Assignment: The Economics of Global Warming

l6_correcting_the_market_failure_2013.pdf

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L6: Correcting Market Failure (c)Ruth Forsdyke

- Fossil fuel use for international trade was not accounted for under the Kyoto Protocol. Raising the price of fossil fuels would raise the price of transportation helping to correct the externality. - International trade agreements like the WTO and the NAFTA fail to contain provisions to make users pay for their GHG and other environmental externalities. In absence of Pigouvian pricing of inputs to production (like a tax on GHGs), it would be money efficient to allow importers to place tariffs on imports based on the GHGs that were created during production of the good. This is difficult to do under WTO rules. WTO rules need changing. Currently, the EUʼs carbon tax on emissions on air traffic is being challenged by China under WTO rules. =================================================================== * Draft Copy_ not for widespread distributions as permissions for copyrighted items not attained. - no copyright claim on copyrighted or public domain media. Copyrighted media used under Dalhousies Copyright Act. Hence, this document is not for public distribution. Cover picture container ships released into public domain by Ruth Forsdyke (please cite).

Topics List: 1.Introduction & basic policy types. 2.Backgrounder on Transport Emissions. 3. Regulating Markets with GHG Negative Externalities

3.1 Quotas 3.2 Taxes 3.3 Targets along supply chain 3.4 Quality Mechanisms

4. Comparing Price vs Quantity Mechanisms 5. Regulating Markets with GHG Positive externalities. 5.1-Backgrounder forest carbon sinks

5.2- Pigou’s model of Positive Externalities. 5.3- Regulating a market with Positive Externalities.

6. Removal of Inefficient Subsidies on Fossil Fuels 7. Equity 8. Summary

1-Introduction:

- Having just introduced the Alfred Pigou’s externalities and monetary social efficiency framework, the key framework employed in environmental economics, and a necessary tool to understanding global warming economics, we are now ready to investigate policies to correct the market failure.

Arthur Cecil Pigou (1877 - 1959)

Recall that Pigou’s framework illustrates that if there are negative externalities, a perfectly competitive model market will maximize the total private surplus of the market but not the total social surplus; Prices will be too low because they do not reflect full social costs while output will be too high.

Pigouvian policies work by getting private parties to take into account their externalities by making them pay the external costs or rewarding them with the external benefits.

This is called “internalizing the externalities”.

- There are a variety of available policy tools .

- Economists categorize policies according to:

1) Whether they target prices, quantities, or qualities of GHG impacting goods or services.

2) What is the most direct target of the policy.

The policy can most directly target: i) intended outputs of production units, i.e. “thneeds”, including goods, services and intermediate goods at the various stages along the supply chain,

ii) residual byproducts (the GHGs) iii) human attitudes, beliefs, norms, values via information provision and moral suasion.

- Multiple policies can be employed simultaneously.

In this lecture, we will focus on policies, which most directly target the thneeds markets.

- There are two types of production units to consider. Those that cause atmospheric GHGs to...

1) increase and hence cause negative externalities (ex. transport in cars) or

2) decrease and hence cause positive externalities (ex. natural forests or wetlands).

Firstly, since we have already developed the corresponding Pigouvian framework, we’ll look at policies to correct failure in markets that cause negative GHG externalities. Our application will be gasoline.

Secondly, after introducing Pigou’s framework to examine market failure due to positive externalities, we look at a positive-externality-causing thneed, the service of protecting natural forests, which remove carbon dioxide from the atmosphere through photosynthesis and store it in the carbon sinks (carbon sequestration).

Throughout, we’ll discuss pros and cons of policies which target market prices, quantities or qualities vs. other targets such as the GHGs themselves.

2-Brief Backgrounder on Transport Emissions

Source image: Transport and Its Infrastructure (IPCC, 4th Assessment Report) http://www.ipcc.ch/pdf/assessment-report/ar4/wg3/ar4-wg3- chapter5.pdf

To investigate policies to correct market failure in the case of negative GHG externalities, we will investigate the context of travel emissions.

- for detailed discussion of the

Transportion services are an important source of GHG emissions. In 2004, transport emissions made up about 13% of world GHG emissions about 6.4 Gt.

θWTransport = 0.13

EW2004 = 49 Gt Transport Share = θWTransport * EW2004 = 0.13 *49 Gt = 6.4 gigatonnes

The 2004, emissions from the transport sector weighed about 50 times as much as the human population.

To calculate world (W) emissions from the transport sector, multiply world total emissions by the transport share.

- Fastest growing share in Annex 1 countries and second in non-Annex 1 countries.

6.4 Gt underestimates the total share of emissions due to transport as many transport emissions are accounted for in other sectors.

- energy to make transport vehicles, roads, ports, airports and railway tracks and to provide power for these sectors.

6.4 Gt

- ex. GHG byproducts of growing crops like corn and palm oil to make biofuels and food to power cyclists, pedestrians and donkeys.

- Details are found in National GHG inventories and these would allow us to make estimates of the amounts of the other sectors that contribute to the transport sector. - The sectoral picture here is constructed from the GHG inventory data available at: Greenhouse Inventory Data: http://unfccc.int/ghg_data/items/3800.php

- Under business as usual (BAU), i.e. a lack of regulation, transport GHG emissions expected to double globally by 2050.

- fastest growing sector in Annex 1 countries and second in non-Annex 1 countries. As such, regulating transit emissions is essential to preventing a 20C temperature rise.

Source image: Transport and Its Infrastructure (IPCC, 4th Assessment Report) http://www.ipcc.ch/pdf/assessment-report/ar4/wg3/ar4-wg3- chapter5.pdf { also see pg. 162, DP for a brief summary} - Shipping of crude oil and oil products made up 40% of the demand for shipping services in 2005 (pg. 335) - Canadaʼs transport sector (only including oil combustion not making cars and so on) was responsible for 24% of GHGs (considerably higher than the world average) - From 1990 to 2008, emissions from Canadian cars fell by 12%. While this looks good on the surface, it isnʼt because emissions from “light trucks” rose by 55%. - Under the Corporate Average Fuel Efficiency Standards (CAFE standards), car maker fleets had to achieve average fuel efficiency standards for new vehicles. Cars had a tighter standard than light trucks. Car makers responded by marketing light trucks to consumers instead of cars, thereby successfully changing peopleʼs preferences. These “light trucks” are the SUVs and minivans which were not popular before the 1990s. This is an example of a poorly designed policy. - Another reason for North American automakers favouring light trucks was due to a higher tariff rate on light trucks than cars. The tariffs were imposed on European automakers in retaliation for a European tariff on frozen chickens. - Emissions from domestic aviation, domestic marine, rail, buses and motorcycles also rose. International trade increased massively in the 1990s, for example due to signing of free trade agreements (ex. WTO and NAFTA). This also increased transport emissions.. http://www.climatechange.gc.ca/default.asp?lang=En&n=97C0E131-1

Under BAU, the stock of light duty vehicles (i.e. cars and “light trucks”) is expected to triple by 2050.

- Light duty vehicles include cars, SUVs and minivans, i.e. private passenger vehicles. - According to the Stern Review (Annex 7c.), in the early 2000s, fuel efficiency in the USA was about 2/3 the level in the EU. The EU has significantly higher gasoline taxes providing people with incentives to drive more fuel efficient cars. Crude oil is also higher priced in the EU vs American market (Brent Spar Price is $113/barrel vs. $ 98/barrel in USA. - the Keystone XL pipeline is being extended from Cushing to Port Arthur Texas to export oil from US refineries. Without a current increase in production from Alberta Tar Sands to Cushing, we would expect the US price of gasoline to rise. The State of Nebraska has approved the pipeline. There is great pressure for Obama to approve it. However, American climate scientist has heavily advised against this warning that in order to prevent the > 2 degrees temperature rise, non-conventional oil and gas must remain in the ground. Source Image: Pg. 334 of 334, Transport and its Infrastructure (IPCC) http://www.ipcc.ch/pdf/assessment-report/ar4/wg3/ar4-wg3-chapter5.pdf

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# cars/ 1000 people

year

USA

Canada

ChinaGhana India

Germany

Russian Fed.

Brazil

Denmark Japan

We can see that cars per capita varies greatly by country with an upward trend globally with about 13% owning cars.

World

- Passenger cars refers to motor vehicles other than 2-wheelers, intended for carriage of passengers and designed to seat no more than 9 people (so this includes SUVs). - Interestingly we get a massive increase in cars per capita in the USA after the crash. One hypothesis as to the reason is recessionary spending. Another is that due to a steep increase in the price of oil, people decided to buy a second more efficient car but have not yet retired their gas guzzlers. This might be an interesting 4th year project. - Although Germany has more cars per capita than Canada, they are more fuel efficient.

Kaya Type Equation for Cars:

Total Emissions from cars

= Population * Cars/capita * Average distance driven per car * Average energy per unit distance * GHGs/ unit car energy

Some ways to reduce emissions from cars: 1) Make fewer cars by building efficient public transit systems and efficient urban planning such as compact cities/ this will also save people time. 2) make engines more efficient. 3) change to less carbon intensive fuel. 4) reduce emissions from non-CO2 GHGs from vehicle exhaust and climate controls. 5) reduce the birth rate. 6) roundabouts which keep traffic flowing/ ban drive throughs. 7) use existing cars less. 8) make them lighter. 9) working from home. 10) job sharing so people are not so rushed. 11) Regulate automobile advertising which targets self esteem.

Kaya Type Equation for Cars:

Total Emissions from cars

= Population * Cars/capita * Average distance driven per car * Average energy per unit distance * GHGs/ unit car energy

= 1,337,825,000.00 0.04381451535* = 58,616,154 cars

PopulationChina2010 * Cars/capitaChina2010

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(b ill)

Cars/ 1000

people

2003 - 2010: In China, cars per 1000 people increased from 10 to 44. Due to the large and growing population, # of cars rose from ~ 12 to 59 million between 2003 & 2010.

# of cars per 1000 people data source: http://data.worldbank.org/indicator/IS.VEH.PCAR.P3 population of china data source: http://search.worldbank.org/data?qterm=population&language=EN

100 km

Calculating GHG footprints from driving:

- Suppose this car meets the CAFC fuel efficiency standard = 6.8 L/ 100 km

- Carbon footprint (E) = 6.8 L * 3.0167 kg/L = 20 kg CO2e

- External cost to drive 100 km = ?

- Assume PCO2e = $50/tonne

- To visualize 6.8 L of oil, imagine 6 litres of milk.

100 km

Calculating GHG footprints from driving:

- Suppose this car meets the CAFC fuel efficiency standard = 6.8 L/ 100 km

- Carbon footprint (E) = 6.8 L * 3.0167 kg/L = 20 kg CO2e

- External cost to drive 100 km = 20 kg CO2e * 50 $/tonne CO2e * 1 tonne/ 1000 kg = $1

- Assume PCO2e = $50/tonne

- To visualize the equivalent weight of 20 kg of carbon dioxide, note that 20 kg = 44 lbs-- so imagine the weight of 44 lbs of butter. This is also about 1/3rd of my weight. - Since GHGs are invisible, we have a hard time taking them seriously, visualizing them may help us to understand the problem.

100 km

- Current gasoline price in Halifax = 125.1 cents/ L

(41.82 cents of this is tax including provincial, federal excise taxes and GST/PST)

Current gasoline cost consumer to drive 100 km = 125.1 cents/ L* 6.8 L/100km = $ 8.51

If drivers had to pay for the GHG externality at the low carbon price of $50/tonne, how much would it cost them?

- For example, the Nova Scotia excise tax on gasoline is 15.5 cents/L with the national excise tax of 10 cents/L. The GST/PST of 15% is then applied on top of that. - The tax breakdown is a sales tax of 16.32 cents/L and 25.5 cents/L of excise tax. - Since drivers do not pay the full social cost of driving (i.e. this tax is too low), they are subsidized. Subsidies are inefficient. - The subsidy is even worse for other types of fuel. For example, Nova Scotiaʼs fuel taxes are: 15.5 cents/L gasoline. 15.4 cents/L diesel. Propane = 7 cents/ L. Marine fuel = 1.1 cents/L Aviation fuel = 2.5 cents/L Biofuels (which have higher GHG footprints than diesel when sink damages are estimated) are subsidized in many places.

100 km

If we made this driver pay for the estimate of the damages inflicted on others, which is referred to as “internalizing the externality”, given our (rather low) carbon price, it will cost this person $1 more to drive a 100 km raising the price to $9.51/km.

- As more people switch to public transit, there will be more routes and the bus will stop more frequently reducing the current inconvenience of the bus in Halifax. Cars confer negative externalities on bus riders by clogging up the road and reducing ridership of public transit making it less efficient. - Bus riders confer positive user externalities both on other bus riders (due to increasing demand which increases # and frequency of routes) and due to reducing traffic conjestion which helps both cars, buses and cyclists move faster. Once public transit is efficient, car riders have more incentives to use it.

100 km

- On average, about 40% of the GHGs from driving are produced when the car is made. - Hence, as a rough estimate of the full LCA GHG footprint, our car would produce 1.4 * 20 kg CO2 e/100 km = 28 kg CO2e/100 km raising the external cost to 1.4 $/ 100 km. - The GHGs released when the car is driven are called variable external costs (they vary with the output level, here driving) - The GHGs released when the car is produced are called fixed external costs.

- The #s ignore sink damages such as when Tar Sands oil is mined in Canada or Venezuela or when biofuels are used.

- If a person commuted 20 km per day to work and back, the cost of commuting per week would only increase by $1 such that this carbon tax would not affect driving much. - At a carbon price of $100/tonne, the number rises to $2.8 additional dollars per 100 km. - At a carbon price of $200/tonne, the number rises to $5.6 additional dollars per 100 km. - At a carbon price of $1000/tonne, the number rises to $22.8 additional dollars per 100 km. Say, you drive 10,000 km per year (about 200 km per week), your yearly tax with a carbon price of $50/tonne CO2e would be $140/ year. We can see that this carbon tax is too low to have much of an impact on driving for the typical Canadian. A carbon tax of $500/year would increase this number of $1400/year which would affect low and middle income people who drive cars given that the median Canadian income is $23,000 with a median Nova Scotian income of $17,000 per year. However, the government generates revenue in an efficient manner and can reduce income taxes on these groups. - As more people switch to public transit, there will be more routes and the bus will stop more frequently reducing the current inconvenience of the bus in Halifax. Cars confer negative externalities on bus drivers by clogging up the road and reducing ridership of public transit making it less efficient.

Transport Policy - fuel efficiency standards - taxes or quotas on gasoline, diesel, aviation fuel or crude oil (or all). - measuring GHGs as they exit tailgate of transport vehicle and taxing them as part of a general carbon tax policy. - taxing cars when purchased. - subsidizing public transit. - good urban planning. - subsidies to take inefficient vehicles off the road. - policies to reduce birth rate. - subsidies to low GHG fuel sources. - subsidies to R&D on low GHG transport technologies. - job sharing. - moral suasion (provide information about global warming crisis and encourage people to reduce transport footprints/ regulation of car ads may help.)

- Fuel efficiency standards are a good thing (if applied without SUV/minivan loopholes) but on their own are insufficient. If your car is more efficient, it takes less energy to drive a km making the price of driving cheaper. People may then decide to drive more because it is cheaper. This can actually cause GHGs to increase. This is an example of Jevonʼs Paradox by the 19th century economist Stanley Jevons.

3-Pigouvian Policies to regulate markets with Negative Externalities

Now, we will use our Pigouvian framework to investigate policies which directly target markets which produce goods, services or inputs including fossil fuels.

We will assume that the thneed is gasoline.

Quantity of Thneeds/ period

$ / thneed

0 0

100

Qm = 40

Pm = 60

$M C

Pr iva

= 2 0 +

$ MB Private

= 100 - Q=

$ MB Social

$ MCExternal

= $50 / thneed

$M C So

cia l

= 7 0 +

Recall our market failure.

QSE = 15

PSE = 85

- Make sure you understand the graph before moving on. Identify the deadweight loss of the market.

Money Socially efficient allocation = Policy Goal

Quantity of Thneeds/ period

$ / thneed

100

Qm = 40

Pm = 60

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE

PSE

Privately efficient allocation

DWL

= Max TSS

- The perfectly competitive market produces 40 thneeds at a price of $60/ thneed. This results in a loss of total social surplus (relative to the maximum) of the area labelled DWL (deadweight loss). - The money socially efficient allocation maximizes the total social surplus (pink triangle) at the socially efficient price of $85/tonne and quantity of 15 thneeds/ period. - To “correct the market” regulations will “internalize the externalities” meaning that they fall on private parties changing their incentives such that the regulated market will operate at the socially efficient allocation. - The essence of the environmental economics approach is to align private costs and benefits with social costs and benefits. - We saw in the car example that charging people $50/tonne CO2e will not make much of a difference on Canadian driving habits. However, it may help to get people used to the idea and it will provide government revenue allowing reductions in inefficient taxes like income taxes and corporate taxes.

There are three basic types of policies which directly target externalities in a market. These are: 1) Price mechanisms (ex. taxes on output of goods with negative externalities like transport and subsidies to goods with positive externalities like forests and wetlands)

2) Quantity mechanisms (ex. quotas on output of goods with negative externalities and floors on goods with positive externalities such as forests and wetlands.

3) Quality mechanisms (ex. quotas on output of damaging varieties of goods such as electricity produced using inefficient coal fired generators or a minimum on the amount of electricity produced using renewable energy such as renewable energy quotas). Performance standards (ex. fuel efficiency standards), Technology Standards, and Design standards (like urban planning rules) are examples.

Next, we look at these 3 policy types for goods which produce negative externalities using gasoline as our example.

What quota would you impose on the good, service or input to achieve Social efficiency?

3.1_Quotas

Quota

Quantity of Thneeds/ period

$ / thneed

100

Qm = 40

Pm = 60

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85

Privately efficient allocation

- The quota can be illustrated as a vertical line at the socially efficient point. - The quotas will need to be distributed among firms (for example, by permit giveaway or by auction). - A problem with this can be political corruption whereby politicians accept bribes from firms to secure quotas. - Bribes may be indirect (ex. election campaign finance) - Ways to enforce quotas include fines and jail sentences. - Firms with deeper pockets to hire expensive lawyers may challenge government in court, increasing regulatory costs.

What does the new supply curve look like with the Quota?

- Go back to last slide, think about the question and try to draw the new supply curve before moving on.

Quota

Quantity of Thneeds/ period

$ / thneed

100

Qm = 40

Pm = 60

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85

Old Supply

New Supply

Demand Immediately after quota is applied, price is $60/ thneed. Is there excess demand or excess supply?

- The new supply curve is the same as the old supply curve below the quota. If P< 35, the inverse supply is: P (Q) = 20 + Q - If P = $ 35/ thneed, firms will supply 15. - If the price exceeds $ 35/ thneed, they will still supply 15 because they will be fined otherwise. Hence, the supply curve is a vertical straight line for P>=15 (i.e. above the quota) - The crimson dots represent the new supply curve.

What happens to the market price after the Quota is Imposed?

Hint: Look back at the previous slide and notice that immediately after the quota is imposed, the price will be the old market equilibrium price of $60/ thneed.

Is there excess demand or excess supply at the old equilibrium price?

Right after quota is imposed, BEFORE price has adjusted, the price is Pm = 60 $/ thneed (the old equilibrium price) ....

Demand (60) = 40 thneeds/ year

New Supply (60) = 0 thneeds/ year

Demand (60) > New Supply (60) ==> Excess Demand

Prices are driven up. Prices stop rising at PSE = $85/ thneed at which point, Demand (85) = New Supply (85)

This is the regulated market equilibrium. Note that the regulator targeted the quantity but the market did the work raising the prices. Hence, the quota is called a “quantity mechanism”.

The Invisible Hand Adjusts the Price:

Quota

Quantity of Thneeds/ period

$ / thneed

100

Qm = 40

Pm = 60

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85

Demand (60) = 40

Supply (60) = 15

Demand > Supply

∴ excess demand

Prices rise until Demand = Supply

- “Shift” Supply - Move along Demand

Excess Demand

- Note, the supply curve “shifts” and then we move along the demand curve --i.e. as the price rises, people reduce their demand. - If the quota is set correctly, social efficiency is attained. - We note that the price increase rations the goods to the people with the highest willingness to pay and so we can see how Pigouvian Policy can potentially harm low income people. However, the money income is highly correlated with GHG footprints. - If quotas are given away (not auctioned), government will collect no revenue to compensate low income people for price increases.

Quota

Quantity of Thneeds/ period

$ / thneed

100

Qm = 40

Pm = 60

$M C Pr

iva te

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85

Under Quota, the quantity falls and the price rises until the new demand =the new supply at the SE allocation such that TSS is maximized.

Now lets look at the effect of the policy on the social welfare of the private parties, third parties and government.

The government can either give away quotas or auction them or a combination of these two approaches. If quotas are given away, the government receives no revenue. In the next example, we will assume that the quotas are given away.

Quota

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85

How does Quota affect consumers?

A B

F Find total consumer surplus under market allocation, under quota and the change.

Pm = 60

Qm = 40

- Try this on paper and then check your answer on the next slides. Use letters to indicate the areas.

Quota

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85 A B

Total Consumer Surplus (QM) = A+B+C+D

Qm = 40

Pm = 60

Quota

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85 A B

Total Consumer Surplus (QSE) = APm = 60

Qm = 40

Quota

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85 A B

∆ Total Consumer Surplus = - (B+C+G)

Pm = 60

Qm = 40

Quota

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85

How does Quota affect producers?

A B

F Find total producer surplus under market allocation, under quota and the change.

Pm = 60

Qm = 40

- Try this on paper and then check your answer on the next slides. Use letters to indicate the areas.

Quota

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85 A B

Total Producer Surplus(Qm) = D+ HG

Pm = 60

Qm = 40

Quota

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85 A B

Total Producer Surplus(QSE) = B + C + D

Pm = 60

Qm = 40

- Now the total revenue is B+C+D+E and the total producer costs is only E (they sell less goods). - Selling fewer goods will DECREASE producers total revenue but each good sells for a HIGHER price and this effect will INCREASE their revenue. If the latter effect dominates, then the total producer surplus could increase (as when a monopoly restricts output to drive up the price thereby increasing their profits). - Hence, the effect on the total producer surplus is ambiguous depending on the size of the quota. - Note that many firms are not competitive. For example, Nova Scotia Power is a regulated monopoly in electricity transmission and has a near monopoly in generation and is subject to price ceilings.

Quota

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85 A B

∆ Total Producer Surplus(QSE) = (B + C + D) - (D+H) = B+C - H

Pm = 60

Qm = 40

If H > B+ C

If H < B+ C

Quota

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85

If, instead of being given away, quotas are instead auctioned off in a perfectly competitive market...

A B

Total Producer Surplus= B

Pm = 60

Qm = 40

- Firms are going to like quota give away but will not like it if quotas are auctioned. An example of a situation in which quotas are auctioned is fish permits. In practice, large trawling companies have purchased quotas or rent them from individual fishers to whom they were given.

What about the change in welfare of the 3rd Parties due to the quota policy? (the people and animals who experience the damages from byproducts like the GHGs and biodiversity losses).

- To find the total change in surplus to the third parties, we will need to find the area representing the total external costs under the quota policy and subtract it from the area representing the total external costs under the market policy. - Try this and then check your answer on the upcoming slides.

Quota

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85 A B

F Total External Costs (Qm) = C + D + F + G + H

Pm = 60

Qm = 40

- Note that the total external costs at the market allocation is the area under the marginal external cost curve from 0 to 40. However, since we have removed the marginal external cost curve we will illustrate this area another way. - Since total social costs is equal to the area under the marginal social cost curve and the total private costs are the area under the marginal private cost curve, the area between the marginal social cost curve and the marginal external cost curve must equal the total external costs. - Recall that marginal external costs are $50/ thneed, so total external costs at market quantity are equal to $50/thneed * 40 thneeds = $2000.

Quota

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85 A B

Pm = 60

Qm = 40

Total External Costs (Qm) = C + D

- Now the external costs are much smaller as there are fewer thneeds and hence fewer GHGs.

Quota

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85 A B

Pm = 60

Qm = 40

∆Total External Costs = (C + D) - (C + D + F + G + H) = - (F + G + H)

The total external costs fell by area H + G + H making the third parties better off which was the point of the policy.

∆ Total Consumer Surplus

= B+C - H

∆ Total Producer Surplus(QSE)

= - (B+C+G)

- ∆Total External Costs

= (F+G+H)

∆ Total Social Surplus = + F

- Based in changes in their respective total money surpluses, consumers are worse off, producers may be either better or worse off, third parties are better off, and society as a whole is better off (the total money social surplus went up by the area equal to the deadweight loss). - Recall that F is the total deadweight loss! - I have assumed quotas were given away here. If they were auctioned, producers are also worse off but government will gain a revenue from selling the quotas. Identify the government revenue under quota auction as an area before moving to the next slide.

Quota

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85

How does Quota affect each group?

A B

Government Revenue (if auctioned) = $50/ quota * 15 quotas = $750

Pm = 60

Qm = 40

- This assumes that the auction is perfectly competitive in which case the firmʼs are willing to pay $50 per quota which is their marginal profit from the quota. - If the quota market is not competitive due to few firms and possibly corrupt practices like bribes to government officials and bid rigging (where firms meet before and collude to agree to make low bids), the government would get less than the area C+D with the firms getting the portion that the government does not get.

Summary Quota Model - the regulator sets the market quota equal to the SE quantity and passes a bill of law making it illegal for firms to supply more than this amount. - there is excess demand at the unregulated price and so the price rises to the $ SE price. The regulated market is now in equilibrium at the $ SE allocation. - the externality is internalized. The users pay the full social costs. The total private surplus and total consumer surplus falls while the total producer surplus may rise or fall. - the total social surplus is maximized such that the regulated market is said to be monetarily socially efficient. 56

- Efficient quota alloction may not occur due to rent seeking activities like bribes (such as election campaign finance) and bid rigging.

- if relationship between thneed output (ex coal or crude oil) and GHGs is known, quota can be a quick way to hit the target GHG reduction with fewer possibilities of cheating via loopholes. For example, James Hansen recommends regulating rate of fossil fuel extraction.

- firms will prefer quotas to taxes because they get to pollute for free. This leaves them with more has a merit of giving them money to finance green technology invention and adoption conditional upon government imposing incentives for them to do so.

- politics should not inhibit our ability to think clearly about “in principle options”. - bid rigging is illegal under Competition Law. - an example of a firm getting contracts without a proper process is Halliburtonʼs war reconstruction contracts in Iraq. The ex CEO of Halliburton was Dick Cheney who at the time of the contract allocation was the Vice President of the USA. He also served to profit from this due to holding stock options. This is an example of the common phenomenon of a “revolving door”. Halliburton was a key player in the also BP Deepwater Horizon Oil Spill in the Gulf of Mexico due to using substandard cement practice. This was the biggest oil spill of all time (42 times bigger than the Exxon Valdez oil spill). Oil spills are another massive externality from transport.

- quotas may lead to inefficiency if quotas are not tradable because firms may be unable to adjust their scale to an efficient level. Ex. in an extreme case, if all firms get equal number of quotas which are not tradable and the industry shrinks such that each firm has too small a scale to be profitable, it would be efficient to allow some firms to leave the market. - On the other hand, environmental regulations may make efficient scale smaller (ex. due to higher transport costs) in which case, lack of tradable quotas would not allow firm size to shrink.

- For example, suppose we had 10 firms in the market. Under the market allocation, each firm would produce 4 thneeds. Under the regulation, each firm would produce 1.5 thneeds. The firms may be unable to cover their fixed costs of production and all of them would need to leave the market. On the other hand, if 7 firms leave the market, the 3 remaining firms would produce 5 thneeds each enabling them to cover their fixed costs. With only three firms, the market is unlikely to be competitive and so we would need to use a different model. - Recall first year model of perfect competition in which firm scale is found at point were U shaped MC intersects minimum of U-shaped average cost curve (with 0 profits but positive variable profits--i.e. producer surplus).

3.2_ Pigouvian Taxes on Outputs of Production Units

The second class of policies are price mechanisms which means the price is the direct target. Pigouvian taxes are directly levied on goods with negative GHG externalities raising their relative price, thereby providing incentives to substitute out of the good entirely or into low GHG versions.

Source: International Energy Agency G

e rm

a n

U .K

F ra

n ce

Ja p

a n

C a n

a d

U S

AAvg Tax $/ Litre March 2008

1.36 1.32 1.27

0.60

0.31 0.11

- In which of the countries in the graph would you expect people to drive more efficient cars? Answer EU - The main reason is higher gasoline taxes which provide people with incentives to either not drive, to drive less or to drive more fuel efficient cars (Resources for the Future). If you go to Europe, you will notice cars are smaller.

- Fuel efficiency standards are tighter in Europe also while crude oil also has a higher price (http://www.bloomberg.com/ energy/) Fuel Tax Graph: International Energy Agency

- A Pigouvian tax targets price directly and then quantities adjust via the “invisible hand mechanism.

- Consider a constant marginal tax (T = $50/ thneed) equal to the MCExternal of producers. - The producers’ $MCPrivate (inverse supply) shifts up by T to $MCPrivate_New (social inverse supply) so they internalize the externality--see green dashed line.

$MCPrivate_New = $MCPrivate_Old + T = 20 + Q + T = 70 + Q

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

= 2 0 +

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85

70 Pm = 60

Qm = 40 $M

C Pr

iva te (n

ew )

= 2 0 +

Q +

The marginal tax is equal to the marginal external cost at the SE output level (which is $50/ thneed).

The MCPrivate rises by the marginal tax (green arrow) causing the inverse supply curve to shift up by $50/ thneed (green dashed).

- In our example, in which the marginal external costs are constant such that the marginal external cost is a horizontal line. If it were not horizontal, the new supply curve will not overlap the marginal social cost curve (as here), but will still intersect it at the socially efficient allocation.

Quantity of Thneeds/ period

$ / thneed

100

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85

70 Pm = 60

Qm = 40 $M

C Pr

iva te (n

ew )

We can think of the new marginal private cost as the “social supply curve”, the supply curve that would exist if the producers had to pay the full monetary social costs of the externality.

$M C Pr

iva te (o

ld )

Question: Right after the tax is imposed, the price of thneeds is $60/tonne. Use the concepts of excess demand or excess supply to explain what happens to the price and quantity of thneeds as the market adjusts to the regulation.

Answer: Start in unregulated market with Pm = $60/thneed and Qm = 40 thneeds. Now add the tax causing the supply curve to shift upward to the left. At the price of $60/ thneed, the demand is 40 thneeds while the supply is 0 thneeds. Hence, demand exceeds supply. The firms will discover they can increase prices. As they increase prices, demand will fall (movement along demand curve).

Now lets look at the effect of the Pigouvian tax policy on the social welfare of the private parties, third parties and government.

Source Picture Parliament Buildings of Canada: http://en.wikipedia.org/wiki/Parliament_of_Canada

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85

How does Tax affect consumers?

A B

F Find total consumer surplus under market allocation, under quota and the change.

Pm = 60

Qm = 40

$M C Pr

iva te (

ne w)

- Try this on paper and then check your answer on the next slides. Use letters to indicate the areas.

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85 A B

Total Consumer Surplus (QM) = A+B+C+D

Qm = 40

Pm = 60

$M C Pr

iva te (

ne w)

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85 A B

Total Consumer Surplus (QSE) = A

Pm = 60

Qm = 40

$M C Pr

iva te (

ne w)

- The socially efficient allocation is where the marginal cost social curve intersects the marginal social benefit curve (as long as its socially efficient to produce any thneeds at all which wouldnʼt be the case if the MC social curve intersects the y-axis above 100 in our case). - Suppose the Factory is producing a quantity (Q) on x axis that is less than Qse), we see that the marginal social benefit exceeds the marginal social cost. For Q < Qse,t is socially efficient to produce an additional Qth unit as the society will gain more social benefits than it costs them so the marginal social surplus must be positive. - If, on the other hand, at a given Q, the marginal social benefit is lower than the marginal social cost, as is the case when Q < Qse, then it will increase the total social surplus if you decrease output by one unit since you will forgo fewer social benefits than social costs saved. Social “when to stop rule”: MBsocial = MCsocial (if Qse > 0).

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85 A B

∆ Total Consumer Surplus = - (B+C+G)

Pm = 60

Qm = 40

$M C Pr

iva te (

ne w)

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85 A B

Find total producer surplus under market allocation, tax regulation, and the change.

Pm = 60

Qm = 40

$M C Pr

iva te (

ne w)

- Try this on paper and then check your answer on the next slides. Use letters to indicate the areas.

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85 A B

Total Producer Surplus(Qm) = D+ HG

Pm = 60

Qm = 40

$M C Pr

iva te (

ne w)

- Recall this is the total revenue (D+ H + E + I) - total producer costs (E +I)

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85 A B

Total Producer Surplus(QSE) = B

Pm = 60

Qm = 40

$M C Pr

iva te (

ne w)

- Now the total revenue is B+C+D+E and the total producer costs is only E (they sell less goods). - Selling fewer goods will DECREASE their total revenue but each good sells for a HIGHER price and this effect will INCREASE their revenue. If the latter effect dominates, then the total producer surplus could increase (as when a monopoly restricts output to drive up the price thereby increasing their profits). - Hence, the effect on the total producer surplus is ambiguous depending on the size of the quota. - Note that many firms are not competitive. For example, Nova Scotia Power is a regulated monopoly in electricity transmission and has a near monopoly in generation and is subject to price ceilings.

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85 A B

∆ Total Producer Surplus(QSE) = (B) - (D+H)

Pm = 60

Qm = 40

$M C Pr

iva te (

ne w)

- Note that this is the same welfare result as would occur under quotas if they are auctioned off in a perfectly competitive market. - We can see here that firms are going to tend to prefer quota give- aways to Pigouvian taxes. We will expect strenuous lobbying by firms to prevent Pigouvian taxes being put into place and we do. Usually, they firms are reported in the paper as saying that jobs will be lost. Firms may also threaten to leave the country to operate in a country with lower pollution regulations. This is called a “pollution haven” effect.

What about the change in welfare of the 3rd Parties due to the quota policy? (the people and animals who experience the damages from byproducts like the GHGs and damages to the natural ecosystems).

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85 A B

Pm = 60

Qm = 40

∆Total External Costs = (C + D) - (C + D + F + G + H) = - (F + G + H)

$M C Pr

iva te (

ne w) The third parties gain

due to the reduction in the total external costs (identical result as with tax)

The total external costs fell by area H + G + H making the third parties better off which was the point of the policy.

Question: How much tax revenue will the government collect? Show using areas on graph.

Quantity of Thneeds/ period

$ / thneed

100

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE = 15

PSE = 85 A B

F Government Tax Revenue = C+ D = $50/ thneed * 15 thneeds = $750/ period.

Pm = 60

Qm = 40

$M C Pr

iva te (

ne w)

- Note that if the MCExternal is not horizontal as in our example, the green new supply curve will not overlay the MCsocial curve and it may be the case that the total tax is greater than the total external costs. In this case, lump sum rebates can be provided or the tax may only be applied above a particular output level. The problem here is that is would be administratively complex to apply a tax rate that increases with output levels. - Since MCExternal are constant over short run for GHGs due to these being cumulative pollutants, we do not have to worry about this problem for global warming regulations.

∆ Total Consumer Surplus

= B - (D+H)

∆ Total Producer Surplus(QSE)

= - (B+C+G)

- ∆Total External Costs

= (F+G+H)

∆ Total Social Surplus

= + F ∆ Total Tax Revenue = C+D

- Based in changes in their respective total money surpluses, consumers are worse off, producers are worse off, third parties are better off, and society as a whole is better off (the total money social surplus went up by the area equal to the deadweight loss). - Recall that F is the total deadweight loss!

3.3 Targets along Supply Chain

75(5) 7(7) 90 (45) 385 (385)

Extraction Initial Processing RefiningTransport Transport

Combustion Final Product

10.32 L 125.5 ¢/L

Pigouvian Taxes are ideally levied along the supply chain at the stages where the emissions are produced. This provides the most direct incentive to reduce the emissions at the point of creation. We can see here that the Tar (Oil) Sands CSS Bitumen creates the same amount of emissions as conventional oil (West Texas Intermediate) when combusted (385 kg CO2e/ bbl gasoline) but creates far more emissions in total (560 vs 450)

3(3)

Source: IHS CERA: http://www.api.org/aboutoilgas/oilsands/upload/CERA_Oil_Sands_GHGs_US_Oil_Supply.pdf - This source is based on a Life Cycle Analysis commissioned by the oil industry. It does not include GHG emissions due to damage to the carbon sinks or due to pipeline construction. The CSS bitumen is the dirtiest oil source based on the analysis because the process of steam injection is very energy intensive. The mining is slightly less energy intensive but results in destruction of boreal forests and wetlands such that overall, it may have the higher GHG footprint. - The CSS bitumen mining could have its footprint lowered by switching to lower GHG energy sources such as wind power, solar power or nuclear power. - That said, even for the CSS bitumen, 64% of the emissions are produced during combustion for a total of 360 bbl refined product (ex. gasoline or diesel).

Crude Production

Crude Transport

Distribution Crude Refining

tonnes CO2e/ barrel refined crude

0.1

0.2

West Texas Int.

CSS Bitumen

- If we only levy the tax on the final product (ex gas tax at pump), the Tar (Oil) sands gasoline would be priced the same as the West Texas Intermediate providing no private incentives to substitute into the lower GHG oil or for the Tar Sands producers to find lower GHG ways to make the oil if cost effective.

- Other than GHG emissions differences in the two basic extraction processes, strip mining and In Situ, the 7 categories of Tar Sandʼs crude differ according to the liquids in which they are diluted. Since bitumen is a tar like substance, it cannot be piped along lines or refined in conventional refineries until it is diluted to make it into a liquid form. The bitumen can be diluted in light oils and also in condensed natural gas. The GHG intensity of the diluting fossil fuel will hence also affect the GHG intensity of the crude oil. - Mining and in situ will also differ with respect to their impact on carbon sinks, biodiversity loss and other local water and air pollutants. Source Data = IHS CERA: http://www.api.org/aboutoilgas/oilsands/upload/ CERA_Oil_Sands_GHGs_US_Oil_Supply.pdf

If taxes are applied based on GHGs at each stage, the CSS bitumen gasoline costs 24% more.

$50/tonne * 0.175 tonnes/barrel = $8.75/barrel

upstream tax

$50/tonne * 0.06 tonnes/barrel = $3/barrel

CSS Bitumen

West Tex. Int.

pump tax $50/tonne * 0.385 tonnes/barrel = $ 19.25/ barrel

full life- cycle tax

$ 28/barrel

$ 22.25/ barrel

$ 19.25/ barrel

10.32 L

- We can see that the CSS bitumen is much more GHG intensive during the extraction - processing- transport and refining stages than the cleanest crude oil (almost 3 times the GHG emissions) while both oils produce about the same amount of GHG emissions during combustion. Along the whole life cycle, the CSS bitumen produces about 27% more GHGs than the cleanest crude. - Note: The 7 Tar Sands crude oil categories are one out of two basic categories 1) Strip mined and 2) In Situ (with two categories Steam Assisted Gravity Drainage (SAGD) and Cyclic Steam Generation (CSS). Under strip mining, the boreal forests and Earth crust from above the oil is removed. Under In Situ methods, the tar sands are too deep to be strip mined. Because the bitumen is highly viscose, it can only be removed by heating it up to make it flow. Steam is injected down the drill and the bitumen becomes viscous enough to force it out. Ignoring the GHG emissions due to sink destruction and pipeline construction, the In Situ process uses 15% more energy over the entire life cycle than the average US crude while the mining uses 5% more energy. - these taxes are on the refined final product (ex. gasoline).

Blunt Tax = $50/tonne CO2e * . 0.480 tonne CO2e/ barrel = $24/barrel

Correct Tax CSS Bitumen = $50/tonne CO2e * 0.560 tonne CO2e/ barrel = $28/barrel

Ex. Apply full Pigouvian tax on average GHG final product (gasoline pump)

Production GHGs

Combustion GHGs

West Tex Intermediate

US Av’g Dom. Crude

Mining Dilbit

Mining Bitumen

SAGD Dilbit

Mining SCO

SAGD Bitumen

SAGD SCO

CSS Bitumen

0 .4 .6.2

GHGs (tonnes CO2e)

T a r

S a n

d s

C a n

- All estimates based on IHS CERA report (see figure three)

Houston

Keystone (built)

Keystone XL (proposed)

Port Arthur

Cushing

Steel City

Hardisty

Northern Gateway (proposed)

Trans Canada

Enbridge

Exports

Oil Sands

- Note that Enbridge has many other pipelines (ex. from Tar Sands to Chicago linking up to Montreal (where there are refineries) and running down to Cushing, a big pipeline hub (not shown). - An Environmental impact assessment of the Northern Gateway Pipeline is currently underway. Concerns are oil spills off BCs coast which would ship diluted bitumen in tankers to places like China and California for refining. - The Cushing to Port Arthur Stage of Keystone XL Pipeline has already been approved. If the top part is not allowed to go ahead, we would expect higher oil prices in the USA because some of the oil will be exported. This might increase pressure for the top portion to be built to allow for more Canadian crude exports. - Oil shocks have macroeconomic impacts.

3.4_Quality Mechanisms

Source Photo: Alfred Cecil Pigou: New School Website

Other means to directly regulate markets include technology, design, and performance standards.

An example of performance standards is are fuel efficiency standards (CAFE) which specify that the fleet of new cars must meet a minimum fuel efficiency. These do not guarantee GHG caps will be met due to reducing the price of driving a mile such that people may increase their driving which can include decisions to build homes further from work (Jevon’s Paradox).

Renewable energy quotas specify that a minimum amount of energy will be made by renewable energy. For example, there are minimum quotas on biofuels and for electricity, many places including Nova Scotia have renewable energy targets.

Studies have found that ethanol biofuels produced from corn create more GHGs than diesel such that this policy was poorly designed. If instead, full Life Cycle Analysis had been conducted and taxes levied on GHG produced by each type of fuel, these high GHG biofuels policies would not have been put into place.

Searchinger, T. et al (2008) Use of U.S. Croplands for Biofuels Increases Greenhouse Gases Through Emissions from Land Use Change, Science, 319, 1938.

Technology, design and performance standards can work faster than markets due to human brains being substituted for markets.

For a trivial ex., this unnecessary plastic laundry scoop could be banned as a wasteful technology without any LCA as it is a “no brainer” wasteful product.

They may also allow early deployment of technologies which are currently expensive but are expected to become cheaper over time (ex. solar power).

The big drawback is flexibility in contrast to general policies like carbon taxes which leave firms with freedom to choose cheapest abatement technology, thereby making use of decentralized force of invisible hand.

4_ Comparing Price vs. Quantity mechanisms

1) Pigou taxes generates revenue while quota (if given away) does not. Uses include:

- tax shifting reduce other taxes helping to compensate consumers for the price rise (ex. income taxes + lump sum rebates particularly on low & middle income groups). - finance green climate fund, part of the Copenhagen mechanism to provide lower income countries with GHG mitigation and adaptation capacity. - corporate tax reductions reducing probability of movement to low tax zones called pollution havens. - subsidize subsidize renewable energy adoption and research and development (R&D) by government & universities, or paid as grants to firms.

-The BC carbon tax is revenue neutral meaning that taxes were removed elsewhere (income and corporate) so government revenue did not change. Many of the tax decreases were on corporations. Lump sum rebates given to households. - It is important to note that even though one might think that the low income people will merely go and buy the same products thereby undoing the policy, they will still find that the GHG intensive thneeds are relatively expensive in comparison to green alternatives. For example, the bus will be relatively cheap in comparison to the car due to fewer GHG emissions per passenger mile while the CSS Bitumen gasoline will be relatively expensive in comparison to the Texas Intermediate. - Taxes on externalities are monetarily socially efficient (as illustrated above). To contrast, taxes such as income tax reduce total social surplus (in money). Hence, taxes on externalities allow us to replace inefficient taxes with efficient ones.

MCExternal

Quota hits target

Thneeds/ year

$ / thneed

2) Hitting the target: If the government does not estimate demand and supply curves accurately (which is likely due to difficultly of getting estimates of firm’s costs), quotas (if enforced) guarantee output is capped whereas with a tax, output may not fall as much as the government wants such that total external costs are higher than wanted. This is particularly problematic if the marginal external cost curve is increasing rapidly above the desired cap.

- Similarly, a strict floor on forest size and quality guarantees a minimum amount while subsidies to get private parties to conserve forests donʼt guarantee that we will save the minimum.

4) Tax enables firm scale to adjust flexibly to the policy in contrast to quotas. For example, if the industry gets smaller, some firms may need to leave the industry. On the other hand, if efficient scale gets smaller with environmentally friendly technologies, firms may want to enter industry. Tradable quotas can work similar to taxes in this respect although they may also enable big firms to hoard quotas to prevent market entry reducing competition.

3) quotas are highly subject to political lobby which can lead to corruption. Ex. firm Y donates money to campaign of politician X.

5) quotas may be rapidly applied to reduce or ban obviously wasteful practices or technologies. For example, plastic laundry scoops bundled with powder laundry detergent, or bottom trawling (which damages ocean bottoms) could rapidly be banned. The same holds for tech, design and performance standards.

6) quotas with rations may be a very fair policy and this is why we see food rations during wars. For example, a one child policy is more equitable than allowing people to buy the rights to have children (tax on children).

- it seems to me that powder is likely to be better than liquid laundry detergent all else equal due to being much lighter which reduces transport emissions. Refilling containers of powder detergent seems to be the greenest option. A LCA comparison could be done to compare these.

7) a drawback of the tax is that lower profits leaves firms with less finance for research and development and adoption of low GHG technologies (ex. electric cars, fuel cell tech.). However, tax revenue could be used to provide marginal subsidies to incentivize firms to reduce their GHGs.

- multiple policies can be used simultaneously. For example, we could tax carbon dioxide emissions and ban plastic laundry scoops sold and place limits on fossil fuel extraction rates while putting floors on the amount of natural ecosystems and their quality.

- we will revisit this when we look at direct regulation of emissions. The arguments will be similar.

5_ Direct Regulation of production units which provide positive GHG Externalities

http://www.cbc.ca/news/canada/british-columbia/story/2010/12/09/bc-forests-carbon-dioxide-report.html

Recall that we are looking at policies to correct market failure due to GHG externalities with a focus on policies which target output of either goods, services or inputs.

In the last section, we investigated policies which target output of goods which cause negative GHG externalities (ex. gasoline).

Here, we will investigate policies which target outputs of goods which cause positive GHG externalities.

What is a good which causes a GHG externality? Give an example?

- the concept of a “policy target” is important here. Recall our gasoline policy was levied on the gasoline itself. An alternative would be to target the GHGs themselves -- next lecture.

5.1_ Backgrounder on Ecosystem Sinks as ex. of goods which provide positive externalities.

http://www.cbc.ca/news/canada/british-columbia/story/2010/12/09/bc-forests-carbon-dioxide-report.html

Ecosystems provide essential services like CO2 removal from atmosphere. - Recall that deforestation caused net emission of ~ 9.25 gigatonnes in 2009.

Equity &

Human Wellbeing or

“Ultimate Ends” Economy,

Technology, Politics & Ethics or

“Intermediate Means”

Natural Environment or Ultimate Means

Herman Daly’s Triangle

- Herman Dalyʼs triangle draws attention to the fact that our human civilizations with our human production systems depend on the natural systems. Both the human production systems and the natural ones, the functioning of which we determine by our decisions, provide us with goods and services. For example, the natural systems provide us with oxygen, nitrogen fixation and carbon dioxide removal services. - Grab shot from economics lecture by Herman Daly available here: http://vimeo.com/11507591 (excellent lecture--Daly was head Environmental Economist at the World Bank and is perhaps the most famous founder of the field of “ecological economics”). Unlike Daly, some ecological economists do not understand neoclassical economics.

The natural systems like this forest provide humans with many thneeds like oxygen production and carbon dioxide removal and nitrogen fixation. Natural systems currently absorb about 50% of anthropogenic GHG emissions.

When humans decide to conserve, repair and expand natural areas, we are deciding to produce natural goods, services and inputs--”natural thneeds”.

Source: Natural Resources Canada

When this Boreal forest and lake system is converted to human uses to produce thneeds such as...

Source: Natural Resources Canada

synthetic crude oil, we loose the natural goods and services, the carbon dioxide renewal services and the many other services which nature provides us with.

- Estimated 315 billion barrels of recoverable crude oil with 175 to 200 billion barrels privately economically recoverable using current technology. - mining and processing bitumen to form synthetic crude releases 0.075 tonnes CO2e/ barrel (source - GHG footprint mining and processing Canadian Tar Sands: = 0.075 CO2e/barrel *(175 - 200 billion barrels) =13.125 - 15 tonnes CO2e - At carbon price of $50/barrel, this is an external cost of $ 656.25 - 750 billion ( bit more than a 3rd of annual GDP). -At a carbon price of $100/ tonne CO2e, the number rises to $1312 - 1500 billion (almost our annual GDP) -At a carbon price of $200/tonne CO2e, the number rises to $2624 - 3000 billion (almost 2 years of annual GDP) Note: most of the footprint is further down the supply chain when the final fuel is combusted. So, the full lifecycle analysis (LCA) footprint is about 4.5 the above number (ignoring the sinks) = 2952 - 3375 bill (at the low $50/tonne carbon price) or 11800-13500 at the $200/ tonne price (7 - 8 years of Canadaʼs GDP). - Data from Canadian Energy Board and Sharpe, A. et al. The Valuation of the Canadian Tar Sands, Centre for the Study of Living Standards. - No permissions for image of Tar (Oil) Sands obtained/ used under Dalhousie Copyright Agreement for fair use. Other photos available here: http://www.edwardburtynsky.com/WORKS/Oil/Oil_Sands_Large/OLF_ALB_11_07_big.jpg

100

1750 - 3000 tonnes CO2 per hectare of land (boreal forest sink lost to wetlands #)

= 80 to 150 typical Canadian yearly footprints (20 tonnes/yr)

- To get the total footprint, we would need to figure out what portion is strip mined vs. what portion is mined using cyclic steam stimulation (which does not result in this massive damage) and multiply by footprint estimates for each type (mining shown here vs cyclic steam stimulation which injects the steam underground). - It is difficult to estimate the rate of success of land reclamation activities at this point in time. A small amount of land has been reforested but the land type has completely changed from wetlands and boreal forests (the best carbon sinks) to a sandy highland.

101

Other anthropogenic causes for damages to Canada’s carbon sink forests include:

- agriculture - forestry, - human residential and industrial building & roads, mining. - global warming causing... a) tree eating beetles and moths able to survive winters further North, b) increased incidence of forest fires [ positive feedback loops]

- these are positive feedbacks of global warming. - warming causes forest fires, which causes a net release of GHGs into the atmosphere causing more global warming and more forest fires and so on.

102

2004: The Forestry sector is responsible for 17% of total greenhouse gas net emissions globally.

- deforestation (carbon sink destruction) = 6 Gt CO2e/year - decomposition logging debris, peat fires, peat decay = 2 Gt - reforestation = - 3.3 Gt

Net emissions forestry = 5.7 Gt/ year.

Forests give positive externalities!

- Data Source: Kump and Mann (DP), Pg. 174 - 175. Based on UN IPPC FAR. - Country trends on page 175.

- Balsam firs are an important tree species in Acadian Coastal Forest Ecosystems.

103

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$#!!"

%!!!"

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&!!!"

&#!!"

'() *+, -."

'/ 0* /(- 1/"

2) (/- ."

'3 45 (-"

6( )* .-4 57 "

'() *+, -." 8- 9- 44 -: "

'/ 0* /(- 13 (/" ;( -7 7.- 45 7"

</ 7/ (1" 7/ 0+ 5/ 7/ (1"

= /1. -4 57 "

= /+> :1 /5 "?9 /(- >/ "

soil = rose plants = blue

- Accounting for changes in atmospheric GHGs due to land use, land use change and forestry (LULUCF) is complicated with uncertainty in numbers.

tonnes CO2/ha

104

Enhancing Forest Health to increase its carbon sink Capacity is an important way to slow global warming.

Alberta

-This map illustrates estimates of flows of CO2/year of the Canadian land mass. - The numbers are in units of carbon (atomic weight = 12 amu). To convert to carbon dioxide weight (44 amu), multiply the numbers by 44/12 = 3.77. Ask me to go over this in class. - This slide shows flows of CO2 while the previous slide shows the amount that is stored (stocks). We can see that stocks are much bigger. Carbon accounting for LULUCF is complicated and there is large uncertainty, yet measures are improving. Alberta map Source: http://en.wikipedia.org/wiki/Oil_sands - According to Natural Resources Canada, Canadaʼs managed forests oscillate between being net sinks and net sources of emissions.

Source Map: Chen, Jing M. (2003) Spatial Distribution of carbon sources and sinks in Canadaʼs forests, Tellus, 55B, 622 - 641. http:// faculty.geog.utoronto.ca/Chen/Chen's%20homepage/PDFfiles/ p71_chen_tellus_b55.pdf

105

- Also, forest destruction causes many other externalities than just the destruction of natural carbon sinks. They provide habitat for many species like this common redpol. When forests are destroyed for farming, forestry, industry and residences and roads, natural ecosystems shrink. Humans need ecosystems upon which to recycle the building blocks for the living systems of which human beings depend. - To estimate a monetary valuation of the positive externalities from forests, we would need to figure out the carbon sink capacity and then multiply this by the carbon price. We would also need to consider all other ecological benefits like nitrogen recycling, oxygen production and also put a value on species like this common redpol (a somewhat dubious exercise).

106

Hairy Woodpeckers

- These Hairy Woodpeckers are medium sized woodpeckers and have similar markings to the smaller Downy Woodpeckers. There are also much bigger Piliated Woodpeckers (these are the ones with the great red crest). I saw a piliated woodpecker on two occasions as a child. - Once, massive Ivory Billed Woodpeckers, inhabited the forests of the Western USA. These birds were reported to be so large and fantastic that people would call them “Oh Lordy Birds” because this is what people would say if they saw one, so amazed were they by its splendor. The Ivory Bills went extinct in the 20th century. Cause: Anthropogenic. Source of this story: Barbara Kingsolver, “The Lacuna”

107

5.1_ Pigou’s model of positive externalities.

http://www.cbc.ca/news/canada/british-columbia/story/2010/12/09/bc-forests-carbon-dioxide-report.html

108

- Lets model a naturally produced thneed (here a natural forest) which produces positive externalities as a byproduct of the human decision to allow the natural system to operate in this land area.

- While it may seem strange to think of the demand and supply of natural forests and wetlands, humans are ultimately in charge of deciding how much natural forest we provide.

- It can make sense to think of natural ecosystem production systems as part of the economy.

- Ex. demanding forests = donate money to a nature trusts which buy up forest lands to protect them, or people replacing lawns with forests, carbon forest offsets (to be discussed later) or through voting for governments with green platforms and influencing governments (ex. write letter) to put into place Pigouvian regulations.

Natural Forest (km2/period

$ / km2

100 $M C

Pri va

$ MB Private QSE = 15

Pm = 60

Qm = 40

MBExternal = 50

Find SE allocation with a positive externality This is the marginal opportunity cost of having a natural forest (ex. cut it down for the wood or mine the land under it)

- Lets model a naturally produced thneed (here a natural forest) which produces positive externalities as a byproduct of the human decision to allow the natural system to operate in this land area. - For simplicity, we assume that there are no negative externalities from the forest. Assume marginal external benefits are $50 per km sq. natural forest.

Natural Forest (km2/period

$ / km2

100 $M

C Pri

va te

$ MB Private QSE = 65

Pm = 60

Qm = 40

The Market for forests fails to produce the socially efficient amount of forest. The price is too low and quantity too low. 150

MBExternal = 50

$ MB social

PSE = 85 $M

C So

cia l

- Add the marginal external benefits to the marginal private benefits (marginal willingness to pay) to get the marginal social benefits. MBsocial = 100 - Q + 50 = 150 - Q - Since, I assumed no marginal external costs, the marginal social costs are equal to the marginal private costs. MCsocial = 20 + Q + 0 = 20 + Q - Find the SE level of output. This is the level which maximizes the total social surplus = total social benefits - total social costs. Set: MB social = MCsocial ==> 150 - Q = 20 + Q ==> Qse = 65 km sq / period. Plug back into MCsocial or MBsocial equation to get the socially efficient price, Pse = $85/kmsq. - think of social MB as the marginal willingness to pay (MWTP) of society as a whole (including future generations) to conserve natural forests. This is higher than the private MWTP ($MBPrivate ) because private parties will fail to take into account positive externalities when deciding how much forest to provide.

Natural Forest (km2/period

$ / km2

100 $M

C Pri

va te

$ MB Private QSE = 65

Pm = 60

Qm = 40

Show that the SE allocation maximizes TSS at Qse but not at Qm so market fails

150

$ MB social PSE = 85

C D

$M C

So cia

- Recall that to do this, you must identify areas under marginal graphs which correspond to respective totals. - Find total social benefits at Qse. - Find total social costs at Qse. - Find total social surplus at Qse. (area between

Natural Forest (km2/period

$ / km2

100 $M

C Pri

va te

$ MB Private QSE = 65

Pm = 60

Qm = 40

Find Total Social Benefits (Qse) 150

$ MB social PSE = 85

C D

$M C

So cia

- Total social benefits at Qse = A+B+C+D+E+F+G+H+I+J

Natural Forest (km2/period

$ / km2

100

$M C

Pri va

$ MB Private QSE = 65

Pm = 60

Qm = 40

Find Total Social Costs (Qse) 150

$ MB social PSE = 85

C D

$M C

So cia

- Total social costs at Qse = F + J + I (there are also total private costs, i.e. all the paid inputs)

Natural Forest (km2/period

$ / km2

100 $M

C Pri

va te

$ MB Private QSE = 65

Pm = 60

Qm = 40

Find Total Social Surplus (Qse) 150

$ MB social PSE = 85

C D

$M C

So cia

- Total Social Surplus = Total social benefits - Total social costs (A+B+C+D+E+F+G+H+I+J) - (F + J + I) = A+B+C+D+E+G+H Question: Now find the total social surplus for the market allocation and show it is lower. Check your answer using the next few slides.

Natural Forest (km2/period

$ / km2

100 $M

C Pri

va te

$ MB Private QSE = 65

Pm = 60

Qm = 40

Find Total Social Benefits (Qm) 150

$ MB social PSE = 85

C D

$M C

So cia

- Total social benefits at Qse = A+B+C+D+E+F

Natural Forest (km2/period

$ / km2

100 $M

C Pri

va te =

$M C

So cia

$ MB Private QSE = 65

Pm = 60

Qm = 40

Find Total Social Costs (Qm) 150

$ MB social PSE = 85

C D

- - Total social costs at Qse = F (there are also total private costs, i.e. all the paid inputs)

Natural Forest (km2/period

$ / km2

100 $M

C Pri

va te

$ MB Private QSE = 65

Pm = 60

Qm = 40

Find Total Social Surplus(Qm) 150

$ MB social PSE = 85

C D

$M C

So cia

- Total Social Surplus = Total social benefits - Total social costs = (A +B+C+D+E+F) - (F) = A+B+C+D+E - We can see that the total social surplus is lower at the market allocation in comparison to the SE allocation by area G+H which is the deadweight loss of the market. As with a negative externality, when a good, service or input causes a positive externality, the market fails. - With the negative externality (ex. bitumen), the market produces too much and the price is too low while with positive externality (ex natural forest), the market produces too little and the price is too low.

118

5.3 How can we correct a market with a positive externality?

- As with the negative externality causing thneed (gasoline) we will now consider the price and the quantity mechanisms to provide the socially efficient amount of forest.

Qualities also need to be considered. Ex. boreal forests store more carbon dioxide than tropical rainforests, yet the latter contain vastly more biodiversity.

- As the negative externality, we will consider the price and the quantity mechanisms. Qualities also need to be considered. For example, some land will be more suited for highly productive forests than others. A section of forest which is home to an endangered species would also need to be a priority. - As climate changes, ecosystems will change as warm tolerant species are able to migrate further North. Maintaining North-South forest corridors which enable species to move is important. Its especially important to conserve forests around riparian zones due to symbiotic relationships between terrestrial and aquatic ecosystems. For example, bears leave fish carcasses in the forest and also their dung. Hence, the ocean provides fertilizer for the forest. The nutrients from the forest run into the rivers and are delivered to the oceans and lakes enhancing their productivity.

Natural Forest (km2/period

$ / km2

100 $M

C Pri

va te

$ MB Private QSE = 65

Pm = 60

Qm = 40

Marginal Subsidy = S

150

$ MB social

PSE = 85

$M C

Pri va

te - S

Price Mechanism: - If we pay the firm a subsidy (S) of $50 per km sq of natural forest, its private marginal costs fell by $50/ unit and so the supply curve shifts down by this much. - Now human production units can afford to produce the good (here forests) at a lower price. Due to the lower price, the demand for forests rises and we move along the demand curve so more forest is provided in equilibrium.

Natural Forest (km2/period

$ / km2

100 $M

C Pri

va te

$ MB Private QSE = 65

Pm = 60

Qm = 40

Set Floor on amount of natural forests 150

$ MB social

PSE = 85

Quantity Floor

Quantity Mechanism: - A quantity floor is the opposite of the quotas we discussed (which are also quantity ceilings). The floor provides a minimum on the amount of forest that must be supplied. Quality conditions can also be specified. For example, a section of Northern Madagascar contains the 19 last individual members of the Northern Sportiff Lemur species which are almost extinct. This forest could be preserved under a quality criteria of prioritizing habitat of species that are highly endangered. Given that lemurs are primates with which humans recently share ancestors (about 63 million years ago), I think that the conservation of this species should be a massive global priority.

121

5.4- Removal of Inefficient Subsidies on Fossil Fuels

Socially Efficient

Quantity of Thneeds/ period

$ / thneed

100

Qm = 40

Pm = 60

$M C

Pr iva

$ MB Private

= $ MB Social

$M C So

cia l

QSE

PSE

Private Efficiency

Qsubsidy = 40

$M C

Pr iva

te - S

Allocation with subsidy

- Unfortunately, instead of taking the advise of economists, to raise the price of goods which create GHG byproducts, the fossil fuels are often subsidized. Returning to our original example of the thneed (like the bitumen) which produces a negative externality, suppose that the government mistakingly gives the bitumen company a subsidy of S. This shifts the supply curve downwards so that the firms prices are driven downwards. When prices are lower demand increases (move along demand curve) so more bitumen gets sold and more GHGs are produced. Now the deadweight loss has grown from A under the market allocation to A+B in the subsidized situation.

123

6- Equity Pigouvian policies whether falling on goods, services, inputs or on greenhouse gas byproducts will affect people differently.

For example, suppose you emit 10 tonnes of CO2/year and the carbon tax is $25/tonne CO2e (as in Australia), your yearly carbon tax will be 10 *25 = $250/year. It the tax was $100/tonne, your yearly tax is $1000.

Middle and High income Canadians will not be hurt much by this tax unless they have gigantic footprints.

However, low income people will take a hit here even in Canada. To compensate these people for the tax, lump sum rebates and progressive income taxes are required. The problem is even larger on a global scale due to such great income disparities.

- That said, income is highly correlated with greenhouse gas emissions per capita such that high income people will pay more tax. Also, damages are expected to harm low income people more heavily than high income people (especially in global South). Hence, not doing anything about global warming would be highly inequitable too.

124

7- Summary:

- Given our current technologies, most consumption goods provide net private benefits (surplus) but also external costs due to their effect upon environmental quality.

- Economists have the goal of making society a better place and use criterion such as social efficiency and equity to evaluate various options.

- Under the $ social efficiency criterion, economists choose the number of consumption goods that maximizes the total money social surplus (total social benefits of a consumption good minus the total social costs). Social costs have two categories, private and external costs. Social benefits are likewise private or external.

- Markets fail to be socially efficient when there are externalities. For example in the case of negative externalities, the market price is too low and the market quantity too high for social efficiency. In the case of positive externalities, markets tend to provide too little of the good and the price is too low.

- Since markets fail, economists want to regulate the market to make it behave “better” according to “social welfare criterion” such as monetary social efficiency and equity.

- There are three basic types of policy targets, quantity, price and quality. We looked at examples for regulating negative externalities including a quota on output (an example of a quantity instrument) and a tax on output (an example of a price instrument).

- It is best to target policy along supply chain where GHGs are released, not just on final stage.

- To regulate goods like forests which provide positive externalities, we can use the quantity mechanism of a floor or a price mechanism of a subsidy.

- Quality mechanisms include standards on allowable technologies including sustainable forestry and building codes.

- We looked at policies to regulate markets guide them to produce the socially efficient quantities and qualities of output (TSS is maximized). The externalities are said to be “internalized” such that the users (consumers and producers) pay for negatives and are subsidized for positives.

- The monetary total social maximizing goal may disproportionately harm low income people, income redistribution policies like income tax reductions on low and middle income people will need to be simultaneously implemented. These may provide compensation while still providing incentives to reduce GHGs since GHG intensive goods will be relatively expensive.

- Economists often recommend targeting byproducts like GHGs directly instead of goods, services (like electricity or cars). This approach has the merits of enabling firms to find the most cost effective methods to reduce emissions (we look at this in the next lectures).

- However, regulating goods, services and inputs may be the simplest regulation in some cases. For example, in the case of cars, it is much easier to tax gasoline than GHG emissions. Regulating goods, services and inputs can also potentially be rapidly implemented.

“Thneeds” Residual Byproducts

inputs services goods

Forests provide CO2 removal services

C ru

d e

- crude oil, trees for paper and wood, includes technologies

- transport to work - trees as an end product

Next Class, we shift our focus away from markets in GHG intensive goods and services to the GHGs themselves. We will develop the MAC MD framework which will allow us to understand policies like carbon taxes, emissions standards and cap and trade markets.

- The two basic targets are the goods, services and inputs produced in either the human production systems or the natural ones (or mixed ones) OR the by targeting damaging residual byproducts (like the GHGs or ecosystem destruction and species extinctions. - In this lecture, we have focused on policies which target the thneeds directly (not the byproducts). - We will see later that there are pros and cons of either approach with ideally economists recommending that we target our policy directly at the GHG residual byproducts. The reason is simple--if we target the thneeds, firms have no incentives to find low GHG ways to make these thneeds. However, we can always target particular qualities of thneeds. We will look at this argument in the next lecture.

An example is targetting electricity via a Pigou tax on electricity. This approach would be foolish as firms will have no incentives to find greener low GHG ways to make the electricity. It is better to target the GHGs as they leave the smokestacks. Firms can then focus on reducing these GHGs as cheaply as possible. In our car example however, it will be expensive to target GHGs as they leave the tail pipe of over 800,000 automobiles. It is much simpler to tax gasoline and emissions at earlier stages along the supply chain. A possible drawback is that there is no incentive to figure out a way to capture the emissions from the car. http://www.cbc.ca/news/politics/story/2012/01/18/pol-keystone-xl-pipeline.html

Dr Seuss (1971), The Lorax, Random House.

130

Appendix:

Quantity of Thneads/ period

$ / thneed

Q m=40

100

100 MCexternal = 90

Qse = 0

Pse > 100

MCSocial = 110 + Q

policy goal

110

Suppose that the MC (external) is $90/ unit. Here, the marginal social cost of producing a good always exceeds, the $ marginal social benefit, the monetary social surplus is maximized at Q = 0 at which point TSS = 0. The TSS loss at the market equilibrium is equal to the purple shaded area.

Case in which SE to ban good or service

Pm = 60

QSE = 0

$M C Pr

iva te

$ MB Private = $ MB Social

DWL

Question: What is the maximum total social surplus in this market?

Answer: 0

Quantity of Thneads

$ / thneed

Unregulated Supply Curve

Private MC Producer = 20 + Q

Demand Curve (Private MB consumers and social MB)

Pm = 60

Q m=40

100

QSE=26.7

MCsocial = 20+ 2Q

PSE = 73.4

Regulated Supply Curve Private MC producer + marginal tax = 20 + Q + T

If the marginal external cost is not constant, a constant marginal tax will equal the vertical distance between the unregulated supply (MC private curve) and the socially efficient price at the SE level of output = 73.4 - 46.7 = 26.7 (see pink arrow on graph)

Marginal cost external = Q

46.7

Case of upward sloping marginal external cost curve

References: Pipe Dreams? Jobs Gained, Jobs Lost By Construction of Keystone XL, Cornell University Global Labour Institute

Oil Sands, Greenhouse Gases, and US Oil Supply: Getting the Numbers Right: IHS CERA (industry commissioned)

IPCC (2007) Transport and its Infrastructure (4th Assessment Report, Working Group 3) http://www.ipcc.ch/pdf/assessment-report/ar4/wg3/ar4-wg3-chapter5.pdf

Searchinger, T. et al (2008) Use of U.S. Croplands for Biofuels Increases Greenhouse Gases Through Emissions from Land Use Change, Science, 319, 19

Sharpe, A. et. al (2008) The Valuation of the Alberta Oil Sands, Centre for the Study of Living Standards.

World Bank Population & cars per capita data