spend money to promote regulations
that are beneficial to them
• private individuals use the government to guarantee extra
benefits (rents) through government-mandated restrictions on
economic activity
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Regulatory instruments
Most environmental regulations fall into two broad categories.
Prescriptive regulations
• government prescribes to consumers and firms what to do
• “command and control” regulations
Economic incentive-based regulations
• provide incentives for polluters to do what is perceived to be in
the public interest
• rely on market forces
• first need to correct prices or lack of property rights
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Types of prescriptive regulations
(1) Technology standards
• typically specify particular type of equipment that must be used
Examples:
• requirement for smokestack
scrubbers
• bans on certain pesticides
• Renewable Energy Target
(RET)
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Types of prescriptive regulations
(2) Performance standards
• typically stipulate the maximum emissions allowed per unit of
activity
• can have greater cost-effectiveness compared to technology
standard due to greater ability of firms to innovate
Examples:
• CAFE standards in the US
(how far vehicles must travel
on a gallon of fuel)
• Top-Runner efficiency
program in Japan
• Energy ratings for new homes
in some Australian states
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Types of prescriptive regulations
(3) Direct provision
• the government could provide the service
Examples:
• national parks
• Snowy 2.0
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Prescriptive regulations
Advantages:
• greater certainty in how much
pollution results from
regulations
• compliance is easier to
achieve due to simplified
monitoring
Disadvantages:
• administration can be costly
• firms have reduced incentives
to find better (cheaper) ways
to control pollution
• does not account for damage
from pollution that remains
• difficult to satisfy
equimarginal principle
• rebound effect from efficiency
standards
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Types of incentive-based regulations
(1) Pollution fees
• involve payment of a charge per unit of pollution emitted
Countries where a carbon tax is implemented.
Source: World Bank
Examples:
• Carbon taxes
• Subsidies for renewable
electricity generation
• Cigarette tax
• Fuel excise
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Types of incentive-based regulations
(2) Marketable Permits
• allow polluters to buy and sell the right to pollute.
Murray Darling Basin regions.
Source: MDBA
Examples:
• Greenhouse gas emissions
trading scheme in Europe
• Murray Darling Basin Scheme
• Sulphur dioxide cap and
trade, part of Acid Rain
Program
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Types of incentive-based regulations
(3) Liability
• if you harm someone, you must compensate that person for
damage.
Clean up of Exxon Valdez oil spil.
Source: MDBA
Examples:
• Third party liability insurance
for car accidents
• Exxon Valdez oil spill 1989
• BHP and Vale dam collapse
in Brazil 2015
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Incentive-based regulations
Advantages:
• lower informational
requirements
• enhanced incentives to
innovate
• polluter pays for control costs
as well as pollution damage
• equimarginal principle holds
for most types of
incentive-based regulations
Disadvantages:
• difficult to make
incentive-based regulations
that perfectly address
complexities
• difficult to adjust level of
incentive in accordance with
new information
• political challenges for
instituting emissions fees
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Equimarginal Principle
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Abatement
Abatement means reducing pollution
Example:
Say an unregulated firm chooses output to maximize its profits, and
this activity produces emissions of x˜ = 100.
A regulator intervenes and says that the firm must reduce pollution to
x = 90.
abatement = 100− 90 = 10
a = x˜ − x
x = x˜ − a
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Abatement
A firm’s costs:
− increase with the quantity abated
− decrease with the level of emissions allowed
For a firm with abatement level a = x˜ − x
− marginal cost of abatement MC (a) is positive
For a firm with level of emissions x
− marginal savings from emissions MS(x) is positive
− marginal cost of emissions MC (x) is negative and
MC (x) = −MS(x)
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Equimarginal Principle
For efficient regulation, lower cost abatement should always occur
before higher-cost abatement.
The Equimarginal Principle:
Assume that the marginal damage from pollution does not depend on
which firm causes the pollution. Then abatement should be carried
out by each firm until the marginal cost of abatement is the same
across all firms.
When controlling emissions from several polluters, the marginal cost
of emission control must be the same for all polluters.
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Pollution: Damages and Savings
• Pollution on horizontal axis
• Marginal saving (MS) from
pollution is different for firm 1
and firm 2
• Declining marginal savings
due to increasing marginal
abatement costs
• What is the unregulated
outcome?
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Pollution: Damages and Savings
• Sum marginal saving
horizontally to get aggregate
MS curve
• Pollution by each firm adds to
total pollution
• Aggregate MS curve measures
the marginal saving from
reducing total pollution by
one unit
• Marginal Damage (MD) same
as previously (vertical sum
over all individuals, since
non-rival)
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Pollution: Damages and Savings
• Optimal outcome where
saving from last unit of
pollution (to the marginal
polluter) equals the marginal
damage (to all damaged
parties)
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Pollution: Damages and Savings
• The two firms pollute
different amounts
• but the marginal saving from
pollution to each firm is the
same
• If one firm has MS lower than
the other, this cannot be
optimal because we could find
a Pareto improvement
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Abatement: Costs and Benefits
• Abatement on horizontal axis
• Marginal cost (MC) of
abatement is different for
Firm 1 and Firm 2
• Increasing marginal cost of
abatement, because it gets
harder and harder to reduce
pollution
• What is the unregulated
outcome?
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Abatement: Costs and Benefits
• Sum marginal cost of
abatement horizontally
• Abatement by each firm
reduces total pollution
• Aggregate MC curve
measures the MC of the last
unit of abatement achieved
• Marginal benefit curve is the
marginal benefit aggregated
over all individuals affected by
the pollution – it is non-rival
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Abatement: Costs and Benefits
• Optimal outcome where
benefit of the last unit of
abatement (to all people
affected) is equal to the
marginal cost of that
abatement (to the abating
firm)
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Abatement: Costs and Benefits
• At the optimal outcome, each
firm has a different level of
abatement
• but the marginal cost of
abatement is the same for
each
• If one firm had higher MC
than the other, the abatement
is not being provided at the
lowest cost – not pareto
efficient
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Cost Benefit Analysis
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Cost Benefit Analysis
Cost benefit analysis (CBA) compares the benefits of a proposed
regulation (or policy) with the cost
Goal is to maximize total surplus
= consumer surplus + producer surplus
= total benefits - total costs
Choose the regulation / project that maximizes total net gains over
all consumers and firms
• consistent with the potential Pareto improvement criterion
• must have enough benefits to compensate for the costs
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Cost Benefit Analysis
Cost benefit analysis has two uses
• judge the desirability of a proposed policy before it is enacted
• assess the performance of a policy after it has been enacted
The following groups often do CBA
• Government departments - often have particular guidelines
• Project proponents - may be part of the approvals process
• Academic economists - often assessing performance of past
projects
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Example: allow logging in a forest?
Aim to put a dollar value on the project-specific costs benefits.
Benefits:
• value of logs harvested (revenue - costs) – costs may depend on
type of harvesting e.g. selective harvesting would be more costly
• incremental value of jobs created
• increase in recreation/tourism – e.g. 4-wheel driving, trail-biking
Costs:
• loss of recreation/tourism – e.g. bushwalking
• loss of biodiversity – forests provide habitats and wildlife corridors
• impact on water quality, soil erosion, wind damage
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Caveats
It’s difficult to measure some benefits and costs
• benefits of replacing plastics with paper depends on how much
damage plastic does to marine life
• benefits of protecting cultural heritage sites are difficult to
measure
Cost Benefit Analysis is concerned with net benefits:
• same as the potential Pareto improvement criterion
• but policy makers may care about who pays and who benefits
• incidence may be important (lecture 5)
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Cost effectiveness analysis
In some instances, CBA may be difficult or unnecessary
Stylized example: policy goal may be to increase the average lifespan.
This could be achieved by:
• reducing pollution
• improving health care
• promoting healthy life style (food standards, education, safety)
A cost-effectiveness analysis determines which option is the least-cost
method of achieving the policy goal.
Easier than CBA because it only measures the financial cost of each
option.
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Discount factors
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Time
What do we do when costs and benefits occur at different times?
We need to consider discounting future costs and benefits, to reflect
peoples preferences.
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Discount factors
• Generally, people prefer benefits now rather than later.
Do you prefer $100 now or $100 next year?
• Likewise, people prefer to delay costs.
Do you prefer to pay $100 now or $100 next year?
• Conceptually, there is some offer where people are indifferent
between current and future payment.
Do you prefer $100 now or $120 next year?
This indifference between two net benefits separated by time
determines an individual’s discount factor.
A discount factor is a number indicating how much a person discounts
net benefits that accrue on the future relative to the present.
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Discount Factors
Say that the simple interest rate for one year is 20%.
If I invest $100 today, how much would I receive:
• a year from now?
$120
• two years from now?
$144
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Discount Factors
Say that the simple interest rate for one year is 20%.
If I invest $100 today, how much would I receive:
• a year from now? $120
• two years from now? $144
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Discount Factors
Notation:
• Simple interest rate r (also called the discount rate)
• Today’s investment y
How much money will I receive:
• a year from now? (1 + r)y
• two years from now? (1 + r)2y
• T years from now? (1 + r)T y
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Present Value
If I want to have $200 in my bank account next year, and the interest
rate is r , then how much do I need to invest now?
Rearrange the formula (1 + r)y = 200:
y =
1
1 + r
200
y =
1
1.2
200 = 166.67
“At a discount rate of 20%, the present value of $200 received a
year from today is $166.67”
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Present Value
If I want to have $200 in my bank account in two years, and the
interest rate is r , then how much do I need to invest now?
Rearrange the formula (1 + r)2y = 200:
y =
1
(1 + r)2
200
y =
1
1.22
200 = 138.89
“At a discount rate of 20%, the present value of $200 received two
years from today is $138.89”
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Present Value
Taking the Present Value (PV) of a future payment allows us to
compare costs and benefits that occur at different points in time.
Let X be the payment which occurs t years in the future, and r the
discount rate:
PV =
1
(1 + r)t
X
The discount factor is 1(1+r)t
This is a number (≤ 1) that we use to scale future payments down to
get the present value.
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Present Value
Index time by t = 0, 1, 2, ...,T where t = 0 is the current period.
Consider a stream of costs {C0,C1, ...,CT} and a stream of benefits
{B0,B1, ...,BT} that occur in each period.
The Net Present Value (NPV) of these streams is:
NPV =
T∑
t=0
1
(1 + r)t
(Bt − Ct)
If the stream of costs and benefits are constant over time (at C and
B) then we can re-write the formula as:
NPV =
(B − C )
r
(
1− 1
(1 + r)T
)
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Present Value
A project or policy is worthwhile if it has a positive Net Present Value
Several factors therefore affect decision-making:
• The value of the benefits and costs
• The timing of the benefits and costs
• The length of the project
• The assumed discount rate r
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Present Value
In practice, how should we set the discount rate?
• Set it equal to the market interest rate
• Use the rate at which governments can borrow money
• Use the social opportunity cost of capital
• Get an insight from experiments
This choice is very important for policies where the costs are short
term, and the benefits are long term. For example, climate change
policy, infrastructure investment.
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Stern Review on the economics of
climate change
• 700 page report, released 2006, updated 2008
• main author: Nicholas Stern, economist at London School of
Economics
• Key messages:
− GHG emissions are externalities
− “the biggest market failure the world has seen”
− “benefits of strong, early action on climate change considerably
outweigh the costs”
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Stern Review on the economics of
climate change
• analysis based on an Integrated Assessment Model called
PAGE2002
• recommended spending 1% of global GDP annually, starting
now, or risk losing 20% of GDP in the future
• recommended a carbon tax at $360 per ton
• these figures are significantly higher than what many economists
had recommended before
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Critical reception
• little argument about the science
• a lot of debate about the economics
• Report supported by IEA (Mandil), World Bank (Wolfowitz),
Solow, Sen, Stiglitz, Sachs
• Nordhaus, Dasgupta think Stern analysis and conclusions are off,
mostly because the discount rate was set too low
• Weitzman, Tol, Arrow think Stern’s conclusions are “right for the
wrong reasons”
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Discount Rate r and Discount Factors
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Present value of $1 million in climate
damages in 2050
Discount Rate Discount Factor Present Value
1.4% 0.499 $499,000
6% 0.054 $54,000
10% 0.009 $9,000
At a 10% discount rate, willing to pay no more than $9,000 today to
avoid $1 million in losses in 2050
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Discounting with the Ramsey Equation
r = ρ+ ηg
Notation
• r : real interest rate
• ρ: pure rate of time preference (social discount rate)
• η: consumption elasticity of marginal utility
• g : growth rate of per capita consumption
Stern: 1.4% = 0.1% + 1×1.3%
Nordhaus: 5.5% = 1.5% + 2×2%
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High Discount Rate
Use the r that is observed in market data
• r measures the real return on capital, the real interest rate, the
opportunity cost of capital, real return on investment
• can take the yield on investments corrected by the change in the
overall price level, for example
− real return on 20-year US Treasury bonds in spring 2007 was 2.4%
per year
− real pre-tax return on US corporate capital over last four decades
has averaged about 6.6% per year
With these interest rates, expect investment in abatement of green
house gasses to yield the same ‘return’ as other investments.
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Low Discount Rate
Ramsey and others argue for a low ρ (and hence low r) on ethical
grounds
• ρ represents a rate of intergenerational discrimination
“Nordhaus’ ρ of 3% per year is unconscionable - it means that
somebody born in 1960 “counts” for twice as much as somebody
born in 1995, who in turn “counts” for twice as much as somebody
born in 2020” – Brad de Long 2006
This is a normative judgement.
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