Environmental and Natural Resource Economics Tietenberg Solutions Manual by Ace Test Banks

Environmental and Natural Resource Economics Tietenberg 10/12th Ed Solutions Manual

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Instructor’s Manual for Environmental and Natural Resource Economics, 12th edition Originally prepared by Professor Lynne Lewis, Bates College, Maine, USA Revised and updated by Dr Leonie Stone, SUNY Geneseo, New York, USA

Chapter 2 The Economic Approach: Property Rights, Externalities, and Environmental Problems Chapter 2 reviews many of the basic economic concepts that will be used in later chapters. The chapter begins with a discussion of the interactions between the environment and the economy, followed by an explanation of the difference between positive and normative economics. Static efficiency is defined, and consumer surplus and producer surplus are reviewed. The characteristics of an efficient property rights structure are defined and deemed to be necessary for markets to efficiently allocate resources. The remainder of the chapter discusses four cases of market failure: externalities, common property resources, public goods and imperfect market structures. The chapter ends with a discussion of possible remedies to a market failure, including legal remedies, and government regulation. This chapter briefly reviews a lot of material that will seem abstract and difficult to the students with a more limited economics background. You can expect to spend some number of days reviewing the material in this chapter, especially if you are teaching non-majors or those with only one semester of college level microeconomics.

◼ Teaching Objectives 1. Discuss the relationship between the environment and the economic system. 2. Explain the difference between normative and positive economics. 3. Define static efficiency. 4. Review consumer and producer surplus conceptually and graphically. 5. Define an efficient property rights structure, and explain how this property rights structure leads to economic efficiency. 6. Discuss the relationship between profit and producer surplus, and define scarcity rent. 7. Explain the concept of an externality, and show how externalities lead to market failure and an inefficient allocation of resources. 8. Define common property resources, and explain why common property resources tend to be overused. 9. Define public goods, and explain why the private market does not produce the efficient quantity of a public good.

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• Environmental and Natural Resource Economics, Twelfth Edition

10. Discuss monopoly, asymmetric information, and the government’s behavior as sources of market failure. 11. Discuss possible remedies to market failure including legal remedies, and government regulation.

◼

Outline

I. The Human–Environment Relationship A. The Economic Approach 1. Positive economics attempts to describe what is. 2. Normative economics deals with what ought to be. 3. Some timely examples of where normative decision-making will be prevalent include dam removal and policies to prevent or mitigate climate change. II. Environmental Problems and Economic Efficiency A. Static Efficiency Resource allocations satisfy the static efficiency criterion if economic surplus is maximized. Economic surplus is the sum of consumer surplus and producer surplus. 1. Consumer surplus is the difference between total willingness to pay for the good and the actual cost of the good. 2. Total willingness to pay is a measure of the total value received from a good. 3. Producer surplus is the difference between the price of the good and the marginal cost of producing the good. 4. The supply curve is the marginal cost curve. Make sure students understand this fact. III. Property Rights This section focuses on the idea that economic efficiency depends on well-defined property rights. A. A property right is an entitlement held by either an individual or a state. B. A well-defined or efficient property right will be: 1. Exclusive: All benefits and costs accrue only to the owner. 2. Transferable: Property rights can be exchanged voluntarily. 3. Enforceable: Property rights cannot be seized by others. Owning a resource with these characteristics ensures that the resource will retain both its use value and its asset value. Resources for which the asset value cannot be captured will typically be overexploited (e.g., common pool resources). This concept will be covered later in the chapter, but it might be a good time to remind your students of the concept of opportunity cost and introduce them to the idea of intertemporal opportunity cost. C. In a system with well-defined property rights, static efficiency is achieved. Self-interested parties make choices that are efficient from society’s point of view. D. In the short run, producer surplus is equal to profit plus fixed cost. The area under the marginal cost curve is total variable cost. In the long run, producer surplus is equal to profit plus rent. Rent is the return to scarce inputs owned by the producer. Under perfect competition, long-run profit equals zero and producer surplus equals rent. [Remind your students that economic profit is not the same as accounting profit.] E. Scarcity rents are the returns that persist in the long-run competitive equilibrium. IV. Externalities as a Source of Market Failure Information Classification: General

Chapter 2

The Economic Approach: Property Rights, Externalities, and Environmental Problems

Market failure can be the result of a property right system that fails to achieve exclusivity, transferability, or enforceability. If an agent making a decision does not bear all of the consequences (costs and benefits) of that decision, then the characteristic of exclusivity is violated. This results in what is called an externality. A. Externalities or third party effects exist whenever one agent’s activities affect another agent’s welfare. B. An external diseconomy or negative externality imposes costs on a third party. An example of a negative externality is a steel mill upstream from a fish hatchery. If the steel producer does not take into account the costs from waste discharges that might harm the hatchery, these costs are passed on to the fish hatchery and any other “third” or downstream parties. [The textbook example is one of a steel mill upstream from a resort hotel. Both are users of the river.] C. Marginal social costs (all costs to society) will not be equal to marginal private costs (producer’s costs). Take some time to discuss the difference between MCS and MCP, which can be thought of as marginal external cost (MCE). D. The private market equilibrium will be at a point where too much steel is being produced. The price of steel will be too low. Too much pollution is being produced. This is illustrated in text Figure 2.5. It is simplest to assume that marginal private benefits are equal to marginal social benefits, both of which are given by the demand curve. The private market reaches equilibrium, but does not take into account the third party effect (or damages in this case) imposed on the downstream party. At the private market equilibrium, marginal social costs are higher than marginal benefits, resulting in a deadweight loss. The market failure results from a negative externality. E. Some potential solutions, such as a tax that raises private costs and reduces output could be briefly introduced here and returned to in later chapters. Many different examples will be useful to help illustrate this concept. Use examples from the text or from the news. F.

An external economy or positive externality occurs whenever an activity imposes benefits on a third party. Classic examples of positive externalities include the external benefits from vaccines or education. Individuals who plant flowers in their yards will maximize their own net benefit from the flowers when deciding how much to plant. It is unlikely that the third party benefits that accrue to passersby will be included. Likewise, the decision to get a flu shot is likely driven by the benefits received from not getting the flu—not from the benefits of associated individuals who will also have less chance of getting the flu if you get immunized. In this case, marginal private benefits will be lower than marginal social benefits. Too little will be produced by the private market and prices will be too high. Again, this case can be illustrated graphically with the simplifying assumption that marginal social costs equal marginal private costs to emphasize the difference in marginal benefits.

A positive externality also provides an argument for government intervention. An example would be a subsidy to the producers, which increases output and lowers price. V. Alternative Property Rights Structures and the Incentives They Create There are four general property rights regimes that create different incentives for resource use (or misuse). A. Under private property regimes, individuals hold entitlements. B. Under state-property regimes, governments own and control property (e.g., some parks and forests).

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• Environmental and Natural Resource Economics, Twelfth Edition

C. Common-property regimes are those in which property is jointly owned and managed by a specific group. Common property regimes are quite variable, but many result in overexploitation of the resource. Over-fishing in local fisheries or over-hunting can be good examples. A few successful examples exist such as the system of allocating grazing rights in Switzerland. D. Under res nullis or open access regimes, no one owns or exercises control over the resources. This type of regime leads to the “tragedy of the commons” because the resources can be exploited by whoever can get to them first. E. Common pool resources are characterized by non-exclusivity and divisibility. These characteristics allow the resource to be exploited by anyone. Access cannot be denied, and the amount captured will be eliminated from the original amount available (divisibility). Unrestricted hunting access of the American bison, unregulated groundwater withdrawal, and high seas fisheries are all examples of resources that share the characteristics of common pool resources and the tragedy of the commons. The mentality associated with these open access resources is “get it while the getting is good” and “if I don’t get it, someone else will.” The asset value of the resource is essentially zero since non-exclusivity implies that it cannot be saved for later. [Ask your students what this implies about the effective discount rate.] VI. Public Goods A. Public goods are both indivisible and nonexcludable. B. Indivisibility means that one person’s consumption does not affect another’s. C. Nonexcludability means that persons cannot be kept from enjoying the benefits of a good even if they do not pay for it. D. Clean air, national defense, and biological diversity are all examples of public goods. E. Biological diversity includes the amount of genetic variation among individuals within in a single species and the number of species in a community. Species have value beyond intrinsic value by providing ecological stability, and potentially providing sources of food, raw materials and medicines. The private market will not produce the efficient amount of biological diversity. F.

Public goods will be underprovided in a private market because of free-riders. A free-rider is someone who derives benefits from a commodity without contributing to its supply. Someone who does not pay taxes, for example, cannot be excluded from the provision of national defense. Likewise, someone who does not contribute to the nature conservancy will not be excluded from the biodiversity benefits from land preservation.

G. An efficient allocation is determined by the intersection of the demand curve and the marginal cost curve. In the presence of free riders, the private market demand curve will not reflect all of the benefits of the resource resulting in under-provision of the resource. Additionally, efficient pricing requires that a different price be charged to each consumer. Since the excludability criterion is violated, consumers may not reveal their true willingness to pay. The market demand curve is derived in text Figure 2.7 from two individual demand curves. VII. Imperfect Market Structures A. Markets that are not competitive will exhibit inefficiencies. Monopolies will supply too little of a good at too high a price. A cartel is a group of producers who form a collusive agreement to gain monopoly power. OPEC, for example, colludes in order to gain monopoly power. Restricting output raises the price of oil. B. At the monopoly output, marginal benefits are greater than marginal costs. Net benefits are not maximized and there is a deadweight loss. VIII. Asymmetric Information

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Chapter 2

The Economic Approach: Property Rights, Externalities, and Environmental Problems

A. When one party has more information about a given situation than the other party there is asymmetric information. In this case the decision maker with too little information cannot make an efficient decision. B. Labeling is one solution to the problem of asymmetric information, as in the case of organic food labeling. Labels provide information to the buyer. IX. Government Failure Governments, as well as markets, can also be sources of inefficiency. A. Rent-seeking behavior may persuade government officials to pursue options that are beneficial to a specific interest group and would not maximize social net benefits. Agricultural producers seeking price supports or consumer groups seeking subsidies are examples of rent seeking. B. Incomplete information is other source of inefficient government policies. X. The Pursuit of Efficiency A. Private resolution through negotiation is the simplest means of restoring efficiency, but large numbers, poorly defined property rights, and high transactions costs make this difficult in practice. B. Legislative and executive regulation are remedies that can take several forms, including taxes and regulatory laws. Gasoline taxes and regulations on unleaded fuels are potential discussion topics as are proposals for carbon taxes. The subject of zoning laws also typically makes for a lively discussion topic. XI. An Efficient Role for Government The role of the government in restoring efficiency is considered. If transaction costs are high, corrective action might not be the best response. In other cases it is. Introducing the need to evaluate each decision individually is important here. Most decisions are normative and the need for students to analyze each case will be important in this and later chapters.

◼ Common Student Difficulties Many students will struggle with some of the concepts in this chapter. Students who have taken only one or two economics classes will need to be provided with many concrete examples, and even the serious economics students will need to see a few examples. Some students may be frustrated with the amount of time spent on this chapter and the review of economic models and concepts. Use as many interesting environmental and resource examples as you can to keep them interested. They need to master this material in order to be successful with the later chapters. Take time to review the basic supply demand model and the concept of static efficiency. Emphasize that demand is measuring the willingness to pay and supply the willingness to sell. Make sure they understand consumer and producer surplus. Discuss the difference between total willingness to pay and marginal willingness to pay and have them identify these concepts graphically. Make sure they understand that the supply curve is the marginal cost curve. Review key cost concepts as necessary, such as total cost, variable cost, fixed cost, and marginal cost. These concepts will be especially useful in the environmental section of the course. The externality graph can be conceptually challenging. Take time to explain the difference between the private marginal cost and the social marginal cost. Use a concrete example and some numbers that can then be plotted on a graph. If your students are up for it, have them identify producer surplus, consumer surplus, and total external cost on the graph to compare the private and social equilibrium. Once they understand the graph and the two equilibrium points, discuss bargaining. Have them think about what

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• Environmental and Natural Resource Economics, Twelfth Edition

each party would be willing to pay and willing to accept from the other party. Make sure they understand that it does not matter who owns the resource or the right to pollute. Finally, introduce the concept of a tax on output and show how a tax could lead the private market to produce at the socially optimal quantity. The idea of a common property resource is straightforward, but thinking about how one person’s actions affect another’s can be less clear. Use different examples such as farmers grazing cattle on common land, or fishermen fishing in a common lake to have them think about the difference between average benefit and marginal benefit. Simple numerical examples can be useful. Since common property resources can be overexploited, have them think about how to remedy the situation. Take time to explain the difference between a private good (an apple, a car, a book, etc.) and a public good (flowers or trees planted on campus). Students buy private goods every day. If they decide not to buy a good, they do not get to enjoy its benefits. Public goods on the other hand can be enjoyed even if they are not paid for. Take time to derive the market demand curve for a public good and then show what happens when one or more people decide they will free ride and refuse to pay.

◼

Suggested Classroom Exercises

The economy as an asset: students are often pretty enthusiastic about resource and environmental issues. Before delving into the economic models presented in this chapter, have a short discussion based around text Figure 2.1. Have them identify key scarce resources and waste products. Get them to share opinions about how scarce some resources actually are and how polluted the air or water might be. Ask them how they think we should address resource scarcity, or whether they think zero pollution is possible. Get them to think about tradeoffs between economic growth and environmental quality, and opportunity cost. Static efficiency: use a simple algebraic example to review these concepts. The demand curve for a product is given by QD = 400-20P and the supply curve for a product is given by QS = 16P-32. a. Illustrate the demand curve and the supply curve on the same graph. b. Find the equilibrium price and quantity. c. Find numerical values for the consumer surplus and the producer surplus. d. Identify consumer surplus and producer surplus on your graph. e. Find numerical values for the total willingness to pay for the equilibrium quantity and the total variable cost of supplying the equilibrium quantity. Identify these areas on your graph. Externalities: use a simple algebraic example to help them understand the difference between a private and social equilibrium. Demand: P = 100 - 2Q = MB Supply: P = 10 + 0.5Q = MCP Find the equilibrium price and quantity and illustrate graphically. Suppose MCE = 0.5Q. What happens to the marginal external cost (the marginal increase in damages from pollution) as more of the good is produced? Find the marginal social cost MCS = MCP + MCE. Illustrate this new cost curve on your graph. Find the socially optimal equilibrium price and quantity. Which area on the graph represents the net gain from moving to the socially optimal equilibrium point? Common Property: this example works well if your class is not too large. Buy a few bags of cheap candy. Distribute the candy around the room. Give one person a very short amount of time to gather

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Chapter 2

The Economic Approach: Property Rights, Externalities, and Environmental Problems

candy. Record the amount they find. Redistribute the candy around the room. Now repeat the example a few times with more people gathering candy. Record how much each person finds. You should find that the average number of pieces of candy found diminishes with more people hunting for candy. Point out that the typical person will only think about their personal “catch” when hunting for candy and will not think about how their hunting affects the quantity available for others. Five fishermen live in a village and have no other employment or income earning possibilities besides fishing. They each own a boat that is suitable for fishing, but does not have any resale value. Fish are worth $5 per pound and the marginal cost of operating the boat is $500 per month. They all fish in a river next to the village, and they have determined that when there are more of them out there on the river fishing, they each catch less fish per month according to the following schedule: Boats Fish Caught per Boat (pounds) 1 200 2 190 3 175 4 155 5 130 If each fisherman acts in his own best interest, will he continue to operate his boat each month? If so, how much income will he earn per month? If the fishermen band together and act as a group, how many boats will they choose to operate? If income is divided evenly, how much will each fisherman make? Public Goods: come up with a public good that will be provided on campus such as more trees, more flowers, or more recycle bins. To supply the public good, students must contribute. The more money raised, the greater the amount of the public good supplied. Get students to think about what the good is worth to them. Have them write this number on a piece of paper and turn it in as a secret ballot. Now tell them that student volunteers are going to go around and collect funds in order to supply the public good. Ask them how much they will contribute and have them write this number on a separate piece of paper as a second secret ballot. Open the ballots and see what happens. Private Bargaining: here is a simple bargaining example. There is a factory that is dumping toxic waste into a river where a resort is located downstream. At the moment the factory is not filtering the water that it dumps into the river. There is a filter it could install that would remove a significant amount of the toxic elements from the water before it is dumped in the river. The factory and the resort have each assessed the situation and come up with the following data: Gains to: No Factory Factory with filter Factory with no filter Factory $0/day $700/day $800/day Resort $400/day $250/day $100/day If the factory is given ownership of the river, what choice will it make? How much would the resort be willing to pay to get the factory to make another choice? Will the factory accept? If the resort is given ownership of the river, what choice will it make? How much would the factory be wiling to pay to get the resort to make another choice? Will the resort accept?

◼

Essay Question

Monopolies and cartels are usually associated with economic inefficiencies and deadweight losses. With a common-pool resource, however, asset values are non-existent and resources are depleted more quickly than would be optimal. Debate 2.1 examines how OPEC, a cartel, sets prices. Discuss the role of this type pricing with respect to resource conservation.

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Chapter 3 Evaluating Trade-Offs: Benefit–Cost Analysis and Other Decision-Making Metrics Chapter 3 presents three decision-making metrics that can be used to evaluate policy options. The bulk of the chapter covers benefit-cost analysis, and explores the connection between static efficiency and maximizing net benefits. The first equimarginal principle and pareto optimality are introduced. Present value is reviewed and there is a discussion of which discount rate is best. Some difficulties associated with measuring benefits are raised, and there is a discussion of how to estimate costs. Cost effectiveness analysis and impact analysis are discussed as options to benefit-cost analysis. Since resources are limited it is not possible to undertake all ventures that might be desirable. The government for example has limited resources and cannot possibly address and solve every single environmental problem. Students need to understand how to wisely use scarce resources and this chapter provides a framework for allocating scarce resources.

◼ Teaching Objectives 1. Understand that all actions have benefits and costs, and all benefits and costs are valued in terms of their effect on humanity. 2. Understand that (total) benefit is measured as the area under the demand curve, and total cost is measured as the area under the supply (or marginal cost) curve. 3. Define net benefit graphically as the difference between total benefit and total cost. 4. Explain that all costs should be measured as opportunity costs. 5. Define present value and the discount rate. Illustrate the basic discounting equations. 6. Calculate the present value of net benefits and show how benefit-cost analysis can be used to evaluate specific options. 7. Define optimality and economic efficiency. 8. Distinguish between static efficiency and dynamic efficiency. Use the equimarginal principle to illustrate both efficiency and inefficiency. 9. Define the concept of Pareto optimality.

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• Environmental and Natural Resource Economics, Twelfth Edition

10. Apply these concepts to real world examples. 11. Discuss several issues in estimating benefits such as the difference between primary and secondary effects. 12. Explain the different approaches to cost estimation. 13. Understand how to quantify risk and how to decide how much risk is acceptable. 14. Discuss how to choose the discount rate, and explain the difference between the social and private discount rate. 15. Discuss cost effectiveness analysis and impact analysis as alternatives to benefit cost analysis when benefit data is lacking.

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Outline I. Normative Criteria for Decision-Making A. Benefit-cost analysis provides a method for determining whether or not an action should be supported. Most simply, if the benefits exceed the costs, then the action should be supported. 1. Benefits can be derived from the demand curve for the good or service. 2. Total willingness to pay or total benefit is the area under the demand curve from the origin to the chosen quantity. 3. Costs are measured by the marginal cost curve. 4. All costs should be measured as opportunity costs. Opportunity cost is the net benefit foregone when an environmental service is lost to a different use. 5. Marginal opportunity cost is the cost of producing the last unit. 6. Total cost is the sum of the marginal costs or the area under the marginal opportunity cost curve up to the chosen quantity. This will also be the area under the supply curve in purely competitive markets. 7. Net benefit is the excess of benefits over costs or the area under the demand curve that lies above the supply curve. This is also consumer plus producer surplus. B. Benefit-cost analysis requires comparing benefits and costs that usually occur at different points in time. The concept of present value allows us to incorporate the time value of money and to compare dollars today to dollars in some future period by translating everything back to its current worth. 1. The present value of benefits, $B, received n years from now is $Bn /(1 + r)n, where r is the discount rate. 2. The present value of a stream of benefits {B0,…,Bn} received over a period of n years is the sum from time i = 0 until year n of $Bi /(1 + r)i. 3. Discounting is the process of calculating present value. C. Finding the Optimal Outcome 1. An allocation is efficient or has achieved static efficiency if the net benefit from the use of those resources is maximized by that allocation. If at an allocation marginal cost is greater than marginal benefit, then net benefits are less than the maximum possible, and the allocation is inefficient (too much has been produced). Likewise, if marginal benefit is

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Chapter 3

2. 3. 4. 5.

Evaluating Trade-Offs: Benefit–Cost Analysis and Other Decision-Making Metrics

greater than marginal cost, net benefits can be increased by increasing the allocation. Thus, an efficient allocation will be achieved when marginal benefit and marginal cost are equal. Inefficient allocations do not maximize net benefit. The first equimarginal principle says that net benefits are maximized when the marginal benefits from the allocation equal the marginal costs. An allocation is Pareto optimal if no other feasible allocation could benefit some people without any negative effects on at least one other person. Allocations that do not satisfy Pareto optimality are suboptimal. An allocation has achieved dynamic efficiency if it maximizes the present value of net benefits.

II. Applying the Concepts A. This section presents some examples of actual studies in which benefit-cost analysis has been used. The benefits and costs of U.S. air pollution control policy are discussed as are preservation versus development conflicts. The boxed Examples 3.2 and 3.3 in this chapter are useful case studies to discuss in class. B. Issues in Benefits Estimation Benefit-cost analysis involves judgments on: •

Which effects should be included (e.g., should secondary effects be included)?

•

How many people incur benefits and costs and are the benefits and costs the same for each person?

•

How to handle intangible values or those that cannot be reliably assigned a monetary value.

What should be counted might vary depending on the nature of the local economy. Thus it will vary by place and time. How these variables are measured is also important. Students may have trouble, for example, with the idea that the additional labor hired for a project will not be counted in an analysis if it is simply a transfer of labor that would already be employed elsewhere. A natural reaction is to include this on the benefit side when it is actually simply a rearrangement of productively employed resources. The quantification of intangible benefits will also likely be a stumbling block. The importance of sensitivity analysis should be stressed. C. Approaches to Cost Estimation Estimating cost is typically more straightforward than estimating some types of benefits. Difficulties involve estimating expected future costs and getting reliable cost information from firms. Some common approaches include the following: 1. The survey approach involves asking polluters about their control costs. 2. The engineering approach uses engineering information to estimate the technologies available and the costs of purchasing and using those technologies. 3. The combined approach uses both 1 and 2. D. Treatment of Risk For many environmental issues, scientific uncertainty complicates benefit-cost analysis. Thus, identifying and quantifying risks and then deciding how much risk is acceptable is important. Since it is very tedious and sometimes unfeasible to do a benefit-cost analysis for every possible outcome, we usually must utilize expected values. 1. A dominant policy is one that confers the highest net benefits in every outcome.

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• Environmental and Natural Resource Economics, Twelfth Edition

The expected value of net benefits is the sum over the possible outcomes of the present value of net benefits of that outcome weighted by its probability of occurrence. The policy selected should be the one with the highest expected present value of net benefits. The above approach assumes risk neutrality. Whether or not it makes sense for the government to assume that society on the whole is risk neutral (versus risk loving or risk averse) should be discussed. The evaluation of irreversible decisions requires extra caution.

E. Choosing the Discount Rate The discount rate is defined as the social opportunity cost of capital. The discount rate will have two components: the riskless cost of capital and the risk premium. The rate on long-term government bonds is a common choice as a measure of the cost of capital. This can then be adjusted by a risk premium to reflect the level of riskiness of the particular project being considered. The appropriate rate to use will depend on the nature and expected lifetime of the project, who is doing the financing, and the level of risk. The power of the discount rate to sway a decision one way or another should not be overlooked (Example 3.4). Sensitivity analysis to the choice of the discount rate should be performed. Numerical examples will facilitate the explanation of these concepts. A simple homework assignment will also help illustrate discounting. For example, an assignment could be designed such that the present value of net benefits flips from being greater than zero to less than zero with a change in discount rates. A 10-year project with equal expected annual benefits and differing annual costs, for example, could be put into a spreadsheet. Students can be asked to evaluate the project using both rates and to make a decision. Variations on this type of exercise can include changes in estimated benefits or costs or a change in the expected lifetime of the project. III. Divergence of Social and Private Discount Rates A. Private market decisions or outcomes may differ from society’s decisions. This will be the case if individual rates of time preference differ and if private risk premiums differ from social risk premiums. The risk premium is the amount required to compensate capital owners for potential differences between expected and actual returns. Different discount rates will result in market outcomes that are not efficient. Asking your students about their rates of time preference in relation to an expected sum of money or student loans should result in a variety of responses. Topics such as gambling or speeding on the highway can spark discussion (and interesting stories) and help to illustrate rates of time preference and variations in risk perceptions. B. A Critical Appraisal Concern over the reliability of benefit and cost estimates is commonplace and should not be ignored. Unreliable estimates limit the value of a benefit-cost analysis. Ex-post benefit-cost analysis can be useful for fine-tuning the methodology of future benefit-cost analyses. Some examples from ex-post analysis are presented. Accounting stance, or the geography of who benefits and who pays, should also receive attention. Whether the costs and benefits are measured at the local, national or international level will affect the results. (See, for example, Howe, C.W. “Project Benefits and Costs from National and Regional Viewpoints: Methodological Issues and Case Study of the Colorado-Big Thompson Project,” Natural Resources Journal 261 (Winter 1987): 5–20.) The pros and cons of benefit-cost analysis should be overviewed and outlined at this point. Teaching students to think critically about these issues is important. IV. Cost-Effectiveness Analysis

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Chapter 3

Evaluating Trade-Offs: Benefit–Cost Analysis and Other Decision-Making Metrics

Cost-effectiveness analysis is a useful alternative to benefit-cost analysis when the measurement of benefits is impossible, or estimates are unavailable. This alternative involves the minimization of the costs of achieving a policy target, such as an emission standard. A minimum-cost solution requires the equalization of the marginal costs of all possible alternatives (Second Equimarginal Principle). Various proposed standards can thus be compared for their cost effectiveness. A numerical example of this concept will be extremely helpful. V. Impact Analysis Environmental impact statements attempt to quantify consequences of an action. Impact analysis is useful when the data needed for either a benefit-cost analysis or a cost-effectiveness analysis is unavailable. These present the analyst with as much raw information as is available without any optimization or benefit-cost analysis. More sophisticated environmental impact statements sometimes include benefit-cost analysis or a cost-effectiveness analysis.

◼ Common Student Difficulties Students with a limited background in economics will have trouble with the equimarginal principle and will frequently confuse total and marginal cost. Simple numerical examples that illustrate the maximization of net benefits in terms of equalizing marginal cost and marginal benefit should help. They may also have difficulty with the concept of optimization and Pareto optimal allocations. This might be a good place to also start talking about the role of government intervention. The concept of discounting might also be problematic for some students. Examples they can relate to (all students will likely have a high rate of time preference for money) will illustrate present value and the role of the discount rate. Asking them if they would like $100 today or $100 on the day they graduate should nicely illustrate the time value of money. If they are skeptical, this type of question should help prove to them that most people have positive rates of time preference (prefer benefits sooner and costs later).

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Suggested Classroom Exercises

Total Benefit and Total Cost: an example that illustrates the difference between total benefit and cost and marginal benefit and cost will be very useful. Use the equations given below and have the students calculate total benefit, total cost, marginal benefit, and marginal cost for values of X ranging from 35 to 45. Next have the students graph total benefit and total cost on one graph, and marginal benefit and marginal cost on the other graph. Have them find the optimal value of X. TB = 314X - 1.6X2 MB = 314 - 3.2X TC = 50X + 1.7X2 MC = 50 + 3.4X The Discount Rate: An in-class example or problem set related to discounting will not only let the students learn with a hands-on example, but will likely ease their minds about the difficulty of the concept. Alternatively this problem can be done at home using a spreadsheet program. The spreadsheet problem set below is a hypothetical example of two proposed uses for a coastal area. Obviously, you can think of many different scenarios and sets of numbers. You can tell the students, for example, that a coral reef area will either be protected or mined. A set of costs and benefits is given for a 10-year period. As you can see in the answers, I have set this problem up so that the net present value changes from positive to negative with a change in the discount rate. This is a nice illustration of the effect of the discount rate. The example is also set up so that a different project would be pursued at a different rate. Additionally, the answers can be

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• Environmental and Natural Resource Economics, Twelfth Edition

calculated using a continuous discount rate if you are teaching your students both discrete and continuous discounting. A discussion on the choice of the discount rate could be started here or saved for a later chapter. Problem Set 1. Discount rates Project 1. Gringoland Marine Park 0 Costs (thousands of $) Construction Recurring costs Foregone recreation Benefits Increased tourist revenue Net NPV @ 5% NPV @ 10%

Years 5 6

1250 130 130 130 130 130 20 20 20 20 20 20

130 20

130 130 20 20

130 20

300 300 300 300 300 300

300

300 300

300

200

200 200

200

Project 2. Gringoland Coral Mining Costs (thousands of $) Extraction costs Costs of coastal erosion Benefits Revenues from limestone Net NPV @ 5% NPV @ 10%

3000 200 200 200 200 200 200 4500

Answers: Project 1. Gringoland Marine Park Years 0

Costs (thousands of $) Construction

1250

Recurring costs Foregone recreation

130

300

–970

150

Benefits Increased tourist revenue Net

150

NPV

188.26

–970 142.86 136.05

129.58 123.41 117.53 111.93

106.6 101.53 96.691

92.087

NPV

@ 10

–48.31

–970 136.36 123.97

112.7 102.45 93.138 84.671

76.974 69.976 63.615

57.831

181.14

–970 142.68 135.73

129.11 122.81 116.82 111.12

105.7 100.55 95.644

90.98

Continuous r NPV

Information Classification: General

Chapter 3

NPV

@ 10

–68.44

Evaluating Trade-Offs: Benefit–Cost Analysis and Other Decision-Making Metrics

–970 135.73 122.81

111.12 100.55

90.98 82.322

74.488 67.399 60.985

55.182

Continued

Project 2. Gringoland Coral Mining Years 0

200

1300

–200

Costs (thousands of $) Extraction costs

3000

Costs of coastal erosion

200

Benefits Revenues from limestone Net

4500

NPV

–244.35

1300

–190.5 –181.4 –172.8 –164.5

–156.7 –149.2 –142.1 –135.4 –128.9 –122.8

NPV

@ 10

71.09

1300

–181.8 –165.3 –150.3 –136.6

–124.2 –112.9 –102.6 –93.3

–172.1 –163.7

–155.8 –148.2 –140.9 –134.1 –127.5 –121.3

–163.7 –148.2 –134.1

–121.3 –109.8 –99.32 –89.87 –81.31 –73.58

–84.82 –77.11

Continuous r NPV

–234.86

1300

–190.2 –181

NPV

@ 10

97.92

1300

–181

◼

Essay Question

Consider a project that will require a sizeable expenditure today in order to realize a stream of net benefits over the next 20 years. What happens to the present value of net benefits as the discount rate rises? Is it likely that different people evaluating the same project would end up choosing different discount rates? Discuss.

Information Classification: General

Chapter 4 Valuing the Environment: Methods In the last chapter, students learned about benefit-cost analysis as a tool for evaluating policy options. In order to use benefit-cost analysis, all relevant cost and benefits must be monetized. This chapter explains the different methods that can be used to measure and quantify the benefits of some proposed action. The methods that will be learned in this chapter can be used to place a dollar value on an environmental improvement, or can be used to place a dollar value on the damages done to the environment. The difficulties associated with placing a dollar value on goods and services that are not traded in markets are explained. It is important at this point to remind your students why they are learning this material and what you expect them to get out of it. Something I have found to be useful when teaching the non-major is to let them know that I do not expect them to become economists. I do, however, expect them to understand enough about economic methodology to think critically and to be able to decipher it. If, for example, a cost-benefit analysis crosses their desk some day, would they understand why a certain discount rate was chosen? Would they know whether all the relevant benefits and costs were included? Would they be familiar enough with the methodologies chosen by the analysts? As cost-benefit analysis is very important to the policy process, and many times required, knowing whether an analysis has been done well or thoroughly will be very important. Even when benefits are difficult to quantify, economic analysis is important. Some students may balk at the idea of putting a dollar value on nonmarket goods and services. Take advantage of the skepticism! These students provide great ammunition for a discussion on the debate of whether or not some number is better than no number.

◼ Teaching Objectives 1.

Understand why it is important to place a dollar value on the environment and understand the general difficulties associated with coming up with such a dollar value.

Define types of values: use value, option value, nonuse value (or existence value), and total willingness to pay.

Classify the available nonmarket valuation methods by whether they are based on revealed preference or stated preference, and whether they are direct or indirect.

Understand the contingent valuation method and its potential biases.

Understand the difference between willingness to pay and willingness to accept.

Explain the use of attribute-based models as an alternative to contingent valuation.

Information Classification: General

Chapter 4

Understand the travel cost method.

Understand the hedonic property value and wage methods.

Understand the averting expenditure method.

Valuing the Environment: Methods

10. Understand how GIS systems can be used for economic valuation. 11. Discuss how to place a value on a human life.

◼

Outline I. Introduction This chapter begins with a brief summary of the Exxon Valdez spill in 1989 and the billions of dollars spent on cleanup and compensation for damages. There have been numerous papers written on this topic that might be useful additions to class discussions or readings. A comparison is made between the Exxon Valdez spill and the explosion of the BP drilling rig in the Gulf of Mexico in 2010. The American Trader oil spill in Southern California in 1990 resulted in the first jury verdict for natural resource damages, which may provide for interesting classroom discussion. There is an abundance of information available online about the many oil related disasters that have occurred over time. Many students will also be interested in a discussion of the NOAA panel whose aim was to evaluate the use of contingent valuation methods for determining nonuse values (see the text for a more detailed reference).

II. Why Value the Environment? This section discusses why it is important to place a value on the environment. For example, many federal agencies require the use of cost benefit analysis for decision-making. Debate 4.1 asks whether humans should place an economic value on the environment. III. Valuation This section begins with a discussion of the costs and benefits associated with pollution control. The difficulties in estimating physical damages are discussed. If damages can be estimated, the next step is to try to place a monetary value on them. The complexities of assigning monetary value should be emphasized along with the associated controversy. This is also a good time to point out the interdisciplinary nature of the subject. There are sure to be at least a few students in the class who have a strong background in the sciences, which can make for some interesting class discussion. A. Types of Values The difference between stocks and flows and their relationship should be emphasized before proceeding to a classification of values. 1. Use Value: Use value reflects the willingness to pay (WTP) for direct use of the environmental resource. I have found that use value is most easily understood if you remind students that to use something simply requires one of the senses to be active (sight, sound, touch, taste or smell): hearing noise pollution; seeing a grizzly bear; eating freshly caught fish; consuming water by drinking or swimming; taking in a vista while hiking and touching your feet to the trail, smelling flowers or smelling foul air. All of these constitute some kind of use of natural resources and the environment. Distinguishing between active use (consumptive) and passive use (non-consumptive) will help to clarify the concept of use values.

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• Environmental and Natural Resource Economics, Twelfth Edition

Option Value: Option value is the willingness to pay for the future ability to use the environment. This is the value people place on having the option to use or ensuring something exists for potential future use. In order to illustrate option value, ask your students about their future plans. For example, students can be asked questions about their summer travel plans. Do they plan to go to Yellowstone National Park next summer? Most of them will probably say no. But if you ask them if they ever plan to go or would ever like to go, they will likely say yes. Thus, they will understand that they place a value on the park to ensure it will still exist when they do want to go. Nonuse or Passive-use Value: Nonuse value represents an individual’s willingness to pay to preserve a resource that he or she will never use. These values are often called existence values. This is a very different category of value and, of course, represents the most problematic as well as controversial with respect to monetization. These are less tangible values, but can be quite large. Total Willingness to Pay (TWP): Total Willingness to Pay = Use Value + Option Value + Nonuse Value.

B. Classifying Valuation Methods This section is a preview of the rest of the chapter. The methods used to measure benefits can be broadly classified as either stated preference or revealed preference, depending on whether the value is stated from a survey or revealed from market data. The methods are further classified as either direct or indirect, depending on whether the values are directly determined from the data, or indirectly derived from the data. It is important to show students when each technique is or is not appropriate and what the underlying assumptions and limitations are. Additionally, it is important to highlight the differences between these methodologies. Some examples from each type of method are presented in the chapter, but the literature is filled with other examples from which to choose. C. Stated Preference Methods 1.

Direct stated preference methods use surveys to elicit willingness to pay. The contingent valuation method is a survey methodology in which respondents are asked what value they would place on some level of environmental change (such as a change in risk of illness or loss of habitat, etc.).

Potential Biases with Contingent Valuation a. Strategic bias is the tendency to overstate or understate WTP in order to affect policy. b. Information bias occurs when respondents are forced to evaluate goods/attributes for which they have little or no experience. c. Starting point bias is the tendency for reference points for bidding games and payment card mechanisms to induce higher or lower responses. d. Hypothetical bias is the tendency for hypothetical payments to differ from actual payments due to a difficulty in correctly picturing the situation. e. A final source of bias addresses the gap between the willingness to pay to avoid damage and the willingness to accept compensation for damage. f. Compensating variation and equivalent variation are defined as additional methods of measuring the impact on consumer welfare of changes in environmental quality. In theory, these measures should be equivalent. g. A NOAA convened panel on contingent valuation concluded that a carefully designed survey could eliminate or reduce bias. The panel issued guidelines for determining whether a study was suitably designed.

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Chapter 4

Valuing the Environment: Methods

Indirect stated preference methods are also surveys, but these surveys ask respondents to rank a set of hypothetical situations in terms of their desirability. One example of an indirect hypothetical method is contingent ranking. Typically a contingent ranking exercise asks respondents to evaluate bundles of goods with varying levels of certain characteristics and to rank order the bundles. Conjoint analysis is another example of an indirect hypothetical method. Conjoint analysis presents respondents with bundles of attributes from which to choose.

D. Revealed Preference Methods Revealed preference methods are those that are based on actual observable choices and/or goods that have market prices. Loss in value can be calculated easily if prices are directly observable. Indirect revealed preference methods utilize surrogate markets to infer a value. These techniques utilize spending on other goods in other markets in order to extract out the environmental value of that good. E. Travel Cost Method Travel-cost methods infer values of recreational resources by determining how much visitors spend getting to a site (for instance a park or a river) and then using this information to estimate a demand curve for that site. F.

Hedonic Property Value and Hedonic Wage Methods Hedonic property value and hedonic wage methods use regression analysis to infer environmental values from spending on goods that include those values. For example, property values are typically lower in areas with higher levels of air or water pollution. Houses near open space or with nice views will likely be more expensive than similar houses without those amenities. Similarly, workers in high-risk occupations receive higher wages for taking on that risk.

G. Benefit Transfer and Meta Analysis Implementing a reliable study is enormously costly. One solution to this problem is to use a technique called meta-analysis. Meta-analysis utilizes a cross section of contingent valuation studies for determining nonuse values. Another possible solution is to use benefits transfer. It involves the use of estimates from other places and other times being used for similar analysis elsewhere. H. Using Geographic Information Systems to Enhance Valuation Geographic Information Systems (GIS) are computerized mapping models and analysis tools. Specifically, a GIS map is made up of layers such that many variables can be visualized at the same time. For instance, hedonic property valuation models have incorporated GIS technology. Given that hedonic property valuation models are spatial in nature (many variables have to be considered), the use of GIS in this context is a natural fit. I. Averting Expenditure Method The averting expenditure method identifies the actions and expenditures needed to reduce the damage caused by pollution. These expenditures can be used as a lower bound estimate of damages. J. Aggregation When aggregating estimated values into a total value to measure benefits, it can be difficult to determine the extent of the market. Debate 4.3 discusses this issue. K. Partial Values

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• Environmental and Natural Resource Economics, Twelfth Edition

Most methods only capture a portion of the total value of an environmental good or service. Debate 4.4 discusses the difficulty of coming up with a total value when only partial values exist. L. Valuing Human Life This likely controversial subject focuses on calculating the change in the probability of death resulting from a reduction in some environmental risk and then placing a value on that change. The “implied value of human life” is calculated by dividing the amount each person is willing to pay for a certain reduction in the probability of death by the probability of the reduction. A 1996 survey found that most implied values of human life were between $3 million and $7 million. Table 4.4 illustrates the costs of risk reducing regulations. Debate 4.5 explores the ethics of valuing human life.

◼ Common Student Difficulties Many students, especially environmental students, will take issue with the idea of monetization of human life or environmental goods such as aesthetics, endangered species or pure existence values. At this point, the nature of the policy process and the predisposition toward benefit-cost analyses should be emphasized. Non-monetization is the equivalent of putting a zero in the equation. Discussing the debate over whether some number is better than no number could be useful and may also spark an interesting classroom discussion. There are interesting papers on both sides of the debate. (For examples of the critiques of contingent valuation, for instance, see Hausman, Jerry A. Contingent Valuation: A Critical Appraisal, North Holland, 1993. This book contains plenty of class discussion material on the debate.) Reminding your students that a zero is really a zero will surely prompt their interest and protest! Economics majors, on the other hand, may take issue with the existing methodologies available to monetize nonmarket benefits. Some students in my class want reliable numbers and are not sure what to do with ranges or are troubled by the idea of asking people for their own estimates. Again, it is important to emphasize how benefit-cost analysis is used and why it might be important to attempt to place a value on these intangibles. Students may also have trouble with deciding what, if any, secondary effects to include in an analysis. For example, it is a common error to include changes in employment on the benefits side of the equation, even if the labor hired for the projects is merely transferred from elsewhere in the economy. This point will likely need to be reiterated. I have found it useful to find a local proposed development project and ask them to categorize the benefits and costs. Then ask them to identify which method they would use to estimate each itemized benefit and cost. One project that is often of interest is the planting of more trees in an urban area, and the many associated benefits and costs.

◼

Suggested Classroom Exercises

Sample Survey One classroom exercise that I have found to be extremely useful for teaching nonmarket valuation is to ask the students to fill out a questionnaire that illustrates various types of willingness to pay questions. I intentionally build into the questions some of the potential biases that can be associated with contingent valuation surveys in order to illustrate to them (a) how easy it is to unintentionally bias a question; (b) how to avoid some biases; and (c) what protest bids look like. The survey below is a generic example. I use two versions in order to illustrate potential bias, but do not inform them that there are two versions until all the surveys are collected.

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Chapter 4

Valuing the Environment: Methods

I have found that it is helpful to start the questioning by asking the students to value a market good with which they are very familiar and are likely to have a good idea of its market value. The example below utilizes a cup of coffee. To illustrate potential bias, the seller of the coffee differs in the two surveys. The second question illustrates the issue of scale or embedding by asking about two different populations. The third question asks students for their willingness to pay to help cleanup something manmade versus something caused by a natural disaster. The final question asks both willingness to pay and willingness to accept. This survey has worked very well as a tool to illustrate protest bids. When the survey is collected, I inform the students of the two different versions and begin to read some of the answers. You can explain to them that “$0.00. I hate coffee” is a valid zero, while “$0.00. I hate Starbucks” is not a valuation of the good, but a protest of the question and would be a number that is thrown out. “$0.00. I get it for ‘free’ in the dining hall,” is also great for discussion. Is this a valid zero? No! Likewise, you can discuss payment vehicle bias and the common protest of increases in taxes. Additionally, typically at least one student will write down a million dollars for the willingness to accept question. This makes the discussion of WTP versus WTA quite lively. Finally, some socioeconomic questions can be included and a discussion of data analysis could take place for the more advanced student. A sample survey follows.

◼

Sample Survey/WTP Questions

We would like to ask you a few questions concerning your willingness to pay for various goods and services. Please answer all questions honestly, keeping in mind your household budget when choosing a response. Thank you for your participation.

Question 1 Version 1 1. The [add name] student-run coffee house is considering setting up a gourmet coffee stand in [student union name]. Coffee would be sold from 7:00 a.m. until 12:00 noon. What would you be willing to pay for an 8 oz. gourmet cup of coffee from this [school name] student group? $_______________ If you said $0, please tell me why? Version 2 1. [Big company, e.g. Starbucks] is considering setting up a gourmet coffee stand in [student union name]. Coffee would be sold from 7:00 a.m. until 12:00 noon. What would you be willing to pay for an 8 oz. gourmet cup of coffee from Starbucks? $_______________ If you said $0, please tell me why?

Question 2 Version 1 2. There are less than 1,000 American crocodiles left. Habitat necessary for the American crocodile is rapidly being bought for development. The Nature Conservancy is considering buying land in an effort to save this species. What would you be willing to pay in the form of an annual donation in order to buy enough habitat to save 100 crocodiles? $_______________ If you said $0, please tell me why? Version 2

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• Environmental and Natural Resource Economics, Twelfth Edition

Same question: insert 500 crocodiles in place of 100.

Question 3 Version 1 3. Whooping Cranes, an endangered species, rely on several bird sanctuaries in the Midwest for survival. Currently runoff from nearby processing plants is making some of the ponds “oily.” When the cranes land in the water, their feathers become slick with oil. These birds eventually die. It has been discovered that a thin layer of mesh, laid across the pond, protects the birds from the oil by preventing them from submerging in the water. What would you be willing to pay in the form of an annual donation to see that these ponds are covered with mesh, thus saving 1,000 cranes? $_______________ If you said $0, please tell me why? Version 2 3. Whooping Cranes, an endangered species, rely on several bird sanctuaries in the Midwest for survival. The flooding of the Mississippi and tributary rivers destroyed crucial bird habitat. Without aid to replace habitat more birds will die. What would you be willing to pay in the form of an annual donation to see that enough habitat is restored to save 1,000 cranes? $_______________ If you said $0, please tell me why?

Question 4 Version 1 4. Diesel fuel has been leaking slowing into the [local river] from an unknown source. Searches for the source of the leak have been unsuccessful to date. The State of [x] has insufficient funding available to keep searching for the leak. What are you willing to pay, in the form of a one-time donation, to have the leak found? $_______________ If you said $0, please tell me why? Version 2 4. Diesel fuel has been leaking slowing into the [name of local river] from an unknown source. Searches for the source of the leak have been unsuccessful to date. The State of [x] has insufficient funding available to keep searching for the leak. What are you willing to accept, in the form of a one-time payment to you, to have the search discontinued and the slow leak remain? $_______________ If you said $0, please tell me why? 5.

What is your annual income?

What is your age?

Male Female (circle one)

Information Classification: General

Chapter 4

Do you belong to a conservation organization? Yes No Which one? __________ How much do you donate annually?

◼

Essay Question

Valuing the Environment: Methods

Should humans place an economic value on the environment? Using Debate Box 4.1, discuss the issues related to the monetization of nonmarket values. Can you think of a local example where this is relevant? Is this example controversial? Debate Box 4.5 presents two sides of the debate on valuing a human life. Which side is correct? Why is the value of a human life typically higher for someone living in a developed country versus someone from a developing country? Is this fair?

Information Classification: General

Chapter 5 Dynamic Efficiency and Sustainable Development The first part of Chapter 5 explains how to efficiently allocate a scarce depletable resource across two time periods using the concept of the present value of marginal net benefits. The remainder of the chapter discusses issues of fairness and sustainability in comparison to efficiency. In particular, the text addresses whether efficient allocations are fair, and whether the current generation owes something to future generations. The sustainability criterion suggests that an allocation is fair if future generations are left no worse off than current generations. The chapter ends with a discussion of how to apply this rule.

◼ Teaching Objectives 1. Explain how to efficiently allocate a scarce depletable resource over time using a two period graphical model. 2. Define the dynamic efficiency criterion. 3. Define the present value of marginal net benefits. 4. Define marginal user cost. 5. Explain the effect of changes in the discount rate on the optimal allocation of the resource. 6. Define intertemporal fairness and the sustainability criterion. 7. Discuss the relationship between dynamic efficiency and sustainability. 8. Understand simple rules for sustainability. 9. Present alternative definitions of sustainability: weak sustainability, strong sustainability, and environmental sustainability.

Information Classification: General

Chapter 5

◼

Dynamic Efficiency and Sustainable Development

Outline I. A Two-Period Model This section presents a simple two-period model of dynamic efficiency. The goal is to illustrate how to allocate a depletable resource over two time periods for which total demand is greater than the amount available. The presentation is graphical, but the mathematics could also be presented. The optimal solutions (from calculations) are presented in the text and derived in the appendix. More advanced students will likely want to and should see how to solve the problem mathematically. The effect of the discount rate on optimal allocations over time is illustrated nicely in this example. A. If supply is sufficient to meet demand, then a static efficient solution will provide the optimal allocations over time, regardless of the discount rate. B. If supply is not sufficient, we must determine the optimal allocation using the dynamic efficiency criterion: maximize the sum of the present value of net benefits across the time periods. C. The present value of net benefits for a two-period model is equal to the net benefit in Period 1 plus the present value of the net benefit in Period 2. D. The net benefit in each period is the area under the demand curve and above the supply curve up to the allocated quantity (Figure 5.1). The net benefit for Period 2 must be divided by (1+r) to calculate the present value. Net benefit can also be calculated as the area under the marginal net benefit curve (which is the demand curve minus the marginal cost as illustrated in Figure 5.2). E. The dynamically efficient allocation will satisfy the condition that the present value of the marginal net benefit from the last unit allocated to Period 1 equals the present value of the marginal net benefit of the last unit allocated to Period 2. F.

A two period model can be illustrated graphically by flipping the graph of Period 2 such that the zero axis for the Period 2 net benefits is on the right side, rather than the left. The size of the box then represents the resource constraint. Any point on the horizontal axis sums to the amount of the resource constraint (Figure 5.2).

G. The optimal allocation will be the intersection of the Period 1 marginal net benefit curve with the curve representing the present value of marginal net benefit in Period 2. 1. Remind students that you are now drawing marginal net benefits and not the demand curve and show them how to derive the curve. 2. Show students how to calculate the vertical intercept for Period 2 and why it is different from Period 1. 3. Show students how the marginal net benefit in Period 2 will rotate around the horizontal axis as the discount rate changes. H. Prices are calculated by inserting the efficient quantities into the willingness to pay function and then solving for price. I. The opportunity cost caused by intertemporal scarcity is called the marginal user cost. Since current use diminishes future use, the marginal user cost is the present value of the foregone future uses. In the absence of scarcity, the marginal user cost is zero. J.

The present value of the marginal user cost can be illustrated graphically as the vertical distance between the horizontal axis and the intersection of the two present value of marginal net benefit curves. It is equal to the present value of the marginal net benefit in each of the periods at the efficient allocation.

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• Environmental and Natural Resource Economics, Twelfth Edition

K. The marginal user cost for each period in an efficient market is the difference between the price and the marginal extraction cost (Figure 5.3). L. Marginal user cost rises over time at the rate of discount, causing efficient prices to rise over time thus reflecting scarcity. M. A higher discount rate will favor the present and harm future generations. The amount allocated to the second period falls as the discount rate rises. II. Defining Intertemporal Fairness A. The concept of intergenerational equity provides ample room to illustrate the nature of normative decision making. How much should we leave for future generations? What is the appropriate rate of discount? How do we make decisions for a group of people that are not around to negotiate for themselves? B. This section introduces the sustainability criterion, which holds that future generations should be left no worse off than current generations and should perhaps be left better off. Whether or not efficient allocations satisfy this criterion will be explored in the next sections. Rawl’s model introduces the concept of the veil of ignorance, which helps to explain how fairness can be considered in decisions that affect future generations. III. Are Efficient Allocations Fair? A dynamically efficient allocation will not automatically satisfy the sustainability criterion, but can be consistent with sustainability. A. With a discount rate greater than zero, an economically efficient allocation will allocate more of a resource to the first period than the second. Net benefits will be greater in the first period than the second. B. The sustainability criterion can still be met if the first period sets aside sufficient net benefits for the second period. C. These concepts can be illustrated mathematically using the two-period example. IV. Applying the Sustainability Criterion The sustainability criterion is difficult to apply because it requires knowing something about the preferences of the future generation. A more operational criterion is called “Hartwick’s Rule.” The usefulness of Hartwick’s Rule depends on how substitutable physical capital and natural capital are. A. Hartwick’s Rule suggests that if all scarcity rent is invested in capital, then a constant level of consumption can be maintained in perpetuity. B. If all scarcity rent is invested in capital, the value of the total capital stock will not decline. C. If the principal or the value of total capital is declining, the allocation is not sustainable. D. Total capital is defined as physical capital plus natural capital. These are assumed to be substitutable under Hartwick’s Rule. E. Physical capital consists of buildings, equipment, and infrastructure. F.

Natural capital refers to environmental and natural resources.

G. Complete substitutability between physical and natural capital is an extremely strong assumption. H. The maintenance of total capital is termed “weak sustainability.” Weak sustainability suggests that resource use by previous generations should not exceed a level that prevents future generations from achieving at least the same level of well-being. Information Classification: General

Chapter 5

Dynamic Efficiency and Sustainable Development

An alternative definition of a sustainable allocation is called “strong sustainability.”

Strong sustainability implies that the value of the stock of natural capital is maintained.

K. Strong sustainability assumes that there is little or no substitution between physical and natural capital and emphasizes preserving natural capital as opposed to total capital. Again, the focus is on preserving value and on preserving an aggregate of natural capital. L. Another alternative, environmental sustainability, requires that certain physical flows of certain individual resources (such as a fishery or a mineral) be maintained. Thus maintaining the value of an aggregate like natural capital or physical capital is not sufficient. V. Implications for Environmental Policy A. Not all efficient allocations are sustainable. B. Not all sustainable allocations are efficient. C. Market allocations may be either efficient or inefficient and either sustainable or unsustainable. D. Given a number of sustainable allocation possibilities, choose the one that maximizes either static or dynamic efficiency (net benefits or the present value of net benefits), e.g., maximize wealth, subject to a sustainability criterion. E. Policy changes that correct inefficiencies can produce win-win situations because by correcting an inefficiency, net benefits are increased. All of these items will be explored further in later chapters but are a nice introduction for your students.

◼ Common Student Difficulties Two-period problem graphs and the corresponding mathematics will confuse many students. Particularly the use of two y-axes, implying increasing quantities from right to left for Period 2, will be confusing. Taking time to explain this thoroughly will help. You can draw two graphs and then literally flip one over (or tell them that you are flipping it over to the other side). The horizontal axis then becomes the constraint. Reminding them that the curve measures net marginal benefits will be important also. The concept of marginal user cost is not an intuitive concept to most students. This concept is going to come up again in Chapters 6 and 7, so a good coverage of intuition behind this concept is crucial. Giving them practical examples of intertemporal opportunity costs will help. The topics of intergenerational equity and sustainability will likely spark strong reactions and lively discussion. Students may have trouble with the concepts of discounting the future and deciding how resources should be allocated across time. Remind them that we make these sorts of decisions every day and they do also. Student loans allow them to borrow from their future income. Does this make them worse off in the future? If they do not invest in their own human capital, then yes. However, they likely assume they will be better off by borrowing now. Examples using nonrenewable resources such as oil and gas will also be useful to illustrate these concepts. Examples of national income accounting provide interesting presentations of the calculations countries make in measuring income. Physical and natural capital may be assumed to be perfectly substitutable, yet there are many examples of countries with positive growth measured by GDP, but the growth comes from selling off a resource base which implies lower future incomes. Income measurement and sustainability may not be compatible.

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• Environmental and Natural Resource Economics, Twelfth Edition

Tietenberg/Lewis

◼

Suggested Classroom Exercises

A simple exercise that can be useful is to let students try the two-period example using a different demand curve and/or different constraint. For example, a simple change would be to have the demand curve be P = 9 − 0.3q and the constraint could be 30. You can also vary the discount rate. This could be done as an inclass exercise as suggested in the previous chapter or could be assigned at the end of class for brief discussion at the beginning of the next class. Students tend to ask why demand would be the same in both periods. While obviously this is a simplifying assumption used to illustrate a concept, this question provides a great opportunity to suggest a slightly different exercise. You can say, “Ok. What if, due to population growth for example, demand is higher in the second period?” With two different demand curves, the mathematical and graphical analysis is identical, but with different results. Additionally, you can also ask them to do this same exercise with a marginal extraction cost that is higher in the second period than in the first. This could be combined with the two different demand curves, e.g., both demand and MEC are different. This can be a very useful exercise, especially for the more advanced students. As a most challenging problem, you can set it up so that the resource constraint is so tight that the present value of net marginal benefit functions do not intersect the horizontal axis inside of the box, but instead intersect outside of the box. This can be done by reducing the resource constraint or by increasing demand. For example, suppose the inverse demand function for the resource is the same in both periods and takes the form P = 10 − 0.2Q. Assume marginal cost is constant at $2/unit, there are only 20 units of the resource available and the discount rate is 8%. This example should provide an interesting and difficult challenge for most students.

◼

Essay Question

Compare the following three concepts: weak sustainability, strong sustainability, and environmental sustainability. Discuss how a policymaker might decide which sustainability concept to follow. How would the use of a country’s oil resources differ under each of the three sustainability criterion?

Information Classification: General

Chapter 5

Information Classification: General

Dynamic Efficiency and Sustainable Development

Chapter 6 Depletable Resource Allocation: The Role of Longer Time Horizons, Substitutes, and Extraction Cost This chapter begins with a resource taxonomy that is used to classify the stock of a resource. Students will learn that the measurement of a resource stock is not as straightforward as it might seem. Resources are further defined as depletable, recyclable, or renewable. The bulk of the chapter addresses the efficient allocation of a depletable resource over time using an n-period model. Different scenarios are addressed including cases with and without a renewable substitute, and cases where extraction costs are constant or increasing. The chapter ends by addressing the question of whether the market will arrive at the dynamically efficient allocation of a depletable resource.

◼ Teaching Objectives 1.

Introduce natural resource economics.

Present a resource taxonomy to explain how the stock of a depletable resource is measured.

Distinguish between renewable, depletable, and recyclable resources.

Discuss the economic feasibility of resource extraction.

Extend the two-period model to an N-period model.

Present the efficient allocation of resources over time with constant marginal extraction costs and with a transition to a renewable substitute.

Present the efficient allocation of resources over time with rising marginal extraction costs.

Discuss the effects of exploration and technical progress.

Understand under what circumstances the market can be expected to produce an efficient allocation.

◼

Outline I. A Resource Taxonomy

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• Environmental and Natural Resource Economics, Twelfth Edition

Most of this section covers vocabulary related to resource quantities (reserves and endowments) and extractability. Using Figure 6.1 as an overhead will prove valuable. A. A resource taxonomy is a classification system used to distinguish various categories of resource availability. B. Current reserves are resources that can be extracted profitably at current prices. C. Potential reserves depend on prices people are willing to pay for resources. At higher prices, potential reserves are larger since more expensive extraction techniques will be economically feasible. D. The resource endowment represents the natural occurrence of resources in the earth. This is a geological concept since the endowment is not a function of price. Reserves represent an economic concept. E. The United States Geological Survey (USGS) keeps a record of U.S. resources and has developed a classification system based on both economic feasibility and certainty of the resource base. The categories of resources are as follows: 1. Identified resources are of known quantity and quality based on geologic evidence. 2. Measured resources are those for which quantity and quality are estimated with a margin of error less than 20%. 3. Indicated resources have been estimated from sample analyses and geologic projections. 4. Inferred resources are materials in unexplored extensions of demonstrated resources (identified and measured) based on geologic projections. 5. Undiscovered resources are surmised to exist on the basis of geological knowledge and theory. 6. Hypothetical resources are expected to exist. 7. Speculative resources are undiscovered materials that may occur in known deposits in favorable geologic settings. F.

The seven categories listed above will fall into an additional category depending on the economic feasibility of extraction. Reserves will be those resources that are measured, indicated or inferred and economic.

G. Since infinite prices are not likely, the entire resource endowment cannot be made available. H. A depletable resource is not naturally replenished or is replenished at such a low rate that it can be exhausted. The depletion rate is affected by demand. I.

A recyclable resource has some mass that can be recovered after use. Copper is an example of a depletable, recyclable resource.

Current reserves of a depletable, recyclable resource can be exhausted, but can also be augmented by economic replenishment and recycling.

K. A renewable resource is one that is naturally replenished. Examples are water, fish, forests, and solar energy. Some renewable resources are storable and others are not. L. Storage of renewable resources smoothes out the cyclical imbalances of supply and demand (e.g., water storage). Storage of depletable resources extends their economic life. M. The management problem for depletable resources is how to allocate dwindling stocks across generations while transitioning to a renewable alternative. Current use precludes future use (intertemporal opportunity cost). N. The management problem for renewable resources is in maintaining an efficient and sustainable flow.

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Chapter 6

Depletable Resource Allocation: The Role of Longer Time Horizons, Substitutes, and Extraction Cost

II. Efficient Intertemporal Allocations This section revisits and extends the two-period allocation problem presented in Chapter 5. A. Dynamic efficiency is the primary criterion when allocating resources over time. B. Dynamic efficiency assumes that society’s objective is to maximize the present value of net benefits from the resource. C. Recall the two-period model from Chapter 5. In that model, marginal user cost rises over time at the rate of discount to preserve the balance between present and future consumption. This model can be generalized to longer time periods. D. The N-Period Constant-Cost Case 1. 2.

3. 4.

An n-period model is presented and uses the same numerical example from Chapter 5, but extends the time horizon and increases the recoverable supply from 20 to 40. Graphical representations of this model show how marginal user cost rises over time. With constant marginal extraction cost, total marginal cost (or the sum of marginal extraction costs and marginal user cost) will rise over time. The graph shows total marginal cost and marginal extraction cost. The vertical distance between the two equals the marginal user cost. The horizontal axis measures time. Rising marginal user cost reflects increasing scarcity and the intertemporal opportunity cost of current consumption on future consumption. As costs rise, quantity extracted falls over time. Quantity extracted falls to zero at the point where total marginal cost reaches the maximum willingness to pay (or choke price) for the resource such that demand and supply simultaneously equal zero. An efficient allocation thus implies a smooth transition to exhaustion.

E. Transition to a Renewable Substitute 1.

2. 3. 4. 5.

If a renewable substitute is available, the depletable resource will be exhausted at the choke price or at the marginal extraction cost of a renewable substitute if lower than the choke price. For the latter case, marginal cost still rises until the switch is made to the substitute. If a renewable substitute is available, the depletable resource will be exhausted sooner than it would have been without the substitute. The transition point to the renewable substitute is called the switch point. At the switch point, the total marginal cost of the depletable resource equals the marginal cost of the substitute. The transition can also be illustrated for two depletable resources with different constant marginal costs. The total marginal cost of the first resource would rise over time until it equaled that of the second resource, at which time there would be a smooth transition. The rate of increase of total marginal cost slows down after the time of transition because the marginal user cost represents a smaller portion of total marginal cost for the second, higher cost resource.

Increasing Marginal Extraction Cost The case of increasing marginal extraction cost is more complicated, but more realistic. For this case, the marginal user cost declines over time and reaches zero at the transition point. With rising marginal extraction costs, each unit extracted raises the cost of extraction. Thus, as current marginal cost rises over time, the opportunity cost imposed on future generations diminishes. In the increasing cost case the resource reserve is not exhausted.

G. Exploration and Technical Progress

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1. 2. 3. 4.

• Environmental and Natural Resource Economics, Twelfth Edition

The marginal cost of exploration can be expected to rise over time as well. The higher the expected rise in the marginal cost of extraction, the larger the potential increase in net benefits from exploration. Successful exploration would cause a smaller and slower decline in consumption while dampening the rise in total marginal cost. Technological progress would also reduce the cost of extraction. Lowering the future marginal cost of extraction would move the transition time further into the future. Total marginal cost could actually fall with large advances in technology.

III. Market Allocations of Depletable Resources This section examines whether actual markets can produce dynamically efficient allocations, e.g., is profit maximization compatible with dynamic efficiency? A. Markets will behave well as long as the property-rights structures governing the resources are exclusive, universal, transferable, and enforceable. B. A resource governed by a well-defined property rights structure will then have both a use value and an asset value to its owner. C. A use value is the value acquired when the resource is sold, e.g., timber sales. D. An asset value is the value to the owner while the resource is still in the ground. If the price of the resource is rising, the resource in the ground is becoming more valuable as long as it is saved. E. Presented with well-defined property rights and reliable information about future prices, producers will choose an allocation that provides the maximum present value of net benefits for society, or a dynamically efficient allocation provided that social and private discount rates are equal. F.

If extraction of a resource imposes a third party or external cost on society, an allocation will not be efficient. The price of the depletable resource would be too low and the resource extracted too rapidly.

G. The inclusion of environmental costs would result in higher prices that will dampen demand. Thus, the resource should, with all else equal, last longer since the higher marginal cost means that a smaller amount would be extracted. The supply side effect, however, causes the transition point to be sooner. Which effect dominates depends on the shape of the marginal extraction cost curve. H. The concept of external environmental costs ties together the fields of environmental and natural resource economics.

◼ Common Student Difficulties The early part of this chapter contains a lot of vocabulary. Use of Figure 6.1 should be helpful. The question of whether or not we are running out of resources should be presented in the context of the sometimes confusing and misleading indices such as the static reserve index. Examples will be helpful. (See suggested classroom exercises below.) Figures 6.2–6.6 might present confusion. Up to this point, most of the graphs presented have been of price/quantity relationships. It is quite common for students new to economics to see a downward sloping function and assume it is a demand curve. Remind them of the changed axes: for example, quantity as a function of time in 6.2(a) and marginal cost as a function of time in 6.2(b). It is also not uncommon for students to take issue with the assumption of constant marginal extraction costs. It is important to point out the usefulness of this assumption in illustrating the rising marginal user cost and thus rising total

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Chapter 6

Depletable Resource Allocation: The Role of Longer Time Horizons, Substitutes, and Extraction Cost

marginal cost, as this can be a difficult concept. It is also important to highlight the differences between these two assumptions. This simplified version also allows for you to build up to the more complicated models later in the chapter.

◼

Suggested Classroom Exercises

World Resources is an annual publication put out jointly by The World Resources Institute, The UN Environment Programme, The UN Development Programme, and the World Bank. Each year an extensive amount of data on the status of world reserves and other resources are reported. The sections on energy and minerals might prove useful to illustrate some of the difficulties with the types of statistics that are frequently reported on the expected lifetimes of resources. Copying some of this information for the students and asking them to calculate reserve indices for selected metals, for example, is a useful tool and can spark an interesting discussion. Using historical data and comparing those to the more recent data is also a useful exercise.

For the more advanced student As in Chapter 5, changing the numbers for the example presented in the Appendix will be useful as a problem set or an in-class exercise. Additionally, having students do the calculations for the examples presented will also be useful. They can also do the calculations with the addition of environmental damages. Working through the mathematics and graphs may be the best way for your students to learn this material.

◼

Essay Question

Are we running out of resources? Which ones?

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Chapter 7 Economics of Pollution Control: An Overview Chapter 7 is the first of the chapters on environmental economics. Since the use of resources creates a flow of waste, this addresses the questions of: (1) what flow of waste is appropriate, and (2) how should responsibility for achieving this flow of waste be allocated among the different sources of the pollutant when a reduction is necessary? Thus, environmental economics deals with pollution control. This chapter lays the groundwork and defines efficient and cost-effective levels of pollution.

◼ Teaching Objectives 1.

Discuss the different ways pollutants are categorized.

Define an efficient allocation of pollution.

Graphically illustrate marginal damage costs and marginal control costs to define the efficient level of pollution (emissions).

Use the concepts of common-pool resources and externalities to explain why the market will produce too much pollution.

Define cost-effective pollution control for uniformly mixed fund pollutants and nonuniformly mixed surface pollutants.

Present policy options for pollution control.

Compare and contrast emissions charges and tradable emissions allowances.

◼

Outline I. A Pollutant Taxonomy A. The ability of the environment to absorb pollutants is called its absorptive capacity. B. Stock pollutants are pollutants for which the environment has little or no absorptive capacity. Stock pollutants accumulate over time and include nonbiodegradable bottles, heavy metals, and chemicals such as PCBs.

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• Environmental and Natural Resource Economics, Twelfth Edition

C. Fund pollutants are pollutants for which the environment has some absorptive capacity. If the emission rate does not exceed the absorptive capacity, fund pollutants do not accumulate. These include organic pollutants and carbon dioxide. D. Local pollutants cause damage near the source of emissions while regional pollutants cause damage at greater distances. Global pollutants affect the entire planet. Pollutants such as sulfur dioxide and nitrogen oxide are both local and regional pollutants. The horizontal zone of influence addresses the domain over which damage is experienced. E. The vertical zone of damage refers to whether the pollution damages are mostly at ground level or if they accumulate in the upper atmosphere. For some pollutants (lead or particulates), damage is determined mainly by concentrations of the pollutant near the earth’s surface. For others (ozone depleting substances or greenhouse gases), damage is related to its concentration in the upper atmosphere. F.

Appropriate policy responses will vary with the type of pollutant.

II. Defining the Efficient Allocation of Pollution This section defines the efficient allocation of pollution given that some pollution is a necessary byproduct of production and consumption. A. Stock Pollutants 1. For a stock pollutant, damage rises as the pollutant accumulates. 2. The optimal allocation of a stock pollutant is the one that maximizes the present value of benefits from consuming the good (whose production causes the pollution) minus the cost of damage to the environment caused by the pollutant. 3. The efficient quantity of the good would decline over time as the marginal cost of damage rises. The price of the good would also rise over time and the amount of resources devoted to controlling pollution would rise. 4. Stock pollutants create burdens for future generations. B. Fund Pollutants 1. Fund pollutants can be examined using static analysis whenever the level of future damages is independent of current emissions. Pollution control is most easily analyzed from the perspective of minimizing the cost of controlling pollution rather than maximizing the net benefits from pollution. 2. Two types of costs associated with pollution are: a. Damage costs b. Pollution control or avoidance costs 3. Marginal damage costs generally increase with the amount of pollution. With small amounts, the pollutant can be diluted in the environment. Larger amounts will tend to cause substantially more damage. This relationship can be represented by an upward sloping function in a graph illustrating marginal cost as a function of pollution emitted. 4. Marginal control costs typically increase with the amount of pollution that is controlled or abated. Since the axis of this graph is pollution emitted, this will be a downward sloping function. This is equivalent to an upward sloping function if the axis were to measure pollution controlled or if the graph is read from right to left as in Figure 7.2. 5. The cost-minimizing solution is found by equating marginal damage costs to marginal control costs (Q* in Figure 7.2). Points to the left of Q* (greater control) are inefficient because the marginal cost of control is greater than the marginal damage and reflects higher

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Chapter 7

Economics of Pollution Control: An Overview

total costs. Likewise, points to the right of Q* are also inefficient, but now because marginal damage costs are higher than marginal control costs. There is too much pollution. The optimal level of pollution would be zero only if the marginal damage cost function is everywhere above the marginal control cost function. An extremely toxic pollutant would cause this to be the case. [Ask your students to try to draw this case.] Optimal levels of pollution will vary by location and by pollutant.

III. Market Allocation of Pollution This section discusses the air and water as common-pool resources, and pollution damages as an externality of production. A. The air and water are common-pool resources. Remind students of the reason why commonpool resources are overexploited. You might also wish to review efficient property rights. Is it possible for anyone to “own” the air or the water? B. All production and consumption creates some residual waste. Firms and consumers have an incentive to dispose of the waste in the cheapest way possible. If firms and consumers do not bear the full cost of disposal, they will generate too much waste, or pollution. C. Pollution damages are externalities. When pollutants are injected into the air or water, those downwind or downstream of the source are affected. D. Pollution control costs are not externalities, and will have to be paid by the firm. What is cheapest for the firm is not always what is cheapest for society as a whole. E. For stock pollutants, the market would commit too few resources to pollution control and the burden on future generations would be inefficiently large. F.

Firms that attempt to control pollution unilaterally are placed at a competitive disadvantage.

G. The market fails to generate the efficient level of pollution control and penalizes firms that attempt to control pollution. H. There is a strong case for government intervention. IV. Efficient Policy Responses A. Efficiency is achieved when the marginal cost of control is equal to the marginal damage caused by the pollution for each emitter. B. One policy option for achieving efficiency would be to impose a legal limit on the amount of pollution allowed by each emitter. The efficient legal level would need to be set where marginal control costs equal marginal damage costs. C. Another approach would be to internalize the marginal damage caused by each unit of emissions by means of a tax per unit of emissions. The tax could be constant or it could rise with emissions. The efficient charge would be equal to the marginal damage and marginal control cost at the point where they are equal. D. Knowing the level of emissions at which these two curves cross is difficult at best. Control cost information is not always available to control authorities and damages are extremely difficult to measure. [Remind your students about nonmarket valuation covered in Chapter 4.] E. In the absence of that knowledge, pollution control authorities could select legal levels of emission based on some other criteria such as safety, human health, or ecological health. Once this level is set, the most cost-effective policy can be chosen.

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• Environmental and Natural Resource Economics, Twelfth Edition

V. Cost-Effective Policies for Uniformly Mixed Fund Pollutants This section presents a simple example of a pollution reduction standard and compares and contrasts the various methods available for achieving that standard. First, a cost-effective allocation is defined. Then the available policy options are discussed. A. Defining a Cost-Effective Allocation 1. Consider a simple model: two emission sources are currently emitting 15 units each, for a total of 30 units, and the control authority decides a mandatory reduction of 15 units is necessary. How should the 15-unit reduction be allocated between the two sources in order to minimize cost? 2. Figure 7.3 illustrates the solution to the model. The graph is drawn such that the left-hand vertical axis measures the marginal control cost to emission Source 1, and the right-hand vertical axis measures the marginal control cost to emission Source 2. The horizontal axis is constrained to equal 15—measured from either direction. This ensures that any point will represent some combination allocated across the two sources that adds to 15. [This is equivalent to flipping over the graph for Source 2, creating a box that is the size of the constraint.] 3. The cost-effective allocation is found by equating the marginal control costs of the two sources. Total cost is the area under the marginal control cost curve for each firm. Total cost is minimized when the marginal control costs are equated. Any other allocation would result in higher total cost. 4. While simple in theory, the situation is more difficult in practice because control authorities do not often have access to good information about firms’ costs. Plant managers have an incentive to overstate costs. B. Cost-Effective Pollution Control Policies 1. Emission Standards a. An emission standard is a legal limit on the amount of the pollutant an individual source is allowed to emit. b. This approach is referred to as command-and-control. c. The difficulty with using emissions standards is determining how the standard should be allocated across sources. The simplest means of allocation—allocating an equal share to each source—is rarely cost-effective. In the example presented in Figure 7.3, this strategy is not cost-effective. 2. Emissions Charges a. An emissions charge is a fee on each unit of pollutant emitted that is collected by the government. b. Charges are economic incentives that reduce pollution because they cost the firm money. c. A profit-maximizing firm will control (abate) pollution whenever the fee is greater than the marginal control cost. d. Each firm will independently reduce emissions until its marginal control cost equals the emissions charge. This yields a cost-effective allocation (Figure 7.4). e. A difficulty with this approach is determining how high the charge should be set in order to ensure that the resulting emission reduction is at the desired level. An iterative or trial-and-error approach can be used to determine the appropriate rate, but changing

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Chapter 7

Economics of Pollution Control: An Overview

tax rates frequently is not usually politically feasible. However, as long as the charge is the same for all sources, the reduction automatically minimizes the costs of control. f. Another difficulty is that with a charge system, the total amount of pollution cannot be controlled. If many new sources enter the market, they will still pay the fee, but total emissions will rise. g. Charge systems provide incentives for research and development on new and cheaper control technologies because firms will be trying to lower costs and hide those lower costs from the control authority (Figure 7.5). 3.

Cap-and-Trade a. With cap-and-trade, all sources are required to have allowances in order to emit. Each allowance specifies how much the firm is allowed to emit. The allowances are freely transferable. b. The control authority issues the exact number of allowances necessary to achieve the standard. c. Firms with high marginal costs of control will have an incentive to buy allowances from firms with low marginal control costs. Firms with low marginal control costs will have an incentive to sell allowances if the allowance price is above their marginal control cost. The equilibrium allowance price will be the price at which the marginal control costs are equal for both (or across all) firms. d. The incentives embedded in this system result in control costs being minimized, and the control authority does not need information on control costs.

VI. Cost-Effective Policies for Nonuniformly Mixed Surface Pollutants This section discusses nonuniformly mixed pollutants, where it is the concentration at a sensitive site that is measured rather than emissions in total. A. Ambient standards are legal ceilings placed on the concentration level of specified pollutants. B. The Single-Receptor Case 1. For a single receptor two-source case, the source closer to the receptor has a larger transfer coefficient. 2. 3. 4. 5.

The transfer coefficient measures the amount the concentration will rise if source i emits one more unit of pollution. The objective is to meet a concentration target at minimum cost. The cost-effective allocation is achieved when the marginal costs of concentration reduction are equal for all sources. A numerical example is presented in Table 7.1. Policy Approaches for Nonuniformly Mixed Pollutants a. An efficient ambient charge for each source equals that source’s transfer coefficient times the marginal cost of a unit of concentration reduction. Sources will pay different charges. Finding the cost-effective charges would be extremely difficult for a control authority. A uniform charge would achieve the desired reduction, but at higher cost. (This can be seen using Table 7.1.) b. An ambient allowance allows the owner to cause concentration to rise at the receptor by a certain amount. The larger the transfer coefficient, the smaller the amount of emissions will be allowed by the allowance. Sources closer to the receptor must purchase more allowances for a given level of emissions. The sources will pay the same amount for the allowances, but the amount allowed by each allowance varies by location and thus there may be incentives to trade.

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• Environmental and Natural Resource Economics, Twelfth Edition

C. The Many-Receptors Case 1. For multiple receptors, the cost-effective ambient charge paid by any source is equal to the sum over the number of receptors of the transfer coefficient for source i for receptor j times the monetary fee associated with the jth receptor. 2. An ambient allowance system for multiple receptors would require a separate allowance market for each receptor. 3. Control costs that depend on location provide incentives for firms to locate further from receptor sites. 4. Both ambient charges and ambient allowances are very complex and difficult to implement in practice. VII. Other Policy Dimensions This section discusses some of the differences between the two pollution control policy instruments discussed in this chapter (emissions charges and cap-and-trade). A. The Revenue Effect 1. 2. 3.

4. 5. 6. 7.

Environmental taxes and auctioned allowances raise revenue. Revenue can be used to reduce the burden on low-income people, and can be used to promote energy efficiency. Several studies have illustrated that revenue earned could be substituted for other distortionary taxes. Increasing the present value of net benefits in this manner is called the double dividend. The auctioning of allowances has been politically infeasible in many cases to date. Example 7.1 explores the case of the Swedish nitrogen charge that is rebated based on energy production. Example 7.2 discusses the Regional Greenhouse Gas Initiative where allowances have been auctioned off, with an emphasis on Maine’s experience. Allowing some level of pollution with no payment results in an implicit property right. Having to pay an environmental tax, or buy an allowance, results in having to pay for the right to pollute.

B. Responses to Changes in the Regulatory Environment 1.

2. 3.

How new sources are treated differs a. With charges, an increase in the number of emitters will raise total levels of pollution. b. With an allowance system, the total level of pollution is fixed. New emitters will increase the demand for permits and raise the allowance price. Inflation will affect the price of the allowance and result in higher allowance prices. With charges, inflation will result in lower control. Technological progress in pollution control equipment would result in lower allowance prices and lower abatement costs, but the same level of control. With charges, the amount controlled would increase.

C. Price volatility is not an issue with emissions charges because they fix the price. Allowances, however, fix the quantity and leave the price to the market. D. Instrument Choice under Uncertainty 1.

Given the large levels of uncertainty, determining the best policy option usually depends on whether certainty about emissions or certainty about control costs is more important.

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Chapter 7

4. 5.

Economics of Pollution Control: An Overview

Allowances offer more certainly about the level of emissions, and charges result in more certainty about control costs. When the marginal damage curve is steeply sloped and the marginal cost curve is relatively flat, certainty about emissions is more important than certainty about control costs. Allowances are preferred. When the marginal control cost curve is steeply sloped, small changes in the degree of control would have a large effect on abatement costs. The effect on damages would be small if the damage curve is relatively flat. Charges are preferred. Empirical studies are needed to determine what is best in each case. Early studies suggested that for greenhouse gases, the marginal benefit of reducing emissions curve was relatively flat. In this case, a carbon tax would be the preferred choice. New evidence suggests the marginal benefit of reducing emissions curve is highly nonlinear, which would favor cap-and-trade as the preferred policy choice.

E. Product Charges: An Indirect Form of Environmental Taxation 1. 2. 3.

In cases where it is difficult to monitor and keep track of emissions, a product charge can be used. Examples include taxing gas instead of auto emissions, fertilizer instead of groundwater pollution from runoff, or taxing bags to reduce waste. Charges are most efficient if all taxed units result in the same marginal damage.

◼ Common Student Difficulties The concept of the “efficient allocation of emissions” or optimal level of emissions is difficult for some students. This can be quickly overcome if, before you introduce the theory, you ask them what they think the appropriate level of pollution is. Some of them will say zero. You can illustrate that this is not possible. Zero pollution would mean zero production and zero consumption. Since this is not a possibility, we must deal with some level of pollution. This simple illustration will pave the way for presenting the “optimal” level. Graphs representing pollution control can be drawn with pollution emitted or pollution controlled on the axis. When presenting the marginal control cost curve for the first time, it is useful to show that it is an upward sloping function if the graph is read from right to left. In other words, the horizontal axis measures pollution emitted. If we move from left to right it measures pollution controlled. It might be useful to remind your students of the difficulties associated with measuring marginal damage costs, especially damages to ecosystems and to health. You can refer them back to Chapter 4 and the discussion of how we measure the value of nonmarket goods. The policy options presented in this chapter allude to the large uncertainties associated with pollution control policy. The abstract notions of marginal damage cost curves will frustrate some students and is a useful discussion topic.

◼

Suggested Classroom Exercises

This chapter presents a general overview of the economics of pollution control. Any of the classroom exercises suggested for the next few chapters could be utilized in this chapter. In addition, you can look up recent information on cap-and-trade policies or proposals and bring that in for class discussion. You are sure to also find some information on the proposal to adopt a carbon tax. Students are likely to have some strong opinions about cap-and-trade and adopting a carbon tax. Discussions will vary depending on the interests of your students and what is happening in the news at the time. Information Classification: General

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• Environmental and Natural Resource Economics, Twelfth Edition

If your students are more advanced mathematically, you can have them work some numerical examples. Listed below are two suggestions. 1. Suppose there are two firms that each emit 30 units of pollution, and the State Pollution Board wants to reduce this level to a total of 20 units between both firms. They decide to allocate 10 permits to each firm, where each permit will allow 1 unit of emissions per permit. Assume the following information, where TAC is total abatement cost and MAC is marginal abatement cost: TAC1=10+.75A12 MAC1=1.5A1 TAC2=5+.5A22 MAC2=A2. a. If each firm keeps its 10 permits, how much will they each spend in total to reduce emissions? b. Is there a more cost efficient solution than the one you found in part a? Please explain and find this solution. c. How much will the two firms each spend in total to reduce emissions at the cost efficient solution? d. How many permits will be sold? Who will sell them? How much will they sell for? 2. Suppose that the marginal damages to society from air pollution are MD = e - 25, where e is the level of air pollution. Suppose also that the marginal cost of reducing the air pollution on the part of firms is MC = 200 - 2e. a. Find the optimal level of pollution. Illustrate graphically. b. Find the net gain to society, assuming firms were initially not controlling emissions at all. c. What level of tax would achieve the optimal level of pollution? d. Suppose instead of a tax a standard is set so that the level of pollution is 10% below the efficient level. Calculate the cost to society. e. Suppose that the tax is set so that it is 10% too low. Calculate the cost to society.

◼

Essay Question

Can developing countries use the experiences of industrialized countries and move directly to using market-based instruments for pollution control? Debate 7.1 presents two different views on this question. When are market-based instruments the best choice?

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Chapter 8 Stationary-Source Local and Regional Air Pollution Chapter 8 explores the policy approaches used to address stationary source air pollution in the United States. The chapter begins with a description of the command-and-control approach. The theoretical models from Chapter 7 are used to address the efficiency and cost effectiveness of the command-andcontrol approach. Several innovative approaches are then discussed, including California’s RECLAIM program and the sulfur allowance program. This is a more policy-oriented chapter.

◼ Teaching Objectives 1.

Identify the criteria pollutants, and the ambient air-quality standards that have been set for each of these pollutants.

Describe the command-and-control approach.

Discuss the five criteria we can use to evaluate the efficiency of command-and-control.

Discuss the cost effectiveness of command-and-control.

Provide evidence concerning how effective command-and-control has been at improving air quality in the United States.

Discuss some of the innovative approaches that have been used as an alternative to command-andcontrol.

◼

Outline I. Introduction The Clean Air Act Amendments were passed in 1970. The federal government assumed a much larger role in the prevention of pollution. With these amendments, the U.S. Environmental Protection Agency (EPA) was created as the federal pollution control authority. Policies were developed based on whether a pollutant was a “conventional” pollutant or a “hazardous” pollutant. The focus in this chapter is on conventional pollutants. II. Conventional Pollutants This section discusses the command-and-control approach taken by the United States to deal with conventional pollutants. These are common substances such as sulfur oxides, particulates, carbon

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monoxide, ozone, nitrogen dioxide and lead. They are assumed to be dangerous only at high concentrations. A. The Command-and-Control Policy Framework 1. The historical approach to air pollution control has been a traditional command-and-control (CAC) approach based on emissions standards. 2. The conventional pollutants are often called criteria pollutants. For each criteria pollutant, the EPA must establish national ambient air quality standards. 3. Ambient air quality standards set legal ceilings on the allowable concentration of the pollutant in the outdoor air for a specified period of time. The period of time could be annually or a short-term average such as over a three-hour period. 4. In the United States there are two defined ambient standards: a. All pollutants have a primary standard that is designed to protect human health. b. A secondary standard is set to protect aesthetics, physical objects and vegetation. 5. Ambient standards are determined without regard to cost. (Table 8.1 provides some national ambient air quality standards.) 6. The state governments are responsible for ensuring the standards are met. States must design state implementation plans (SIPs) that must be approved by the EPA. Procedures for the abatement of pollutants that affect other states must be addressed by these plans. 7. Nonattainment areas are areas not meeting the original deadlines. These areas are subjected to strict controls. Nonattainment areas fall into one of seven categories. The more severe the nonattainment, the more stringent the control. 8. The EPA has the power to deny certain federal funds to states that fail to provide plans showing how and when compliance will be achieved. 9. The New Source Review Program (NSR) requires all new sources and sources undergoing modification to seek a permit for operation. This program is controversial as highlighted in Debate 8.1. B. The Efficiency of the Command-and-Control Approach 1. The threshold concept suggests the standard be set using a health threshold, given the Clean Air Act does not allow the balancing of costs and benefits. The threshold is defined with a margin of safety sufficiently high that no adverse health effects would be suffered by any member of the population as long as the air quality is at least as good as that specified by the standard. This concept implies that the marginal damage function would be zero until the threshold was reached, but would be positive at higher concentrations. Evidence suggests that this is not the case. 2. The level of the ambient standard has to be set by some other basis given the absence of a defendable health threshold. Efficiency requires a standard that maximizes net benefits. Since reliable estimates of the benefits associated with reducing emissions are so difficult to obtain, and consideration of cost is not allowed, it is impossible to know if the ambient standards are efficient. 3. Standards also tend to be uniform across the country. Uniformity does not acknowledge the number of people exposed, the sensitivity of the area, or the relative costs of compliance. 4. The timing of emission flows needs to be considered since concentrations are important for criteria pollutants. Economic efficiency would suggest tailoring the degree of control to the circumstances—in both space and time. The Clean Air Act, however, rules out intermittent controls. Constant controls also raise compliance costs.

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Chapter 8 Stationary-Source Local and Regional Air Pollution

Most standards are defined in terms of pollutant concentration in the outside air, but the average resident of the United States spends only 10% of their time outside. Therefore, indoor air quality is extremely important, yet is not regulated by the Clean Air Act.

C. Cost Effectiveness of the Command-and-Control Approach 1. 2.

Cost-effectiveness studies can determine if existing standards are being met in the least costly manner. However, we still will not know if the standard is set at the efficient level. Command-and-control (CAC) is typically not cost-effective. The ratio of CAC cost to least cost is presented in Table 8.1 and suggests widely varying differences in the costeffectiveness of CAC policies. CAC will be close to cost-effective only if a high degree of control is necessary such that all sources are forced to abate as much as is economically feasible. (The text cites several studies to support this claim, such as controlling SO2 emissions in Germany.) Example 8.1 looks at the command-and-control of SO2 emissions in Germany. The U.S. experience and the German experience have been quite different with the U.S. pursuing emission trading.

D. Air Quality 1. 2.

While inefficient, CAC policies have resulted in better air quality in developed countries. Developing countries, however, need to find cost-effective ways to improve air quality. Table 8.2 shows national improvement in air quality and reductions in emissions for the United States.

III. Market-Based Approaches This section presents case study examples of innovative approaches to pollution control such as California’s Regional Clean Air Incentives Market (RECLAIM) program and emissions charges in France and Japan. Finding additional data to supplement this section is worthwhile. For example, data on the price of the allowances traded under RECLAIM can be found online. A. Regional Pollution: While the same substances can be both local and regional pollutants, this section focuses on damages caused when a pollutant travels 200–600 miles from its source. 1.

Pollution control policy in the United States (and other countries with federal governments) initially treated all pollutants as if they were local pollutants, and gave local jurisdictions responsibility for meeting air quality standards. By focusing on local standards, the Clean Air Act made regional pollution worse. One example is the use of tall stacks that carry the pollution father away, making it easier and cheaper to meet local standards.

Regional pollutants require policies to be made at a regional level, either interstate or international. Regional solutions can be politically difficult.

The Congressional Budget Office used a simulation to determine the economic and political consequences of various policies. The model relates utility emissions, utility costs, and coalmarket supply and demand levels. The text goes through the options and costs in detail. The general insights are as follows: a. The marginal cost of additional control would rise rapidly, especially after the first 10 million tons have been reduced. Costs would rise more steeply as the amount of required reduction was increased. Stricter standards would require more expensive scrubbers. b. Emissions charges would be more cost-effective than the comparable CAC strategy since it would result in equalization in marginal costs. c. Emissions charges are more cost-effective, but are not the most popular.

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One way to reduce the cost to utilities, but retain the cost-effectiveness would be to institute a sulfur-reduction emissions allowance system. Utilities could create emission reduction credits and sell them to other utilities.

5. The Clean Air Act Amendments of 1990 established a version of an emission allowance program called the sulfur allowance trading program. 6. The sulfur allowance program is a cap-and-trade program. A cap-and-trade program sets an aggregate limit on emissions. Allowances are then allocated to the emitters covered by the cap with total allowances not exceeding the cap. 7. New emitters can be accommodated without total emissions rising since the new emitters can purchase allowances from current emitters. B. Emissions Trading (RECLAIM) 1. State initiatives have resulted in innovative programs such as California’s RECLAIM. 2. The 400 participating industry polluters under RECLAIM receive an annual pollution limit, which decreases by 5–8% annually for the next ten years. Polluters are allowed to use flexible approaches such as purchasing credits from other firms. 3. The difference between the RECLAIM program and traditional programs is that a cap is set on total emissions for the group rather than for each source. Additionally, now it is the polluter who is responsible for identifying the appropriate control strategies rather than the control authority, leading to many innovations. 4. Initial allocations for RECLAIM were inflated in order for the program to gain political feasibility and thus fewer emissions were reduced. 5. During the electricity deregulation fiasco in 2001 prices of emission allowances got so high that the “safety valve” mechanism in the RECLAIM program was triggered. The safety valve suspends the program and an alternative fee per ton program is imposed until prices of emission allowances go down below the threshold. C. Emission Charges 1. Economists usually suggest one of two types of emissions charges. a. An efficiency charge is set up to achieve an efficient outcome by forcing the polluter to compensate completely for all damage. b. A cost-effective charge is designed to achieve an ambient standard at the lowest possible cost. 2. A system of air pollution emissions charges has been used in France and Japan. 3. The French charge system is levied on approximately 1400 firms—all industrial firms having a power-generating capacity of 20 megawatts or more, or industrial firms discharging over 150 metric tons of taxable pollutants. The charge is levied on actual amounts emitted. The revenues are returned to the firms paying the charge mostly as a subsidy for installing abatement equipment. To date, the charge level has been too low to have any economic impact. 4. In 1973, Japan passed the Law for the Compensation of Pollution-Related Health Injury, which compensates victims for medical expenses, lost earnings and other expenses. The program is funded by an emissions charge on sulfur dioxides and from an automobile weight tax. The charge is calculated on the basis of the amount of compensation paid to victims of air pollution in the previous year. Compensation amounts are rising while emissions are falling creating potential future revenue problems. 5. Unlike trading programs or ERCs, where prices respond automatically, emissions charges must be set by an administrative process. [Discussing the politically feasibility of frequently changing charges and taxes would be interesting at this point.] Information Classification: General

Chapter 8 Stationary-Source Local and Regional Air Pollution

D. Co-Benefits and Co-Costs 1. Co-benefits or co-costs arise when compliance with a regulation leads to benefits (or costs) that are not directly tied to the regulation’s intended target. 2. In the sulfur allowance program the targeted objective involved enhancing ecological benefits, but r, it turned out that more than 95 percent of the achieved benefits from this program were associated with human health improvements from the lower emissions. 3. A classic historic case of co-costs occurred when the Clean Air Amendments of 1990 required nonattainment areas to use cleaner-burning (oxygenated) automotive fuels. Ethanol and MTBE (methyl tertiary butyl ether) were the two primary additive candidates. • Most nonattainment sites chose MTBE because it was the cheapest way to meet the requirement. • It turned out that MTBE was a major contributor to water pollution, which in turn caused detrimental human-health effects. • Once the co-costs were clear oil companies turned to ethanol.

◼ Common Student Difficulties Your students may be frustrated by the idea that a firm would intentionally violate a pollution standard. The EPA penalties are designed such that the magnitude of the noncompliance penalty is determined by the economic value of delay to that source. There are some simple noncompliance models that will illustrate this concept to your students. Abstracting from pollution control and discussing other behavior such as speeding on the highway or illegal fishing might help illustrate the concepts. Simple examples illustrating the economic incentives to violate rules and regulations are useful. Students are also sometimes confused or troubled by the idea of selling rights to pollute. Reminding them that we already have a emission trading system may help justify the concept. The experiment suggested below may be helpful as well.

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Suggested Classroom Exercise

My students are usually fascinated by a description of the sulfur-dioxide emissions trading program, yet most know almost nothing about it and quite a few usually have not even heard of it. There are a number of recent articles on this subject and data now exists on the progress to date. A good place to start looking for information is the EPA website http://www.epa.gov/airmarket/trading/factsheet.html#who. You can also find information on the RECLAIM program in California, including data on who buys and sells permits. This information can be found at http://www.aqmd.gov/reclaim/reclaim.html. I have found it useful to develop a simple experiment to illustrate emissions trading. This can be done in a variety of ways. The simplest is to develop three or more hypothetical marginal abatement cost and total abatement cost schedules. Give each student one schedule. For a class of 24, I have used three different schedules; one per eight students. Tell your students that they are currently discharging some amount in tons and the regulatory authority has mandated that this amount be cut in half. Tell them that they have also been granted permits to discharge the 50 percent target. Then let them wander around the room and see if they can find anyone they can buy additional permits from or, alternatively, to sell permits to. Sometimes it is helpful to have them calculate the value of the first permit and their total cost of various abatement amounts. Since they do not know initially if they have high costs or low costs (e.g., if they are buyers or sellers), I have found it useful to make the marginal cost schedules quite different and exaggerate the difference. This can be reduced in alternative forms

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of this experiment. At the end of the experiment I ask them to calculate total cost without trading and their total costs with trading. Total cost with trading will be their new total cost given how many emission allowances they now own plus money spent buying allowances minus money earned selling allowances. Hopefully they will have successfully lowered their total costs, however I have seen many students read the table wrong such that they end up with high costs! Either way, learning by doing should help!

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Essay Question

The New Source Review is a source of great controversy and debate. Should older plants undergoing modifications meet the same stringent standards as new sources? At what point are the enforcement costs too high?

Information Classification: General

Chapter 9 Water Pollution The last few chapters have addressed issues associated with air pollution. This chapter addresses the complexities associated with the management of water pollution. Water pollution has unique characteristics and requires specific policy. Point sources are easier to control and identify, so policy to date has focused on the point sources over the nonpoint sources. Water has many different uses that can be explored – drinking, household use, irrigation, industrial use, recreation, and natural habitat for wildlife. When discussing the history of water pollution policy it is interesting to have students discuss how clean they think the water should be. For example, should all water be of swimmable quality? Another interesting discussion topic involves runoff from household lawns that apply fertilizers and other chemicals to keep their lawns green. For example, does the yard have to have perfectly green grass or are there other options?

◼ Teaching Objectives 1.

Define the sources of water pollution and the types of water pollutants.

Present a history of water pollution control policy in the United States.

Give a brief history of European programs.

Discuss the cost-effectiveness of U.S. policy.

Use examples to illustrate some of the potential problems and possible solutions.

Suggest alternatives to ensure cost-effectiveness and positive net benefits.

◼

Outline I. Nature of Water Pollution Problems A. Types of Waste-Receiving Water 1. Surface water includes rivers, lakes and oceans. Historically, clean-up policies have focused on surface water. 2. Groundwater is subsurface water. 3. Both groundwater and surface water are used for irrigation and drinking. Surface water also provides additional benefits such as recreation and wildlife. This may require that different policies be used to protect the two different types of water.

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Since water sources have been treated as common property, they have been used as a cheap place to dump municipal sewage and industrial waste.

B. Sources of Contamination 1. Point source pollution is discharged into surface water at a specific location through a drainage pipe or ditch. The primary point sources are industries and municipalities. Point sources are relatively easy to monitor and predict. 2. Nonpoint source pollution comes from a variety of sources and includes agricultural and urban runoff. Agricultural runoff contains eroded topsoil, pesticides and fertilizer. Urban storm water runoff contains many pollutants including lead. Nonpoint sources are much more difficult to control due to the unpredictability and uncertainty associated with the exact source. 3. Due to the relative ease of controlling point sources, most past policies have focused on controlling point sources. As such, it is estimated that over half of the waste load to rivers and lakes now comes from nonpoint sources. 4. The primary sources of ocean pollution are ocean dumping and oil spills. This category of pollution has required separate legislative treatment. A history of large spills is included in Table 9.1. C. Types of Pollutants 1. Fund pollutants can be assimilated by water sources if the absorptive capacity of the lake or river is high relative to the discharge. a. Degradable wastes will break down in the water. This process uses oxygen. Large amounts of degradable pollutants can consume enough oxygen to turn an aerobic stream into an anaerobic stream. Without oxygen, aquatic lifeforms will die. b. Controlling the waste load requires monitoring the ambient conditions in the watercourse and monitoring the magnitude of emissions. Dissolved oxygen (DO) is the measure used to monitor ambient conditions. Biochemical oxygen demand (BOD) is the measure of oxygen demand placed on a stream by any particular volume of effluent. c. Emissions measured from a particular point as BOD can be translated in DO measures at various sensitive or receptor points. d. Oxygen sags represent locations along the stream where the DO is lower than at other points. Policy options could focus on a general BOD reduction target (emission permit or emission charge). Ambient control programs (ambient permits or ambient charges) would be aimed at reaching a particular DO target at the oxygen sags. The latter option accounts for the location of the emitter. e. Thermal pollution stems from the injection of heat into a watercourse. Usually this is in the form of used coolant water. Raising the temperature of the water reduces DO. f. Plant nutrients such as nitrogen and phosphorous cause algae growth. Too many nutrients in a stream or water body can cause eutrophication. 2. Stock pollutants are those for which the environment has no absorptive capacity. a. One example of the effect of stock pollutants is the numerous fish consumption advisories due to mercury contamination of fish. b. Medicinal waste is a more recent worry as drugs such as birth control and antidepressants have been found in fish tissue.

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Chapter 9

Water Pollution

c. Accumulating pollutants are extremely problematic because they are difficult to monitor. Examples include metals that accumulate in the food chain and cause damage to humans when ingested through fish consumption.

II. Traditional Water Pollution Control Policy The history of U.S. policy for water pollution control predates that for air pollution. Despite its longer history, it is not superior. This section provides a historical overview of water pollution control policy and legislation in the United States. A. Early Legislation 1. The 1899 Refuse Act was the first federal legislation to deal with discharge into the nation’s waterways. This act was primarily concerned with navigation. 2. The Water Pollution Control Act of 1948 initiated the authority of the federal government to conduct investigations and research into water pollution control— historically a state and local function. 3. The 1956 Amendments to the Water Pollution Control Act provided for federal support for the construction of waste treatment plants and for an enforcement conference. a. Federal support for the construction of waste treatment plants provided municipalities with federal grants to cover up to 55 percent of construction costs of municipal sewage treatment plants. These were grants, not loans. User fees were set at low rates—only high enough to cover the unsubsidized portion of the construction cost plus the operation and maintenance costs. b. Under the enforcement conference provision, the federal control authority could call for a conference to deal with an interstate water pollution problem. These conferences were not successful. 4. The Water Quality Act of 1965 set ambient water quality standards for interstate watercourses. States were required to file implementation plans. However, state plans were vague and set standards that did not relate to ambient water quality. B. Subsequent Legislation 1. The Clean Water Act sets out two goals in its preamble: a. “that the discharge of pollutants into navigable waters be eliminated by 1985”; and b. “that wherever attainable, an interim goal of water quality . . . for fish, shellfish, wildlife and recreation be achieved by June 1, 1983.” 2. The Clean Water Act introduced new procedures for achieving these goals. Permits would now be required for all dischargers and would be granted only when dischargers met the technology-based uniform effluent standards. The move toward uniform standards moved policy away from potentially more cost-effective ambient standards. 3.

The 1972 Amendments to the Clean Water Act set two stages for meeting the effluent standards: a. By 1977, industrial dischargers were required to meet standards using “best practicable control technology currently available” (BPT). Publicly owned treatment plants were also supposed to have achieved secondary standards by this date. b. By 1983, the more stringent “best available technology economically achievable” (BAT) were to help govern the meeting of standards.

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c. The 1972 Amendments also raised the ceiling on the program of subsidizing municipal water treatment plants from 55 percent of construction costs to 75 percent. In 1981, the federal share was reduced to 55 percent. The 1977 Amendments to the Clean Water Act distinguished, for policy purposes, between conventional and toxic pollutants. Additionally, most deadlines of the 1972 Amendments were extended. a. Conventional pollutant treatment standards were now to be based on “best conventional technology.” b. Unconventional pollutants and toxics would still be covered by the BAT requirement. c. The 1977 Amendments also introduced pretreatment standards for waste sent to publicly owned treatment systems. Nonpoint source pollution control was not covered by the Clean Water Act. This type of pollution was seen as a state responsibility. The reauthorization of the Clean Water Act in 1987 provided funding for a program to help states control runoff, but the states held responsibility for nonpoint source pollution control. The federal government has, however, sponsored the Conservation Reserve Program (CRP) that provides subsidies to farmers for planting grass or trees in an effort to reduce erosion and nutrient runoff.

C. In 1999, the EPA proposed new rules for the Total Maximum Daily Load (TMDL) program. A TMDL is the maximum amount of a pollutant that a water body can receive and still meet quality guidelines. The calculation includes a margin of safety. The TMDL program moves water pollution control policy toward ambient standards. D. The Safe Drinking Water Act of 1974 provides more stringent standards for drinking water. The primary regulations set maximum allowable concentrations for bacteria, turbidity and chemical contaminants. Secondary standards for odor and aesthetics were also set. Approximately 60,000 public water systems are subject to these standards. E. Ocean Pollution 1. The Clean Water Act only deals with ocean pollution in so far as it prohibits discharges of “harmful quantities” of oil into navigable waters. A discharger must report a spill and must either contain the spill or pay the cost of cleanup with a maximum liability of $50 million (unless willful negligence or willful misconduct can be proved). Cleanup costs also include natural resource damages. 2. Ocean dumping is not covered by the Clean Water Act, but is covered by the Marine Protection Research and Sanctuaries Act of 1972. Dumping of industrial wastes, sewer sludge or radioactive, chemical or biological warfare agents is prohibited in ocean waters. III. Efficiency and Cost-Effectiveness A. The efficient allocation of uncontaminated water requires the marginal net benefit be equal across all users. If return flows are contaminated, the efficient allocation will change. B. Ambient Standards and the Zero-Discharge Goal 1. The shift from ambient standards to a zero discharge goal was problematic. The feasibility of meeting such a goal is small and thus enforcement is a problem. 2. In 1972, the EPA estimated that the costs of meeting a zero discharge goal from 1971 to 1981 would be $317 million. This figure is five times higher than the estimate of cost to remove 85 to 90 percent of the pollutants ($62 million). For some pollutants, such a high cost might be justified, but the zero discharge goal does not distinguish among pollutant types. C. National Effluent Standards

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Chapter 9

2. 3. 4. 5.

Water Pollution

Cost-effectiveness would require individual standards for each source, but the EPA chose general standards for broad categories of sources. The standards could differ among categories, but were uniformly applied within categories. The EPA had so much trouble defining BPT standards such that few, if any, deadlines were met. The 1977 Amendments changed the timing and focus (toward toxic substances), but still did not result in a cost-effective strategy. The use of policy that focuses on technology rather than the water quality objective is also a poor strategy. The focus should be on maintenance, process change and the like. Studies have shown that uniform standards do not closely approximate the least-cost allocation. A 1968 study comparing least-cost to three other options is also outlined.

D. Watershed-Based Trading 1. Trading programs for watersheds have become more common since 1996 and there are now many small programs in existence. Some examples are listed in Table 9.2. Most of these programs involve point sources purchasing reductions from other point sources that have lower marginal abatement costs. This type of trading is complicated due to the need to account for the spatial distribution of pollutants. Trading ratios are calculated to ensure the required reductions actually take place. 2. Example 9.2 examines the potential for effluent trading by sewage treatment plants discharging into Long Island Sound. The size of the trading bubble has a substantial effect on cost savings. Bennett et al. (2000) find that the present value of total costs falls as the number of trading bubbles is reduced. E. Municipal Wastewater Treatment Subsidies 1. The second phase of the water pollution control program involves subsidies for wastewater treatment. Available funds were initially allocated on a first-come, firstserved basis, as opposed to being spent where they would have had the greatest impact. Under the Municipal Wastewater Treatment Construction Grant Amendments of 1981, states were required to establish project priorities and target funds to the most significant needs. 2. The subsidy program provided funds for construction costs, but not operation or maintenance. This type of program provides incentives to build expensive plants. Since the costs are spread out over many taxpayers, local areas have little incentive to keep construction costs down. This program also does not provide incentives for proper maintenance. A 1976–1977 EPA survey found that only half of the plants were performing satisfactorily. Enforcement is also difficult. F. Pretreatment standards regulate the quality of wastewater flowing into the waste treatment plants. These standards have been set by the EPA, do not rely on economic incentives, and are not cost-effective. G. Nonpoint source pollution has become a significant part of the total water quality problem. More intensive controls have been placed on point sources as an attempt to compensate for nonpoint sources. 1. Studies suggest that some nonpoint sources could be controlled at low costs, especially with policies aimed at reducing nitrogen use. These types of programs would represent large financial burdens to farmers, a factor that would need to be addressed. 2. McCann and Easter (1999) examined the size of transactions costs associated with agricultural nonpoint source pollution control policies. They found that a tax on phosphorous fertilizer had the lowest transactions costs for the Minnesota River.

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3. 4.

5. 6.

• Environmental and Natural Resource Economics, Twelfth Edition

Schwabe (2001) finds that a uniform rollback of 30% reduction in total nitrogen loadings is the more cost-effective strategy for the nutrient heavy Neuse River in North Carolina. Since point sources have been so intensively regulated, it is possible that a balancing of control options for point and nonpoint sources would reduce costs. A study performed by Industrial Economics (1984) on phosphorous control supports this hypothesis. The study for Dillon Reservoir in Colorado found that utilizing a program to control both point and nonpoint sources could achieve phosphorous target at $1 million a year less than if only the four point sources are addressed. As point sources are controlled to higher degrees, the marginal control costs rise, thus making controlling nonpoint sources more feasible. Figure 9.3 illustrates this idea. An additional nonpoint source of water pollution is air pollution that ends up in the water through either wet deposition or dry deposition. This suggests that the external costs of controlling air pollution are higher than previously thought.

H. Atmospheric deposition of pollution highlights the link between air and water pollution. Pollutants in the air frequently end up settling in water. This suggests that controlling air pollution creates an external benefit in terms of reduced water pollution. I.

In Europe, economic incentives such as effluent charges play a much larger role. Examples include effluent charges on BOD and suspended solids used in Czechoslovakia and charges that are related to the degree of compliance in the former West Germany. The German charge is scaled to the degree of compliance the charge is lower for emissions standards that are met. Hungary uses a charge based on the quality of the receiving waters. Sweden has experimented with the construction of wetlands to reduce nitrogen loads to the Baltic Sea.

For developing countries water pollution control is further complicated by poverty, lack of enforcement and lack of technology.

K. The current approach to oil spills relies on liability law to internalize costs. There are problems with this approach. 1. Legal solutions have very high administrative costs and take enormous amounts of time. 2. Vessel owners will choose the level of precaution that equates the marginal cost of additional precaution with the marginal expected penalty. If imposed penalties equal the actual damage and the probability of having to pay the damage equals 1.0, the outcome would be efficient and would internalize costs. However, limited liability does not allow for all costs to be internalized since the vessel owner does not have to pay anything above the limit. (See Figure 9.4) L. An Overall Assessment 1. Several studies have attempted to estimate the costs and benefits of water pollution control policy. One study found that the current net benefits are positive but are likely to become negative as costs escalate in the future. 2. Carson and Mitchell (1993) found that projected aggregate cost would exceed aggregate benefits because of the high marginal cost and low marginal benefits associated with bringing the remaining bodies of water up to swimmable quality. 3. The use of cost-effective policies would reduce costs substantially while not affecting the benefits. Economic incentives would also facilitate change better than technology-based standards that are rigid. 4. The possibilities of using marketable permits for water pollution control are being explored for many bodies of water in the U.S. Permits have value and thus will encourage firms to try to minimize costs. Economic incentives put pressure on sources to find better ways to control pollution.

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Chapter 9

Water Pollution

◼ Common Student Difficulties This chapter contains a large number of scientific terms and terminology related to water and water pollution. As if the economics is not complicated enough, now a whole new vocabulary is added to the mix. Many students will probably know very little about hydrology or about water pollution in general. Distributing a handout that includes a glossary is usually helpful.

◼

Suggested Classroom Exercises

The exercises for allowance trading described in previous chapters can also be used to illustrate a trading program for a water body. The experiment could be altered to reflect an ambient allowance program. The EPA recently published a report on marketable effluent programs for water quality and addressed current and proposed programs. Finding a local case study would make for an interesting discussion as well. See for example, Bennett et al. Cost-effective Control of Nitrogen Loadings in Long Island Sound, Water Resources Research, 36 (12) 2000.

A number of articles have been published on estimating the damages from the Exxon Valdez spill. Some of these would make excellent discussion pieces and would cover many of the topics covered in this course including nonmarket valuation methods, damage costs and enforcement. Natural resources damage assessment is a timely topic and much could be discussed if time permits. A discussion of natural resources damage assessment also provides for review of valuation issues and methodologies.

Most recently, attention has been focused on the interactions between air pollution and water pollution. For example, the effects of the Clean Air Act Amendments on water quality (e.g., atmospheric deposition of nitrogen) have been addressed. This would also make an interesting discussion topic since by now both air pollution control and water pollution control have been introduced.

◼

Essay Questions

Can you draw a graph (using marginal abatement cost curves) that illustrates at what point it makes sense to focus more on nonpoint source pollution control as opposed to point source pollution? What are the necessary components for a successful watershed based effluent trading program? Would an ambient trading program be politically feasible? Discuss the economics of point-nonpoint source trading.

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Chapter 10 Toxic Substances and Environmental Justice Chapter 10 addresses a topic that presents some unique challenges in that cost-benefit analysis is not appropriate. Since the damages from toxic substances are high, and the substances are most often stock pollutants, it is necessary to prevent damage by whatever means are possible. This chapter discusses the laws and regulations that have been put in place to deal with toxic substances and hazardous wastes. Health effects, compensation to victims, responsibility, appropriate disposal, and legal responses are the main components of this chapter. The chapter also explores whether some socioeconomic groups have been more exposed to toxic substances than others. Hazardous spills and sites such as Love Canal in upstate New York and the recent explosions at a Union Carbide plant in India exemplify the problems. Given these pollutants stick around for a long time, the policies the previous chapters have outlined are inapproriate.

◼ Teaching Objectives 1.

Describe toxic substance pollution and the associated health effects.

Outline the difficulties associated with controlling toxic substances in terms of the large number of substances and uncertain health effects.

Determine whether the market achieves the efficient level of safety in the workplace.

Determine whether the market efficiently supplies safe products.

Discuss the best way to deal with cases where third parties are affected by toxic substances.

Examine the decision regarding where to situate a hazardous waste facility and address the impact on third parties in terms of fairness and equity.

Determine whether certain socioeconomic groups are more seriously impacted by toxic substance pollution.

Discuss the different laws that have been put in place to address issues related to toxic substance pollution.

◼

Outline

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I. Introduction A. Emissions standards for air and effluent standards for water are not sufficient control strategies for toxic substances. Many toxic pollutants are stock pollutants and not fund pollutants. B. Nature of Toxic Substance Pollution 1. The goal of current laws controlling toxic substances is the protection of human health. Health dangers depend on the toxicity and exposure. 2. Toxicity to humans occurs when exposure to a substance causes harm. 3. Public policy must balance the benefits and costs of controlling the use of chemicals. C. Health Effects 1. The primary health concerns from exposure to toxic substances are the risk of cancer and the effects on reproduction. 2. One difficulty with relating cancer to toxic substances is that the latency periods for cancer (time between exposure and detection) can run from 15 to 40 years. 3. Since World War II there has been a rise in the manufacture and use of synthetic chemicals. Many of these chemicals are carcinogenic, but the exact relationship between the chemicals and cancer rates is unknown. 4. Scientific evidence suggests that exposure to toxic substances including smoking, alcohol and synthetic chemicals has negative effects on the reproductive system. Infertility and birth defects are possible effects. Both men and women are affected. D. Policy Issues 1. Number and location: approximately 70,000 chemical compounds are used in commerce. Many are not toxic. 2. The latency period makes control more complicated. When short-term exposure causes a detrimental effect, the toxicity is called acute. When the negative effect is caused by long-term exposure, the toxicity is called chronic. The technique for determining acute toxicity is a lethal-dose determination, which is the dose that results in the death of 50 percent of the animal population. Chronic toxicity testing involves exposing animals over long periods of time. All of these tests are expensive and time consuming. As such, not all chemicals are tested. 3. Scientific uncertainty remains hugely problematic for policy makers. Effects on animals are not perfectly correlated with effects on humans, and some effects are compounded by other factors. It is difficult to pinpoint the source of a cancer. If the market generates correct information, government intervention is not necessary. If it does not, and if the government can provide the best information, a policy of government intervention is necessary. Example 10.1 discusses the uncertainty regarding exposure to Bisphenol A. II. Market Allocations and Toxic Substances Three possible relationships exist between the source of the contamination and the victim: (1) employer-employee or occupational hazards; (2) producer-consumer or product safety; and (3) producer-third party. A. Occupational hazards 1. Employees will work in a potentially hazardous environment if they are appropriately compensated. Higher risk calls for higher wages. The difference in wages is called a risk premium. 2. The higher wages represent the real cost of risk to the employer, which will provide an incentive to create a safer work place.

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Chapter 10

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Toxic Substances and Environmental Justice

109

Efficient markets will equate the marginal cost of the increase in wages with the marginal cost of precaution when determining the optimal level of precaution. The lower the level of precaution provided by the firm, the higher the wage bill. The marginal cost of the increase in wages curve slopes downwards. The marginal cost of the increase in wages curve shifts up (increases) with the level of exposure. The marginal cost of precaution curve is upward sloping because taking precautions is costly. The marginal cost of precaution curve shifts left when there are fewer cheap precautionary options available. Four potential equilibrium points result (Figure 10.1). Occupations with more risk will attract workers who are less averse to risk. Higher wages would compensate the employees for the risk and would be cheaper for the employer than producing a safe workplace for the average worker. Empirical studies suggest that willingness to pay for risk reductions is substantial, but varies significantly across individuals. Market solutions to occupational hazards present ethical concerns. Example 10.2 presents one case where pregnant and fertile women were banned from working in a particular area. The ethical question raised is whether or not this represents discrimination against women. Another problem arises due to the lack of information about the degree of risk. The employee might not have complete information about the risks involved. If the employer were to publicize the risks, the employer might risk lawsuits and higher wages. Employees cannot be expected to produce an efficient amount of information about risk since information is a public good to employees, and employees will have incentives to free ride on others’ discoveries. Due to the inefficiencies of the market in providing information, some states have enacted “Right-to-Know” laws. These laws require businesses to disclose any potential hazards associated with toxic substances on the job. Responsibilities include labeling containers, keeping an inventory of all toxic substances used, and providing training in the handling of these substances.

B. Product safety 1. Product safety issues arise in particular with food products that contain chemical additives or pesticide residues. 2.

Safer products are typically more expensive, so that the higher price tag should represent the reduced risk. Consumers will make purchasing decisions by determining whether the cost is justified by the additional safety provided. The market will supply goods with varying degrees of safety. Since different consumers have different degrees of risk aversion, products with varying degrees of safety should be supplied by the market. Uniform product safety would not be economically efficient. The market does not have complete enough information to provide such self-regulation. Latency periods with toxic substances are long and consumers might not be able to pinpoint the source of an ailment. As such, there is a need for some government intervention to ensure product safety and to provide information.

C. Third Parties 1. Third parties who neither produce nor consume a product may be affected by a contaminated aquifer or by runoff contaminated with pesticides. 2.

Third parties have the least power to influence producers and consumers and thus the argument for government intervention is strongest for these individuals.

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Liability law provides a method for internalizing the external costs to third parties. Liability law can force sources to choose efficient levels of precaution and unlike regulation, provides compensation to the victims.

III. The Incidence of Hazardous Waste Siting Decisions A. History 1. 2.

Environmental justice began to attract serious attention in 1982. Approximately 500 demonstrators protested the location of a landfill in North Carolina. In 1987, the United Church of Christ Commission for Racial Justice examined hazardous waste siting for the nation and found race to be a significant factor. This report was updated by the Center for Policy Alternatives in 1994. This new report cited that commercial toxic waste facilities were more likely to be located in minority communities. Hamilton (2003) finds that for most U.S. studies, low income and minority residents do face higher risks from hazardous waste facilities.

B. GIS technology has made it much easier to determine who lives close to a hazardous waste site, or a superfund site. The distribution of risks can also be mapped using GIS technology. C. The Economics of Site Location 1.

4. 5.

The decision regarding where to locate a hazardous waste site must incorporate the incentives of the owners of the facilities as well as the incentives of the communities involved. Owners want to maximize net benefits and will look for the lowest disposal cost site. A location with low property values would also be appealing. The recipient community will also want to maximize net benefits and will want to receive compensation for taking on the additional risk. Low-income communities become attractive sites because of low land values and because those communities may require less in the form of compensation to accept the facility and its risk. Given the assumption that the willingness to pay for risk-avoidance is higher for higherincome families, the community may become poorer as higher income families leave the neighborhood. Full information and adequate enforcement are required for efficiency in location. If there is incomplete information, risk may be undervalued by the recipient community. There is a debate on the direction of the causality between location of hazardous facilities and poor neighborhoods. A real case for the city of Los Angeles is analyzed in Example 10.4.

D. The Policy Response 1. 2.

In 1992, the Office of Environmental Equity was established to deal with the environmental impacts affecting people of color and low-income communities. In 1994, President Clinton issued Executive Order 12898. The goal was to make sure minority groups and low-income populations were not subjected to unequal levels of environmental risk. A 2004 evaluation of this report did not give it a good grade. One problem stems from the lack of a uniform national definition for identifying communities at risk. Currently, the different methods being used are identifying very different numbers of people at risk.

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4. 5. 6. 7.

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In Canada, public participation has been used successfully in some decisions involving where to situate a hazardous facility. Some studies suggest that the presence of high unemployment increases the likelihood that a community would accept a hazardous waste facility. The “NIMBY” phenomenon, or “not in my backyard!” attitude has been explored in both the economics and psychology literature. In a study on the psychology of risk perception, Messer et al., 2004 found that the designation of a site as a superfund site, the cleanup of the site and the associate news all negatively affected property values. Compensation has been used as a policy instrument for achieving environmental justice.

E. Creating Incentives through Common Law 1.

Common law covers cases that are filed based on either negligence or strict liability. The existence of legal options can help control risk from toxic pollution. a. Negligence is the most common legal theory used by plaintiffs. b. Under the body of law that covers negligence, the defendant is responsible for exercising due care. If the defendant is found to be negligent, liability is assessed. Under this law, the victim bears the liability unless it is proved that the defendant was negligent. c. The Learned Hand formula is the test that most courts use in deciding whether or not the defendant has been negligent. Much like the expected-net-benefit formula, if the loss caused by contamination multiplied by the probability of contamination exceeds the cost of prevention, the defendant is guilty of negligence. This formula is compatible with efficiency. d. Violation of a statute can also prove negligence. e. Under the strict liability doctrine, the plaintiff does not have to prove negligence. If the act causes damage, the defendant is liable. Strict liability is used when the contamination is hazardous. Liability for damages is thus transferred to the source. Strict liability is also compatible with efficiency since it makes sense to take extra precautions to avoid large damages for very hazardous substances. f. Both negligence and strict liability doctrines are civil law doctrines in which one private party sues another private party. Civil penalties can be paid by insurance.

Statutory law 1. The body of statutory law that accompanies civil and criminal legal remedies covers the many statutes that have evolved over time. 2. The Toxic Substances Control Act requires the EPA to inventory the approximately 55,000 chemical substances commercially manufactured; it also requires the EPA to be notified of new chemical substances and to produce testing reporting requirements for risk assessment. Test results proving there are no “unreasonable risks” must be submitted 90 days prior to manufacturing or importing a new chemical. The burden of proof rests on the manufacturer with this Act. 3. The Comprehensive Environmental Response, Compensation, and Liability Act also known as the “Superfund Act” of 1980 created a $1.6 billion fund to be used to clean up toxic waste sites. The Act provides compensation for loss or destruction of natural resources, but does not provide compensation for injured individuals. This fund was used, for example, to buy out businesses and relocate residents of Times Beach, Missouri in 1982 after it was revealed that the soil contained dangerous levels of dioxin. Dioxin had been used for dust control in the 1970s. ©2015 Pearson Education, Inc.

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G. The Toxic Release Inventory program was enacted in 1986 as part of the Environmental Protection and Community Right to Know Act. It provides information to the public on the releases over a certain size of toxic substances into the environment. (Data can be found at www.epa.gov/tri.) EPA’s annual reports suggest that this reporting has resulted in reduced toxic emissions. Example 10.3 examines the effect of toxic pollution on home values. H. Proposition 65, the Safe Drinking Water and Toxic Enforcement Act of 1986, is a California statute that requires companies who produce, use or transport the TRI listed chemicals to notify those who could be impacted. Notification involves warning labels, public notification and worker warnings. I.

International Agreements 1. The Basal Convention on the Control of Transboundary Movements of Hazardous Wastes and Their Disposal was developed in 1989 and requires OECD countries to obtain written permission from the government of any developing country before sending toxic waste there for disposal. This Act was meant to protect cash poor nations that might take in waste in return for large compensation. In 1994 an additional agreement prohibited the export of toxic wastes from any OECD country to a non-OECD country. 2. Used electronic goods are often exported to developing countries for disassembly in order to recover valuable components. This can lead to health risks for the workers in the developing countries. At present there are no regulations that govern the export of used electronic goods.

◼ Common Student Difficulties The legal jargon in this chapter might be confusing to some students who are not familiar with such terms. The body of statuatory law is fairly extensive and if time is short, it may be easier to give a general summary and let the students read through the individual Acts on their own.

◼

Suggested Classroom Exercises

Information from the toxic release inventory is available from the EPA (http://www.epa.gov/tri). Reviewing and discussing some of this material would be very timely.

Is it the end of the semester? Perhaps a film is in order. Recent films including Erin Brokovich or A Civil Action have dealt with events related to hazardous waste and toxic waste and wrongful disposal cases.

◼

Essay Question

Why might offering compensation to accept a hazardous waste facility decrease the willingness to accept it? What would you be willing to accept to allow a hazardous waste facility to be located in your hometown?

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Chapter 11 Climate Change I: The Nature of the Challenge Chapter 11 is focused on global warming and climate change negotiations. Addressing greenhouse gas emissions is more complicated than standard stationary source emissions due to the global nature of the problem, and the associated uncertainties. External costs are now imposed on third parties who may reside in different cities, states, or even countries. The chapter covers global pollutants and global problems such as ozone depletion and global warming. All students today are aware of global warming, and many will have very strong opinions on the subject. This makes for some very interesting class discussion.

◼ Teaching Objectives 1.

Discuss the science of climate change, including both the sources and likely outcomes of climate change.

Characterize the broad strategies that can be used to address climate change.

Explain how targets have evolved over time.

Understand incentives for participation in climate change agreements.

Discuss policy timing in terms of how aggressively the global warming problem should be addressed.

Know how the international community solved the problem of the depletion of the ozone layer as an example of global cooperation and negotiation.

◼

Outline I. The Science of Climate Change This section discusses the scientific evidence of climate change and raises some of the potential environmental consequences of climate change. A. Carbon dioxide, methane, nitrous oxide, and chlorofluorocarbons make up a class of pollutants called greenhouse gases. Greenhouse gases trap heat that would otherwise leave the earth’s atmosphere.

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B. As the amount of these gases in the atmosphere rises over time, concern about global climate change is increasing. II. Quantifying the Intensity of the Threat A. The Intergovernmental Panel on Climate Change (IPCC) is the body charged with assessing the scientific evidence on climate change. Some findings from the 2013 report: 1. 2.

3. 4.

The warming of the climate system is undisputable. The increase in the carbon dioxide concentration comes from fossil-fuel use and deforestation, while the increase in methane and nitrous oxide concentration comes from agriculture. The impacts of climate change will persist even if greenhouse gas emissions are stabilized. It is extremely likely that human influence has been the main cause of global warming during the last century.

B. Large quantities of methane are currently trapped in the frozen tundra of the North. As temperatures warm, the trapped methane will be released. This release could accelerate the rate of warming. C. The major impacts of global climate change include rising sea levels, more intense storms, an increase in droughts and floods, intensified ocean acidification, and adverse human health impacts resulting from all of the above. D. Tipping Points 1. The phrase “tipping point” conveys the sense that at a particular moment in time, a small change in emissions can have large, long-term consequences for a system. 2. These “tipping points” involve thresholds where even a relatively small change could push a system into a completely new state. E. Dealing with Uncertainty 1. While the presence of uncertainties favors more aggressive policies (due to the enhanced damages), it is less clear about exactly how aggressive they should be and the best timing for implementing them. 2. Modelers use probability density functions (PDFs) to specify the likelihood of an event that falls within a particularly dangerous range of values, and the nature of that PDF matters. 3. However, due to the special nature of the uncertainties associated with climate change, the appropriate PDF would not be bell-shaped; it would have what is known as a “fat tail.” 4. The models also don’t include all types of damages that are likely to occur, and thus the probability of reaching a dangerous threshold is understated, and the severity of damages anticipated at future temperature levels is likely to be higher than modeled as well. 5. Messages for Policy a. A wait-and-see strategy would be too dangerous because changes in the energy sectors take considerable time to unfold. b. By the time we can get more information, it might be too late (due in part to the degree of irreversibility in the atmospheric system). c. Current action is necessary. d. One take-away message is that strategies that maintain the ability to be nimble as more evidence is gained are especially valued in periods of uncertainty.

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e. Finally, as the window of opportunity closes controversial geoengineering choices that might have seemed too risky or too expensive with more time, could become among the few viable remaining options. III.

Broad Strategies A. Characterizing the Broad Strategies 1. Climate engineering includes strategies such as carbon dioxide removal or solar-radiation management. The first approach seeks to reduce greenhouse gases, while the second seeks to cool the planet by reflecting sunlight away from the planet. The effectiveness of both is uncertain at this time. 2. Adaptation involves changing behavior to adapt to the changing environment. 3. Mitigation attempts to reduce emissions, or increase the planet’s natural capacity to absorb greenhouse gases. Examples include reducing the use of fossil fuels, or increasing the amount of carbon absorbed by trees. B. The Precedent: Reducing Ozone-Depleting Gases 1.

Stratospheric ozone absorbs ultraviolet wavelengths and shields people, plants and animals from harmful radiation. It therefore helps determine the earth’s climate.

The use of cholorofluorocarbons (CFCs) for aeorsol propellants, packing materials and refrigeration has been a large factor in the depletion of the stratospheric ozone shield. Depletion of this protective layer causes increased ultraviolet radiation, which can cause skin cancer and other health problems.

In 1988, an initial group of 24 nations signed the Montreal Protocol. The Montreal Protocol required these nations to restrict the production and consumption of the major ozone-depleting substances by establishing schedules for phasing out their production and use.

The protocol was a success. Currently, 96 chemicals are controlled by the agreement. As of 2008, more than 95% or ozone-depleting substances had been phased out. The ozone layer is expected to return to its 1980 level by 2075.

The Multilateral Fund facilitates the phase-out of chemicals. Industrialized countries contribute to the fund, which is then used to offer assistance to developing countries in eliminating the production and use of ozone-depleting chemicals.

Also contributing to the success of the phase-out was the development of alternatives and thus costs were lower than anticipated.

More recently attempts have been made to come to a similar agreement to phase out the use of hydrofluorocarbons, which replaced chlorofluorocarbons. Reducing the use of HFCs could slow global warming.

IV. The Evolution of Targets A. In 2015 the countries participating in the United Nations Framework Convention on Climate Change (UNFCCC) agreed to a common target: holding the rise in global average temperature below 2°C relative to pre-industrial levels while pursuing efforts to limit the temperature increase even further to 1.5°C if possible (the Paris Climate Agreement). 1. The international community concluded that if the temperature rise could be limited to an increase of 2°C, the benefits (reduced damages) would very likely exceed the costs of attaining those goals. 2. Further, if temperatures rose over 2°C, it would likely raise the likelihood of quicker, more unpredictable damages that could prove difficult, if not impossible, to reverse. Information Classification: General

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B. The temperature increase targets were changed into emissions targets in two steps. 1. figuring out the GHG concentration levels in the atmosphere that would be consistent with staying within the temperature increase targets, and 2. deriving the amount of increased cumulative CO2e emissions (called the carbon budget) that would be consistent with not exceeding that concentration. C. Subsequently, various entities, such as businesses and states, began to pledge to achieve a related goal—carbon neutrality (or climate neutrality)—by a specified date. 1. Carbon neutrality means annual zero net human-caused CO2 emissions, while climate neutrality means zero net CO2e emissions (i.e., including all GHGs). 2. Climate net neutrality means every ton of anthropogenic GHG emitted after the deadline must be offset by an equivalent amount (in terms of their global warming potential) of GHG removed. 3. The initial logic behind this strategy is a recognition that not all emissions end up in the atmosphere. 4. Carbon sinks such as forests absorb carbon from the atmosphere. 5. Therefore, what matters is the difference between what is emitted and how much of that is absorbed or stored before it reaches the atmosphere. 6. As of 2021, a total of 131 countries, covering 72 percent of global emissions were discussing, had announced, or had formally adopted net zero targets. 7. Countries can demonstrate achievement of their net zero goal by proving that the amount of carbon absorbed by forests controlled by them in a target year was greater than or equal to the amount of any remaining emissions in that year. 8. Estimates suggest that national net zero emission targets could, if fully implemented and enforced, reduce best estimates of projected global average temperature increase to 2.0–2.4 °C by 2100, bringing the Paris Agreement temperature goal within reach. 9. Assuming all monitoring of reductions was accurate, these targets could substantially lower projected warming as compared to currently implemented policies (2.9–3.2 °C) or pledges submitted to the Paris Agreement (2.4–2.9 °C). A.

However, considerable controversy arose about the efficacy of net zero climate or carbon goals, especially over their current implementation by the corporate community. 1. The surge in the adoption of corporate net zero pledges has been accompanied by a new public focus on the accounting system used to keep track of the carbon absorption reductions that go into the “net” calculation in these pledges. 2. The bottom line of this concern is that the current accounting system is frequently not only not transparent, but verifiability is weak. 3. Without strengthening, this system is viewed by many as having the potential to undermine the global emission mitigation programs substantially by allowing credit for reductions that are overstated, double counted, or counterproductive in other ways.

Economic Insights on Targets and Timing A. There are enormous uncertainties associated with climate changes. These uncertainties make policy-making very complicated.

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B. Efficiency is achieved when the marginal cost of controlling an additional unit of emissions becomes equal to the marginal reduction in damages that results from controlling (rather than emitting) that unit of emissions. a. Can calculate the optimal point based upon a specific set of assumptions, but different sets of assumptions result in different optimal levels of emissions reduction. C.

Two main choices involve the discount rate and the uncertainty associated with the magnitude and timing of damage estimates. a. Choice of discount rate is crucial to benefit/costs calculations, but the “right” discount rate is unclear. b. Generally, the two main perspectives on discounting in the climate change context lie between normative discounting and opportunity cost discounting. c. Normative discounting is derived from ethical principles about the treatment of future generations. d. Opportunity cost discounting focuses on the observed opportunity cost of capital. e. The former leads to a lower recommended discount rate than the latter, and in the last few years there has been a convergence of these views toward the lower rates.

Recall that when the marginal cost of reducing a unit of emissions is less than the marginal social damage that would have been caused by that unit of emissions, we should increase control. a. We can infer the marginal cost of control from current carbon prices in those areas that have put a price on carbon. b. Are the existing marginal costs of control as reflected in carbon prices around the world lower or higher than the marginal damage estimates reflected in the social cost of carbon? c. Fortunately, World Bank reports keep track of the current values of both numbers. d. If we compare them, we find that these carbon prices, as reflected in current carbon taxes or emissions trading markets, are typically considerably lower than common social cost of carbon estimates. e. The implication from comparing these two numbers is that action is not only merited based on science, but it makes enormous economic sense as well; additional action to reduce emissions would increase net benefits.

Economic analysis also points out that the risks of being wrong are clearly asymmetric.

If it turns out that the chosen policy controlled more emissions earlier than ultimately necessary, the evidence suggests that current generations will bear at most a mildly larger-than-necessary control cost.

On the other hand, if current generations act too timidly (less control later than needed) and the problem turns out to be as serious as some predictions indicate, catastrophic and largely irreversible damage to the planet could be inflicted on future generations.

VI. Getting There: The Economics of Global Climate Agreements A. Once the emissions targets were set countries began negotiations to lay out feasible strategies for matching emission reductions with the goals. 1. The negotiations sought enforceable pathways consistent with the targets as well as a process for monitoring compliance with those pathways. a. These pathways had to be incorporated into a durable international agreement with enough signatories collectively agreeing to a sufficient amount of emissions reduction.

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b. For these agreements to succeed signatories should not only be willing to join the agreement, but they should also continue to live up to their responsibilities once the agreement went into effect. B. Game Theory as a Window on Climate Negotiations 1. Game theory can be used to study the incentives faced by each nation when the payoff to each nation depends not only on its decisions, but also on the decisions of other nations. 2. The Barrett model describes self-enforcing agreements as those where the incentives are likely to create stable coalitions. In this game, when new countries join the agreement, existing participants respond by abating more. When countries leave the coalition, participants respond by abating less. 3. A stable, successful agreement is most likely to be achieved when the benefits to free riding are low. 4. The existence of a catastrophe threshold makes a successful agreement more likely. The specifics of the catastrophe must be known with certainty and the benefits must be high relative to the costs. 5. Co-benefits are an incentive for nations to participate in climate change agreements. For example, the use of low-carbon fuels not only has positive impacts on global climate change but also has direct impacts on human health in the nation that adopts the lowcarbon fuel. 6. Issue-linkage involves countries simultaneously negotiating trade or other agreements at the same time as the climate agreement. 7. Transfers from the gainers to the losers can make a global agreement more successful, given some countries will gain and some countries will lose. C. One recent proposal to combat free riding seems to be getting some traction, based upon the notion of a “climate club.” 1. This club would be designed specifically to encourage sufficient cooperation among member nations to produce the emission reductions necessary to achieve internationally established goals. 2. This idea envisions two main policy parameters: a. a stipulated international carbon price that all club members would have to enact, and b. a uniform tariff that all nonmembers (those who have failed to enact that carbon price) would face on all goods exported from non-club members to the club member states. 3. In July 2021 the European Union announced its intention to establish a carbon border tax (tariff) of the climate club type. a. Intended to be phased in from 2026, it would be levied on imports of carbon-intensive steel, aluminum, cement, fertilizers, and electricity. b. Designed, in part, to induce non-E.U. competitors to establish carbon prices that are comparable to those in the European Union (thereby joining the club). c. It would work by requiring products from the designated sectors in non-E.U. countries to be accompanied by digital certificates representing the tonnage of carbon dioxide emissions embedded in the goods they import. d. The price of the certificates would be based on the average price of carbon in the E.U.

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e. Any importers that can prove that a carbon price has already been paid during the production of the imported goods, would have the corresponding amount deducted from their final bill. VII. The Precedent: Reducing Ozone-Depleting Gasses A.

Stratospheric ozone absorbs ultraviolet wavelengths and shields people, plants and animals from harmful radiation. It therefore helps determine the earth’s climate.

The use of chlorofluorocarbons (CFCs) for aerosol propellants, packing materials and refrigeration has been a large factor in the depletion of the stratospheric ozone shield. Depletion of this protective layer causes increased ultraviolet radiation, which can cause skin cancer and other health problems.

Also contributing to the success of the phase-out was the development of alternatives and thus costs were lower than anticipated.

More recently attempts have been made to come to a similar agreement to phase out the use of hydrofluorocarbons, which replaced chlorofluorocarbons. Reducing the use of HFC’s could slow global warming.

◼ Common Student Difficulties This chapter sets up the successive chapters, which deal with policy and with carbon trading. The main difficulty in this chapter is the return to discussion of discounting, which is often difficult for students. This chapter adds the distinction between opportunity cost and normative discounting. It may also be a good idea to introduce some discussion of statistics and confidence intervals, as a lead-in to the next chapter, in which students should have some rudimentary idea about probability distributions.

◼

Suggested Classroom Exercises 1. This chapter introduces a game theoretic approach to climate negotiations. If your student have sufficient background to do this, have students formulate the climate negotiation game in game theory terms, and discuss the prisoner’s dilemma and free-riding problems. What is necessary to solve the prisoner’s dilemma in this case? 2. Have students research climate tipping points, as currently projected, how close we may be to them, and what needs to be done. This information changes frequently, so it is very topical and usually brings more stark reality to these figures.

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Essay Questions

Can the success in reducing the use of CFCs provide lessons for other types of pollutants? Discuss.

Under what circumstances will countries wish to join the EU “climate club”. What factors would make countries more or less likely to join?

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Chapter 12 Climate Change II: The Role of Energy Policy Chapter 12 turns to energy policies. It focuses on the transition to renewable energy sources and discusses extensively both the role of energy policy and the many complex issues presented by this transition. Primary considerations are the nonrenewable energy sources of oil and natural gas. These two energy sources are depletable and non-recyclable, yet supply the majority of all energy consumed in the United States. This chapter examines some of the issues associated with the efficient allocation of energy resources and shows how economic analysis can be used in policy making. This is a complex subject and the chapter quickly covers a large amount of material and concepts. Topics of interest include oil prices and cartel activities, energy conservation, electricity production, national security, climate considerations, and the transition to renewable energy sources.

◼ Teaching Objectives 1. Discuss our dependence on depletable, non-recyclable energy resources and review the efficient extraction path of these resources. 2. Discuss energy efficiency and government policies to promote conservation. 3. Explain possible future pathways, including fuel switching. 4. Discuss the alternatives to oil and natural gas, such as nuclear power. 5. Explain issues related to the design of transition policies. 6. Discuss the use of renewable energy credits to encourage the transition to renewable energy sources. 7. Identify the national security concerns related to energy imports.

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Chapter 12

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Climate Change II: The Role of Energy Policy

Outline I. Introduction A. Currently, many countries depend on oil and natural gas for most of their energy needs. 1. Together supply 60 percent of all primary energy consumed worldwide. 2. Adding coal increases the share to 87 percent of the total.) B. Fossil fuels are depletable, nonrecyclable sources of energy and when they are burned, they contribute CO2 to the atmosphere, thereby contributing to climate change. C. Domestic natural gas and oil production in the United States remained relatively stable from the mid-1970s until the middle of the first decade of the 21st century. 1. Then hydraulic fracturing, or “fracking”, which combines horizontal drilling with an ability to fracture deep shale deposits using a mixture of high-pressure water, sand, and chemicals, allowed more extraction at a lower cost. 2. Controversy due to detrimental effects on drinking water, on wildlife habitat, and the fact that the benefits and the costs are received by different populations.

II. Future Pathways A. Energy Efficiency 1. The strongest case for government intervention flows from the existence of externalities in energy choices. a. Since the people making those energy-efficiency investments can capture only a portion of the total benefits, their decisions can be expected to undervalue its importance in their energy choices. 2. National security considerations, such as when Ukraine was attacked by Russia, and climate change externalities are two important examples. 3. However, the case for policy intervention extends well beyond externalities. a. Inadequately informed consumers can impede rational choice. b. Limited access to capital can impede energy-saving investments even when they are efficient and could lower homeowner cost. c. Example 12.1 points out that new billing practices are being developed that may help to diminish this affordability constraint. d. Example 12.2 discusses feedback from energy policies that can reduce their effectiveness. B. Fuel Switching

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1. The second major pathway for mitigating emissions, fuel switching, starts from a recognition that some fuels contribute more to climate change risk than others. 2. How much of a risk of climate change is posed by combustion of a particular fuel depends on the amount of carbon contained within that fuel. a. As can be seen from Table 12.1, among the fossil fuels, coal contains the most carbon per unit of energy produced and natural gas contains the least. b. Switching from high-carbon fuels to low-carbon or zero-carbon fuels, all other things being equal, can lower emissions. C. Beneficial Electrification 1. Beneficial electrification refers to electrifying energy end-uses usually powered by fossil fuels in a way that reduces overall emissions and energy costs to such an extent that the end user and the environment both benefit. a. Examples include switching from gasoline to electric vehicles and/or electric heating/cooling systems when they are powered by clean electricity. 2. One policy innovation, known as the forward capacity market, uses market forces to facilitate capacity planning. a. ISO-New England is the independent, not-for-profit corporation responsible for keeping electricity flowing across the six New England states and ensuring that the region has reliable, competitively priced wholesale electricity today and into the future. b. The Forward Capacity Market (FCM) in New England is designed to assure that system will have sufficient cost-effective capacity resources to meet the future demands both where and when they are needed. c. Forward Capacity Auctions (FCAs) are held annually, three years in advance of the operating period. d. Potential capacity suppliers compete in auctions to obtain a commitment to supply capacity in exchange for a market-priced capacity payment. 3. The objective of the FCM is to assure that sufficient peak generating capacity for future reliable system operation will be available. a. Since ISO-NE does not itself generate electricity, to assure this future capacity, it solicits bids in a competitive auction for additional generating capacity. b. It also solicits bids for legally enforceable future reductions in peak demand from energy efficiency. c. Soliciting both types of bids allows ISO-NE to compare the cost of generating the electric capacity with the cost of reducing the need for that capacity, choosing whichever is cheapest. d. This system allows strategies for reducing peak demand to compete on a level playing field with strategies to expand capacity. D. The Possible Role for Nuclear Energy

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Chapter 12

Climate Change II: The Role of Energy Policy

1. Aside from the fact that it is not a renewable fuel, nuclear has two main limitations—safety and economics. 2. With respect to safety, two sources of concern stand out: (1) nuclear accidents or sabotage, and (2) the storage of radioactive waste. a. The production of electricity by nuclear reactors involves radioactive elements. If these elements escape into the atmosphere and humans are exposed to sufficient concentrations, they can induce birth defects, cancer, or death. b. Although some radioactive elements may escape during the normal operation of a plant, the greatest risk of nuclear power is posed by the threat of nuclear accidents or deliberate sabotage. c. Unlike other types of electrical generation, nuclear processes continue to generate heat long after the reactor is turned off. d. The nuclear fuel must be continuously cooled, or the heat levels will escalate beyond the design capacity of the reactor shield. e. If the high heat causes the reactor vessel to fracture, clouds of dangerous radioactive gases and particulates can be released into the atmosphere. 3. The waste-storage issue relates to both ends of the nuclear fuel cycle—the disposal of uranium tailings from the mining process and spent fuel from the reactors. a. Uranium tailings contain several elements, the most prominent being thorium230, which decays with a half-life of 78,000 years to a radioactive, chemically inert gas, radon-222. Once formed, this gas has a very short half-life (38 days). b. The spent fuel from nuclear reactors contains a variety of radioactive elements with quite different half-lives. c. In the first few centuries, the dominant contributors to radioactivity are fission products, principally strontium-90 and cesium-137. d. After approximately 1000 years, most of these elements will have decayed, leaving the transuranic elements, which have substantially longer half-lives. e. These remaining elements would remain a risk for up to 240,000 years. 4. Another consideration is that nuclear power plant construction has become much more expensive over time, in part due to the increasing regulatory requirements designed to provide a safer system. 5. The transition to lower-carbon fuels has created some renewed interest in the nuclear option. a. The first new nuclear generator in the United States in 20 years entered commercial operation in Tennessee in 2016. During that year nuclear power plants provided a bit over 11 percent of the world’s electricity and reactors were operating in 31 countries. b. The World Nuclear Association announced that some 440 nuclear power reactors were operating in 31 countries and over 60 power reactors were currently being constructed in 13 countries. c. China was constructing eight new reactors a year at the time. 6. Different nations have come to different conclusions about the role for nuclear energy. a. In 1980, the Swedish government decided to phase out nuclear power.

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b. In June 2010, the Swedish parliament voted to repeal this phase-out. c. While Germany and Belgium are phasing out their existing nuclear power, in 2022 President Macron of France announced an ambitious plan to build up to 14 new-generation reactors and a fleet of smaller nuclear plants. E. Policy Design Issues 1. Another common policy approach for overcoming these obstacles involves combining renewable portfolio standards (RPS) for electricity generation with renewable energy credits (RECs). a. Renewable portfolio standards stipulate a minimum percentage of the total electricity generated that must come from specified renewable sources such as wind, hydro, or solar. b. The generating entity can either meet that standard directly by generating the requisite proportion from the specified renewable sources, or indirectly by purchasing renewable energy credits from other independent generators 2. An independent generator producing electricity from a specified renewable source produces two salable commodities. a. The first is the electricity itself, which can be sold to the grid, while the second is the renewable energy credit that turns the environmental attributes into a legally recognized form of property that can be sold separately and used to demonstrate compliance with an RPS. b. Generally, renewable generators create one REC for every 1000 kilowatt-hours (or, equivalently, 1 megawatt-hour) of electricity placed on the grid. c. Providing this form of flexibility in how compliance with the RPS is achieved lowers the compliance cost, not only in the short run (by allowing the RECs to flow to the areas of highest need) but also in the long run (by making renewable source generation more profitable than it would otherwise be in areas not under an RPS mandate). d. By 2021 in the United States, some 30 states, Washington, D.C., and two territories had active renewable or clean energy requirements, while an additional three states and one territory have set voluntary renewable energy goals. e. Globally, as of April 2017, 173 countries had some form of RPS in place. f.

Example 12.3 discusses the cost-effectiveness of these policies.

3. One pricing strategy that promotes the use of renewable energy resources in the generation of electric power is known as a feed-in tariff. a. A feed-in tariff specifies in advance the prices received by anyone who installs qualified renewable generation capacity. b. The magnitude of the tariff is set high enough to assure installers a reasonable rate of return on their investment. c. In Germany this incentive payment is guaranteed for 20 years for each installed facility. i.

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Each year the magnitude of the payment for each cohort of newly constructed generators is reduced (typically in the neighborhood of 1–2 percent per year) in order to reflect expected technological improvements and economies of scale.

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d. A feed-in tariff offers two different incentives: i.

It provides a price high enough to promote the desired investment, and

ii.

it guarantees the stability of that price over time rather than forcing investors to face the market uncertainties associated with fluctuating prices or subsidies that come and go.

4. In Germany the higher costs associated with the feed-in tariffs were typically passed along to electricity ratepayers. a. As a result, German electricity rates were relatively high. b. These higher costs were expected to be temporary, since rising fossil fuel costs were anticipated to rise above the relatively stable prices dictated by feed-in tariffs. 5. Spain refused to allow its electric utilities to pass on the increased cost of electricity resulting from the feed-in tariffs to consumers. a. As a result, its electricity system’s financial deficit became unsustainable, and in 2013 Spain halted new feed-in tariff contracts for renewable energy. 6. In the United States, community solar, is designed to allow homeowners to acquire solar energy. a. Under this program homeowners can acquire a specific share of the kwh of a large solar farm. b. Participants can either be owners (literally purchasing their share of panels as if they were built on their roof) or subscribers (paying a stipulated fee for each kwh produced by their share of panels). 7. Example 12.4 discusses negative prices in the energy industry. III.

Transition Complexities

A. Dealing with Intermittent Sources 1. Supply intermittency requires not only that the new grid must be able to integrate all these renewable sources into a smoothly functioning supply, but supply must also be synchronized with demand to assure that the demands can be met at all locations at all times. 2. The main concern involves resolving a timing mismatch. a. The demand for electricity normally follows temporal patterns. b. The electricity consumed in a given period varies throughout the year in somewhat predictable patterns. i.

In the US, hourly electricity load is generally highest in the summer months.

ii.

During the winter months, the hourly electricity load is less variable.

iii.

During a 24-hour cycle, electricity usage in a typical home follows the daily habits of its residents. Accordingly, the least amount of electricity is consumed at night when most people sleep.

3. The supply of solar and wind power does not follow these same patterns.

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• Environmental and Natural Resource Economics, Twelfth Edition

4. The key to synchronization involves structuring incentives so that both suppliers and consumers have incentives to tailor their choices to be consistent with the overall needs of the system. a. Two main ingredients are having means of storing electricity from surplus supply periods for subsequent use in deficit periods and time-varying pricing (TVP) that is designed to provide incentives compatible with that synchronization. b. TVP generally sets the highest prices when demand would otherwise exceed supply and the lowest prices when supply would otherwise exceed demand. c. TVP provides incentives to shift the timing of electric usage when grid electricity prices are lower. d. New smart technologies are emerging that allow more sophisticated types of pricing systems with more detailed and faster responses to current situations on the grid by electricity grid managers as well as electricity buyers and sellers. e. This combination of pricing and enabling technology is the key to scaling up this timing synchronization, which in turn provides the means for fewer emissions, lower costs, and a more smoothly running electric grid. 5. Also provides more incentive for investing in the capability to store electricity (through large batteries, for example) for both homeowners and the utility. a. Stored power from the batteries can be sold to the grid or used directly by the generating households when prices are high and stored for later sale or use when grid prices are low. b. Pumped storage, is now also in common use. Pumped hydroelectric storage facilities store water in an upper reservoir that was pumped from another reservoir at a lower elevation. i.

During periods of high electricity demand, power is generated by releasing the stored water through turbines in the same manner as a conventional hydropower station.

ii.

During periods of low demand (usually nights or weekends when electricity is also lower cost), the upper reservoir is resupplied by using lower-cost electricity from the grid to pump the water back to it.

c. This combination of enhanced storage complemented by pricing incentives provides means for dealing with the intermittency timing mismatch (the “when” problem), but as explored below, the “where” problem is handled differently. d. Example 12.5 discusses a related approach. e. Example 12.6 discusses solar grids in Kenya. 6. Access to Critical Resources

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a. One additional complicating element in energy policy arises when energy choices depend on the availability of “critical and strategic” inputs from foreign sources, especially when foreign suppliers have the power to limit supply of a critical resource that the importing country depends upon. b. The motives to limit supply include raising prices to increase profits or forcing one or more buyers to change some action that the sellers oppose. c. Circumstances like materials imported through a dedicated pipeline or electrical transmission line create a dependence that is difficult to overcome in any reasonable amount of time, should those pathways be blocked. i.

Vulnerability can also be created when a group of suppliers who collectively control a large part of the market form a cartel to coordinate their decisions.

ii.

During the 1973 Arab–Israeli War, Arab members of the Organization of Petroleum Exporting Countries (OPEC), a cartel, imposed an embargo against the United States in retaliation for the U.S. decision to re-supply the Israeli military.

iii.

In 2010 the Chinese government blocked exports to Japan of a crucial category of minerals used in products like electric vehicles, wind turbines, and guided missiles, triggered by a dispute over Japan’s detention of a Chinese fishing trawler captain.

iv.

In 2021 when Europe was dependent on Russia for about 50 percent of its natural gas supply, natural gas prices rose dramatically, causing some European lawmakers to express concern that this dependency made them vulnerable.

In 2022 when Russia attacked Ukraine, Europe’s dependency severely limited, at least initially, their ability to join other nations in supporting Ukraine by sanctioning Russia’s natural gas sales.

7. Many strategic minerals are currently key ingredients in the production of both electric vehicles (EVs) and the expansion of the electrical grid. a. Lithium, nickel, cobalt, manganese, and graphite are crucial to battery performance, longevity, and energy density in the current generation of batteries. b. Rare earth elements are also essential for permanent magnets that are vital for wind turbines and EV motors. c. For lithium, cobalt, and rare earth elements, the world’s top three producing nations control well over three-quarters of current global output. d. The Democratic Republic of the Congo (DRC) and People’s Republic of China (China) were responsible for 70 percent and 60 percent respectively of global production of cobalt and rare earth elements in 2019. 8. Importing, when possible, from sources that are less likely to restrict supply poses less risk. 9. Investing in lowering the amount of the critical input per unit of output is another possible approach.

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• Environmental and Natural Resource Economics, Twelfth Edition

10. Those who have domestic resources may seek to expand domestic supply. a. A strategic reserve would tailor the response more closely to the national security problem. b. Stockpile of some of the critical material that is held to reduce the impact of a temporary supply restriction if it should occur. c. The Strategic Petroleum Reserve is a U.S. government complex of four sites with deep underground storage caverns created in salt domes along the Texas and Louisiana Gulf Coasts. 11. Does the transition to renewable low- or no-carbon fuels reduce or intensify the national security concerns associated with the U.S. energy situation? a. Unlike fossil fuels, wind and solar sources do not have highly geographically concentrated sources. Further, they are much more widely available domestically. b. Less dependence on energy imports means less vulnerability. c. The heavy dependence on rare mineral sources in a few countries remains a concern. i.

The United States has some domestic sources of some of these minerals, but new mineral mines usually have local detrimental effects and are heavily regulated.

ii.

The industry is gearing up to recycle the minerals from end-of-use products and scientists are trying to discover cost-effective ways to extract lithium from sea water and/or processed water such as the brine in geothermal power systems.

iii.

Hope is also being placed in innovation that will find new economically feasible production possibilities for making the necessary components of the transition from more common, available materials.

◼ Common Student Difficulties While this chapter presents no new economic concepts, it requires students to think about process. Changing to renewable fuel sources is not just a matter of waving hands and doing it; it requires shifting of infrastructure and changes in the way in which people and businesses do things. Likewise, it is easy to think that moving away from fossil fuels solves the problems of both greenhouse gasses and resource scarcity. However, alternatives like nuclear have their own problems, and likewise, rare minerals required for batteries come with many of the security issues that have characterized dependence on fossil fuels. Thus an important lesson to stress in this chapter is the classic economic truth: there is no free lunch.

◼

Suggested Classroom Exercises 1. The pros and cons of nuclear power invariably make for a lively classroom discussion. While the textbook presents some of the costs and benefits of nuclear energy, there is much more information available. Students can research the cost of building new plants, the cost of storage, the energy-generating capabilities, and many other issues. Students could also be assigned as country teams to debate different positions on nuclear energy.

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Climate Change II: The Role of Energy Policy

2. Is the United States vulnerable to national security threats from the withholding of resources? There are many ways to direct a discussion like this, from rising US gas prices when prices rose in Europe in the wake of the Russian invasion of the Ukraine to rare minerals. What minerals does the US mine? Where do other minerals come from? Are these countries likely to be threats to national security or not? This could also involve a discussion of US dependence on foreign oil in the 1970s, as compared to the situation now. This illustrates, in part, how market mechanisms can help lead to solutions.

◼

Essay Question 1. The Arctic National Wildlife Refuge has been targeted as a source of domestic oil, and fracking technology has already increased the production of natural gas in several of the U.S. states. How can environmental and resource economics be used to answer the question of whether or not we should open ANWR to drilling and/or allow more fracking? What factors should be incorporated into the analysis? 2. National security issues have long been a problem with fossil fuels. In what ways are those issues the same or different for electrical batteries that require rare minerals? How can nations without large supplies of such minerals protect themselves in the years to come?

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Chapter 13 Climate Change III: Carbon Pricing Chapter 13 turns to the issue of carbon pricing and explores how carbon taxes and emissions trading systems have worked. The issues related to the design of these programs are discussed, and four existing programs are explained for reference. Finally, the just transition is related to carbon pricing policy.

◼ Teaching Objectives 1.

Understand the effects of carbon pricing.

Explain carbon offset credits.

Discuss how carbon taxes and emissions trading systems have worked in practice.

Discuss some design issues that arise when adopting a carbon tax or emissions trading system.

Discuss controversies associated with emissions trading.

Discuss policy timing in terms of how aggressively the global warming problem should be addressed.

◼

Outline

Carbon Pricing and Emissions Policy Choice A. Carbon pricing is unique in its ability to control GHG emissions sources other than energy with a single policy instrument. 1. Once a price is put on CO2e it promotes: a. (1) fuel switching to lower-carbon fuels, b. (2) energy efficiency by raising the amount of cost savings per unit of emissions reduced, c. (3) reductions in emissions from non-energy GHG sources, and

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Climate Change III: Carbon Pricing

d. (4) technological innovation to come up with new fuels or new energy-saving and emission-reducing techniques. B. To be cost-effective the price on emissions should be applied to all greenhouse gases (via CO2e), not just carbon dioxide, and to all emission sources of those gases, not merely some. C. All emitters should face the same price per ton of CO2e; different prices would result in different marginal costs, thereby violating the equal-marginal cost condition for costeffectiveness. D. Forms of Carbon Pricing 1. Carbon pricing has historically been applied in two different forms: (1) carbon taxes or (2) emissions trading programs (particularly cap-and-trade or cap-and-invest programs). a. For the carbon tax the government sets the price, and the market determines the resulting level of emissions. b. In emissions trading the government determines the allowed aggregate amount of emissions, and the market determines the price that will achieve that level. i.

For any allowed level of emissions there is a price that will result in that level of emissions.

ii.

Conversely if that price is imposed as a tax, that same level of emissions will result.

2. Early in climate negotiations, Europe favored carbon taxes, while the United States preferred cap-and-trade. E. Mitigation by means of cost-effective strategies is the priority, with an emphasis on emissions charges and cap-and-trade. Table 13.1 presents a list of countries that have adopted carbon taxes or cap-and-trade type systems. F. Carbon Offset Markets 1. A carbon offset credit is a transferrable instrument certified by governments or an independent certification body to represent an emission reduction of one metric ton of CO2, or CO2e. 2. Investors in approved projects that reduce emissions below levels that would otherwise prevail get carbon offset credit for those additional emissions reductions. 3. Those who acquire certified offsets can use them to reduce their net emissions anywhere offsets are allowed. 4. Offsets credits can in principle perform several roles in pricing GHGs: a. (1) Expanding the number of reduction projects typically lowers the cost of compliance. b. (2) Lowering the cost of compliance could increase the likelihood of enacting a carbon pricing program by making compliance easier. c. (3) Offsets extend the reach of a program by providing economic incentives for reducing off-site sources that are not covered by a tax or cap.

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• Environmental and Natural Resource Economics, Twelfth Edition

d. (4) Because offsets separate the source of financing (the offset buyer) from the source providing the reduction (the investor in the reduction project), they secure some reductions that might not be secured otherwise. 5. Example 13.1 discusses air capture and storage as an offset. Debate 13.1 considers the effectiveness of offsets. II.

Carbon Market and Taxes: How have these Approaches Worked in Practice? A. Cost Savings 1. Two types of studies have conventionally been used to assess cost savings: ex ante analyses, based on computer simulations, and ex post analyses, which examine actual implementation experience. 2. Most ex ante analyses have found that a change from more traditional sourcespecific limits to more cost-effective market-based measures such as emissions trading or carbon taxes would potentially achieve either similar reductions at a much lower cost or much larger reductions at a similar cost. 3. The evidence also finds, as the theory would lead us to expect, that these two instruments typically produce more emissions reduction per unit of expenditure than other types of policies such as renewable resource subsidies or mandates. 4. Although the number of existing detailed ex post studies, drawn from the experiences of existing programs, is small, they typically find that the cost savings from shifting to these market-based measures are positive, but less than fully costeffective. B. Economic Impacts 1. An analytical exercise by the Stanford University Energy Modeling Forum used 11 different models to assess emissions, energy, and economic outcomes from carbon price policies in the United States. a. Found that carbon prices are estimated to lead to significant reductions not only in CO2 emissions, but also in many conventional pollutants. b. These co-benefits include sulfur dioxide, nitrogen oxides, and particulate matter. They are simultaneously reduced when carbon emissions are reduced. c. Most of the reductions occurred in the electricity sector. d. Expected economic costs are modest, and in any case would be more than offset by benefits from avoided climate damages and health benefits from reductions in conventional air pollution. 2. A different study that specifically focused on employment effects found that while imposing a pollution tax causes substantial reductions in employment in the carbonintensive polluting industry sectors, these effects were found to be largely offset by increased employment in other sectors.

III.

The Sufficiency of Carbon Pricing: Meeting the Goals? A. The World Bank’s review in The State of and Trends of Carbon Pricing 2021 and that report concluded: “However, it is clear the potential of carbon pricing is still largely untapped, with most carbon prices below the levels needed to drive significant decarbonization. More broadly, global emissions have continued to rise and current climate policies from governments

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Climate Change III: Carbon Pricing

and the private sector also continue to fall far short of what is needed to reach the temperature goals of the Paris Agreement.” B. The implemented policies produce price trajectories that are insufficiently aggressive in two senses: 1. (1) the amount of reduction is too small, and 2. (2) its timing is too slow. C. Identifying the sources leads directly to ideas on how to fill the gaps. 1. They include using renewable portfolio standards in the policy mix to hasten the penetration of renewable sources in the electricity sector, and investment tax credits to incentivize both firms and households to make investments in the adoption phase of zero-carbon energy sources, including energy storage, electric vehicles, community solar, and energy efficiency. 2. Although these complementary policies are not as cost-effective as carbon pricing in principle, they seem able to garner political support for additional emissions reductions that are needed. D. While carbon pricing is a direct way to correct the carbon emissions externality market failure, other sources of market failure may be more effectively targeted by other types of policy. 1. Investments in research and development (R&D), the underpinning of innovation, are also subject to an externality. 2. Carbon pricing has encouraged innovation, but is not expected to provide enough innovation. 3. The R&D externality arises mainly because the financial gains from innovation are not all captured by the innovator. 4. Public financial support will be necessary for efficiency to be achieved. 5. This deficiency is particularly important in managing climate change since innovation will likely continue to be an important contributor to a timely transition. 6. Public R&D funding has played an important historical role in many major technology innovations such as the internet and the development of vaccines to protect against epidemics and pandemics. E. Yet considerable risk can also be associated with this public funding. 1. Some R&D funding is associated with basic research on topics that might not pan out. 2. Not all interesting ideas result in the development of new technologies that enhance societal goals. 3. Public-funded research may simply “crowd out” private investment. 4. An economic case can be made for additional public funding of R&D, but how those funds are targeted will matter. F. Network externalities typically stem from the relationship of built infrastructure to the new products. 1. Consider the transition to electric vehicles (EVs). While we have lots of gas stations to serve the existing fleet, a lack of charging stations holds back demand for EVs, while a lack of these vehicles holds back the private supply of charging stations (Stock, 2021).

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2. These circumstances can support two different stable equilibria: one with few EVs and few charging stations and one with many EVs and many charging stations. 3. Policies to help with R&D and network externalities would be useful supplements in the climate risk management policy package. G. Three possible modification targets have received attention: 1. Protecting domestic trade-vulnerable industries, 2. Creative use of the revenue, and 3. Creating new designs that reduce uncertainty about the likelihood of meeting the goals. H. Protecting Trade—Vulnerable Industries 1. Climate change is a global problem, but the policies being rolled out are not internationally uniform, which Increases political reluctance, but can also lead to carbon leakage, where emissions are moved to other jurisdictions rather than being reduced. 2. Not having to pay the carbon prices would make the foreign products cheaper to produce and, hence, more competitive. 3. To respond to this competitive disadvantage, companies in countries with carbon pricing could move carbon-intensive production facilities to non-carbon pricing countries. a. Such carbon leakage could result in carbon emissions being shifted, rather than reduced, an outcome that would undermine global climate policy efforts. 4. A common proposed solution to this problem involves including a border adjustment mechanism in the carbon pricing program. a. A border adjustment mechanism would typically impose a tariff on carbonintensive products imported from jurisdictions with weaker or no carbon pricing. b. The magnitude of the tariff would be based upon on the carbon-intensiveness of the traded goods and would seek to assure that the embedded carbon cost of these products would be equalized across both countries (either by paying the full carbon price or by paying the tariff). c. Equalizing these costs would eliminate any inefficient incentive for shifting emissions, and any tariff revenue collected would be retained by the higher carbon-tax country. I. Using the Revenue: Possibilities and Experience 1. The revenue could, for example, be used to a. (1) reduce the financial burden of the policy on low-income households, displaced workers, or communities hurt by the transition; b. (2) boost the economy; c. (3) pay off debt owed by the implementing jurisdiction; d. (4) increase the magnitude of emissions reductions; or e. (5) bolster underfunded healthcare or educational programs.

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Climate Change III: Carbon Pricing

2. One class of these complementary strategies involves making carbon pricing programs “revenue-neutral.” a. By definition, no revenue from a revenue-neutral policy can be used to fund new or expanded government programs. b. Designed to appeal to voters who are wary of any increase in the size of government. c. Revenue neutrality can be achieved, for example, either by rebating the revenue raised by the program directly to affected parties (in a way that does not interfere with the emissions-reduction incentives) or by lowering other tax rates and using this revenue to offset revenue losses from the lower rates. J. Another apparent source of resistance to carbon pricing arises from opposition to any policy that increases energy prices. 1. Opponents fear that jobs might be lost and that the burden of bearing the higher fuel costs would fall disproportionately on lower-income and minority households. 2. Distributing the revenue back to households or businesses could provide some assurance against these outcomes, because it could offset any negative impact on household budgets, particularly for the most vulnerable households. 3. This revenue-neutral approach was implemented in the British Columbia carbon tax established in 2008. a. All revenues generated by the tax were returned to businesses and households indirectly through reductions in other taxes and directly via lump-sum payments. K. Some programs use some revenue to incentivize greater emissions reductions. 1. Common strategies include using the revenue to pick up part of the cost for those households or businesses who invest in emissions-reducing energy efficiency or in renewable energy such as wind or solar. a. Both types of investments have been shown to boost the economy in highenergy-cost regions, not only by lowering the investors’ energy costs, but also by keeping the revenue circulating in the local area, creating a multiplier effect, rather than exporting it to pay for imported fuels. 2. But studies find that energy efficiency incentives are not as effective in boosting the economy as other revenue uses such as lowering the capital gains or corporate tax rates. 3. Although energy efficiency programs frequently target lower-income households and the resulting investments do lower participants’ energy cost, only those who can afford to participate are benefited. L. Table 13.2 shows revenues and uses from 2017-2018. M. Economic studies have also found that due to the large magnitude of the revenue involved, it is not always necessary to make an either–or decision among these revenue-using choices. 1. Because substantial revenue can be involved in carbon pricing programs, mixed strategies may be possible, thereby covering several bases at once. 2. One constraint on taking advantage of this opportunity is the fact that some carbon pricing program designs have raised less revenue than they might have.

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• Environmental and Natural Resource Economics, Twelfth Edition

a. Some carbon tax programs, such as the Canadian Nation Carbon Pricing Program, only tax emissions over a specified level, rather than all emissions, to protect trade-exposed firms. b. Some emissions trading programs, such as the E.U. ETS, provide some free allowances to trade-vulnerable industries, rather than requiring emitting sources to purchase all allowances necessary to cover their emissions. IV.

Uncertainty-Decreasing Hybrid Carbon Pricing Designs A. Emission Trading Program Hybrids 1. The earliest modification ideas were targeted at reducing price uncertainty in emissions trading, because two different kinds of concerns had arisen: a. (1) prices can fall below expectations and undermine future incentives for emissions reduction, and b. (2) higher than expected prices can undermine political support for the program. c. Experience validates the concern that emissions trading can be plagued by unacceptably low prices. d. In the E.U. ETS, for example, a price decline in 2012 stemmed in part from an administrative overallocation of allowances. e. This excessive supply of allowances, coupled with lower demand due to a recession, and some resulting uncertainty about the future of climate change policy, led to a dramatic fall in prices. f.

In the last decade, new mechanisms have been developed and implemented to deal with this problem.

B. The first element, a minimum auction price (a price floor), prevents auction prices from falling well below expected levels. 1. Administratively determined in advance and generally rises annually. 2. If in a particular auction, calculations reveal that this minimum would be breached, enough allowances are removed from that auction to assure that the price in this auction does not fall below the specified minimum. 3. Prevents the price from breaching the minimum in this specific auction, does not do anything about the existing surplus of allowances that led to the low price. C. The emissions containment reserve (ECR) was created, consisting of two key components: 1. (1) a prespecified trigger price, to determine whether an ECR program is activated in a particular auction; and 2. (2) if it is activated, a prespecified number of allowances up for bid would be transferred to the ECR and would not be sold. D. The second price uncertainty issue deals with prices that could unexpectedly rise to politically unacceptably high levels, thereby undermining the political expectation underlying the implementation of the program. 1. The mechanism to deal with this problem, a cost containment reserve, comes in two versions.

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Climate Change III: Carbon Pricing

2. A soft collar, prespecifies several allowances in addition to the cap, which are withheld in the CCR reserve and sold only if auction allowance prices would exceed the predefined CCR trigger price. 3. A hard collar places no limits on the number of allowances that can be added to the system at the ceiling price; when necessary, enough allowances can be added to keep the auction price from rising above the stipulated trigger price. 4. Although both types of price collars provide a check on unexpected high allowance prices, a hard collar provides more certainty that prices will not rise above politically unacceptable levels, but less certainty that the emission reduction goals will be met. E. Carbon Tax Hybrids 1. The main source of uncertainty with carbon taxes involves the degree to which the program will achieve the emissions goals. 2. The tax rates to be applied in forthcoming years are typically derived from forecasting models, and forecasting is not infalliable. 3. Two categories of policies have been explored in the literature: a. (1) strategic introduction of complementary policies that augment the carbon tax to further reduce emissions; and b. (2) enacting, as part of the carbon tax policy, a mechanism that would adjust, when necessary, the carbon tax rate to restore its compatibility with meeting the established goals as conditions change. F. Carbon Tax Hybrids: Implementing Complementary Policies 1. Two different types of augmenting policies include a. (1) establishing one or more additional regulatory policies to complement the carbon price system, and b. (2) dedicating the additional tax revenue received from the emissions exceeding the target to increasing emissions reductions. 2. In the United States, part of the business community’s support for a carbon tax is predicated on the condition that it will replace some other regulatory climate emissions reduction strategies. a. An augmenting regulatory policy could be brought into play only if the carbon tax fell short of meeting its specified emissions reduction benchmarks. b. One difficulty is that a regulatory approach does not lend itself to finetuning—designing policies to achieve the exact magnitude of necessary additional emissions reductions would be very difficult if not impossible. 3. The second strategy uses the additional revenue from the excess emissions to purchase offsetting reductions (in compliance offset markets, for example). a. In this case the government would be the purchaser (as opposed to private organizations), a difference that puts the buyer in a good position not only to negotiate lower prices for offsetting reductions, but also to assure their quality. G. Policies to Adjust, rather than Augment, Carbon Tax Programs

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• Environmental and Natural Resource Economics, Twelfth Edition

1. An adjustment approach would modify the parameters of the carbon tax itself rather than rely on policies that are outside of the carbon tax program. 2. Two versions: a. (1) a version where both the triggering condition and the adjusting responses are prespecified and occur automatically once the condition is triggered, and b. (2) a version where the triggering condition and the process that will craft the response are prespecified, but the exact adjustments that will flow from that process are discretionary and determined only when the emissions reduction trigger is breached. 3. Aldy (2020) provides a proposed procedure for reviewing and updating a carbon tax, using the United States as an example. a. In this setting the U.S. president would recommend an update to the carbon tax every five years. This process would mandate government agency reviews of the environmental, economic, and multilateral conditions related to climate change at that time. b. The flexibility achieved from institutionalization of such an act-learn-act approach to carbon tax design could not only improve the political viability of a carbon tax, but its enhanced adaptability could likely increase net social welfare over time. 4. The automatic version was introduced by Metcalf (2009) and developed further in Metcalf (2020). a. Actual emissions would be tracked each year relative to a benchmark emissions pathway. b. If cumulative emissions exceeded benchmarks along the pathway, then the tax rate would increase annually more rapidly at a rate established in the initial legislation. c. H. The Canadian National Carbon Pricing Program 1. Any Canadian province or territory can design its own pricing system tailored to local needs, or it can choose the federal pricing system. 2. The federal government sets minimum national stringency standards that all programs must meet to ensure they are comparable and contribute their fair share to reducing greenhouse gas emissions. a. If a province fails to price pollution or proposes a system that does not meet these standards, the federal pricing system is put in place. 3. The federal pricing program has two parts: the fuel charge, a carbon-based charge on fossil fuels; and an emission-reduction system for large industrial facilities known as the output-based pricing system (OBPS). a. Both involve a specified price on carbon. Canada’s minimum national price on carbon pollution for programs that directly set a price on emissions is $65 Canadian per tonne of carbon dioxide equivalent (CO2e). b. Rate increases by $15 per year to $170 per tonne CO2e in 2030.The fuel charge is paid by fuel producers and fuel distributors.

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c. Applies to 21 fossil fuels including gasoline, light fuel oil (e.g., diesel), and natural gas. 4. Facilities covered under the OBPS are generally, with some exceptions, those emitting a quantity of GHGs equal to 50 kilotonnes (kt) or more of carbon dioxide equivalent (CO2e). a. They must pay the charge on all emissions that exceed the annual emission standard for that facility, but they can purchase fuel free of the fuel charge. b. Annual facility emission standards, defined for each sector, are based on the sector’s average emissions intensity. c. For sectors at low or medium competitiveness risk, standards are set at 80 percent of the sector’s average emissions intensity; for high-risk sectors the standard is set at 90 percent or 95 percent. d. Using this ratio and the facility’s output level produces the annual emissions standard for that facility. e. Facilities that reduce more emissions than required by the standard earn credits that they can sell or save for future use. f. V.

Credits can also be acquired by investing in offset activities approved by a federal offset protocol.

Providing Context: A Brief Look at Four Illustrative Carbon Pricing Programs A. European Union Emissions Trading Scheme (E.U. ETS) 1. Launched in 2005, the E.U. ETS has been the largest emissions trading system in the world. 2. The program establishes a cap on the total amount of specified GHGs that can be emitted from installations covered by the system. a. Operates in all 27 E.U. countries plus Iceland, Liechtenstein, and Norway. b. Limits emissions from more than 11,000 heavy energy-using installations (power stations and industrial plants) as well as airlines operating between these countries. c. In total covers around 45 percent of the E.U.’s greenhouse gas emissions. 3. Under this cap, companies receive emission allowances, which they can sell to, or buy from, one another as needed. a. At the end of the year each company must surrender enough allowances to cover its emissions for that year or pay penalties on any excess. b. Companies can bank any spare allowances for future sale or for covering their future needs. The cap (and, hence, the number of allowances) is reduced over time so that total emissions will fall. c. Auctioning is the default method of allocating allowances as of phase 3 (2013–2020). 4. In total, the Commission estimated that 57 percent of the total amount of general allowances were auctioned in phase 3. a. In phase 4 (2021–2030), the share of allowances to be auctioned remains the same.

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• Environmental and Natural Resource Economics, Twelfth Edition

5. The E.U. also has enacted a market stability reserve (MSR). a. Governed by predefined rules that leave no discretion to the Commission or member states in its implementation. b. Each year, by May 15 the Commission publishes the total number of allowances in circulation. c. It specifies how many allowances are placed in the reserve and/or whether allowances will be released from the reserve. d. From 2023 on, allowances held in the MSR above the previous year’s auction volume will no longer be valid. e. Auctioning is the default method of allocating allowances as of phase 3 (2013–2020). f.

In total, the Commission estimated that 57 percent of the total amount of general allowances were auctioned in phase 3.

g. In phase 4 (2021–2030), the share of allowances to be auctioned remains the same. 6. The E.U. also has enacted a market stability reserve (MSR). a. Governed by predefined rules that leave no discretion to the Commission or member states in its implementation. b. Each year, by May 15 the Commission publishes the total number of allowances in circulation. c. It specifies how many allowances are placed in the reserve and/or whether allowances will be released from the reserve. d. From 2023 on, allowances held in the MSR above the previous year’s auction volume will no longer be valid. B. People’s Republic of China Emissions Trading System 1. In July 2021 China launched its official version of an emissions trading system. 2. Targets reductions using an emissions per unit of output benchmark rather than aggregate emissions. In both systems as output increases, the number of allowed emissions increases. a. Standards are based on carbon dioxide emissions. b. Initial allowances are allocated free of charge, but the official plan suggests that covered firms will eventually need to purchase them. c. Different emissions standards are set for each fuel and technology involved in that facility’s operation. d. Using these multiple standards across firms reduces distributional disparities in compliance costs across both technology types and regions in China. e. A single, uniformly applied benchmark would have generated large allowance surpluses for facilities in some provinces and large deficits in others. 3. Initially, this ETS is focusing on large firms in the electricity sector that account for 40 percent of China’s total annual CO2 emissions. 4. Once fully implemented, the program is expected to extend the scope of its control over emissions to include larger facilities in seven additional sectors: petroleum

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refining, chemicals, non-ferrous metal processing, building materials, iron and steel, pulp and paper, and aviation. C. State of Washington Climate Commitment Act 1. In 2021, the Washington State Legislature passed the Climate Commitment Act (CCA), which established a comprehensive emissions trading program to achieve the greenhouse gas limits specified in the state’s 2050 net zero goal. a. From January 1, 2023 on, scheduled to initially cover industrial facilities, certain fuel suppliers, in-state electricity generators, electricity importers, and natural gas distributors with annual greenhouse gas emissions above 25,000 metric tons of carbon dioxide equivalent. Plans call for waste-to-energy facilities to be added by 2027 and certain landfills and railroad companies to be added by 2031. b. Covered entities attain compliance by either reducing their emissions or obtaining allowances to cover any remaining emissions. c. The total number of allowances will decrease over time to meet statutory limits. Some utilities and industries will be issued free allowances; other allowances will be auctioned. d. The program includes both a price floor and a price ceiling. e. Facilities can meet up to 5 percent of their obligations with offsets through 2026, and 4 percent from 2027 to 2030. f.

An additional 3 percent of a facility’s compliance obligation through 2026 can be met through offset projects on Tribal lands, decreasing to 2 percent from 2027 to 2030.

g. Proceeds from the auction of allowances must be used for clean energy transition and assistance, clean transportation, and climate resiliency projects that promote climate justice. h. This latter category includes dedicating a minimum of 35 percent of funds toward overburdened communities and a minimum of 10 percent toward Tribal projects. D. Output-Based Carbon Pricing Systems 1. Fischer (2001) and Fischer and Newell (2008) have shown that output-based systems implicitly subsidize output, since additional output increases the number of allowances a facility will receive from the regulator. 2. Because of this implicit output subsidy, the output-based system tends to be less cost-effective than an equivalent traditional ETS system. a. An empirical study based upon the Chinese system found that achieving established aggregate CO2-reduction targets is significantly more costly under this output-based system than under conventional ETS approaches. b. Costs are estimated to be about 47 percent higher than under a conventional approach. c. The Chinese output-based system is still estimated to generate significant net benefit gains once its environmental benefits are counted. d. Results indicate that the environmental benefits would exceed the policy costs by a factor of about three.

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Policy Design and the Just Transition A. A major aspect of the just transition attempts to make sure that the most vulnerable households are protected from a situation in which they must bear a disproportionate share of the burden. a. Economic studies suggest that damages imposed by a changing climate do impose a disproportionately large burden (as a percentage of income) on lower-income households, both within countries and across countries. b. It follows that the benefits of reducing climate change damages in the future will therefore be generally distributed progressively (disproportionately received by lower-income groups). c. This aspect of meeting the climate challenge therefore meets the fairness criterion. d. But lower-income households typically use a greater proportion of their income on energy expenditure than higher-income households, and carbon pricing works by increasing the prices of carbon-intensive fuels. e. The distribution of the cost burden of the transition to a lower-carbon future via carbon pricing has typically been found to be regressive. f.

VII.

The key to making sure the climate policy transition policy design is progressive for costs lies in how the revenue is used.

Controversy: The Morality of Emissions Trading A. Debate 13.2 discusses the morality of emissions trading.

◼ Common Student Difficulties Most likely, the idea of permit trading and equalizing marginal cost will still be confusing to students. Reiterating the material from the last chapter as well as introducing new examples will help. The application of benefit-cost analysis to issues with long-term consequences such as global warming is controversial. At any positive discount rate, the current cost of controlling emissions will be weighted more heavily than the distant future damages. The present-value component of benefit-cost analysis emphasizes short term consequences. (This topic warrants in class discussion. A recent study on discounting the fardistant future might provide an interesting starting point. See, Weitzman, M.L., 1998, Why the Far-Distant Future Should be Discounted at Its Lowest Possible Rate, Journal of Environmental Economics and Management, Vol. 36, No. 3, November.)

◼

Suggested Classroom Exercises 1. Emissions trading exercise: Develop 3 or more hypothetical marginal abatement cost and total abatement cost schedules. Give each student one schedule. For a class of 24, for example, I have used three different schedules, one per eight students. Tell your students that they are currently discharging some number and the regulatory authority has mandated that this amount be cut in half. Tell them that they have also been granted permits to discharge the 50 percent target. Then let them wander around the room and see if they can find anyone to buy additional permits from or sell permits to. Sometimes it is helpful to have them calculate the value of the first permit and their total cost of various abatement amounts. Since they do not know initially if they have high

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costs or low costs (e.g., if they are buyers or sellers), I have found it useful to make the marginal cost schedules quite different and exaggerate the difference. This can be reduced in alternative forms of this experiment. Again, they can calculate total cost before an after trading to prove that they have reduced cost. 2. Debate 13.2, presented as an essay question below, is also an excellent topic for class debate.

◼

Essay Questions

Compare the advantages and disadvantages of carbon tax systems and emissions trading systems.

As presented in Debate 13.2 (Is Global Greenhouse Gas Trading Immoral?), why might the trading of greenhouse gas emissions be considered immoral? Do you think a case can be made that the trading of all types of emissions is immoral? Why or why not?

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Chapter 14 Climate Change IV Adaptation: Floods, Wildfires, and Water Scarcity Chapter 14 is focuses on adaptation strategies in the face of increasing natural disasters. We are already seeing many of the results of climate change in terms of the number of major storms, wildfires, and flooding. Part of dealing with these problems is mitigating them, but since not all risks can be mitigated, we must also adapt to these changes.

◼ Teaching Objectives 1.

Understand the role of adaptation policy.

Know how mitigation and adaptation strategies are both complements and substitutes.

Understand how the potential for natural disasters is increasing with climate change.

Explain the concept of resilience.

Describe the US flood insurance program and its failings.

Identify proactive and reactive adaptation strategies.

Know potential adaptation strategies to combat sea level rise.

Explain the threat from wildfires, and identify adaptation and mitigation strategies.

Relate marginal concepts to the problem of water scarcity.

10. Explain the evolution of water rights in the US, and the problems that they have created. 11. Identify strategies for managing the risks of water scarcity.

◼

Outline I. Introduction: The Role of Adaptation Policy This section discusses how adaptation fits into a climate change strategy.

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A. Since not all impacts of climate change are preventable, climate adaptation, the subject of this chapter, is an inevitable component of the mix of policies needed to manage the risks from climate modification. B. The Intergovernmental Panel on Climate Change (IPCC) defines climate adaptation as: “In human systems, the process of adjustment to actual or expected climate and its effects, in order to moderate harm or exploit beneficial opportunities. In natural systems, the process of adjustment to actual climate and its effects; human intervention may facilitate adjustment to expected climate and its effects.” C. The IPCC outlines two types of adaptation policies: 1.

proactive policies, which involve taking action in anticipation of a climate change impact, and

2. reactive policies, which are taken in response to a climate change impact that has already occurred. 3. Reactive adaptation policies have been the most common practices in many places, but as the intensity and frequency of these events are expected to grow, reactive policies become very expensive. 4. Adaptation planning first involves conducting a vulnerability assessment to determine who and what is at risk and to what extent. D. The IPCC outlines this process in the schematic in Figure 14.1. 1. The vulnerability of a particular location is determined by examining the level of exposure to the risks and the number and types of hazards faced. 2. While hazards are driven by changes in the climate, vulnerability and exposure are influenced to a large extent by the socio-economic conditions 3. Thus, adaptation policies are very context- and location-specific. E. The two strategies are complements in the sense that the optimal policy response contains both adaptation and mitigation. 1. Since the marginal cost function for each strategy is upward-sloping, this normally means that an optimal strategy would employ both mitigation and adaptation. 2. Deviating from this optimum necessarily means that costs would be higher than necessary. F.

The two strategies are also substitutes: more of one typically means less is needed of the other. 1. Optimal level of either strategy: invest up to the point where the MC of an additional unit of that strategy is equal to the marginal damages (MD) reduced by that unit. 2. So, for either strategy, higher MD imply a higher demand for investing more in that strategy. 3. If the strategies are substitutes, a reduction in the MC of mitigation, for example, should lower the demand for adaptation. 4. In an optimal policy, a lower MC of mitigation with an unchanged MD would imply a higher optimal level of mitigation, which reduces the resulting MD not only for additional units of mitigation, but for additional units of adaptation as well. 5. The lower resulting marginal damages for adaptation would lower the demand for it.

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G. Many think about mitigation and adaptation as an either/or choice and suggest that policymakers should choose the one that is cheaper, but economic analysis points out that this is a false choice. 1. Upward-sloping MC functions for each strategy normally mean that an optimal approach would employ both strategies, and deviating from this optimum causes the costs to be higher than necessary. 2. Adaptation and mitigation are substitutes, but they are not perfect substitutes: adaptation strategies are necessarily targeted at specific problems in specific geographic areas, whereas mitigation strategies have broader, global damage-reduction effects. 3. Their timing differs: mitigation is necessarily done early to prevent emissions from building up in the atmosphere, and while some adaptation can be done early as well, some can also be delayed until a better understanding of the intensity and location of damages emerges. 4. Efficient adaptation is the minimization of the sum of damage costs from climate change plus the cost of adaptive actions. H. Adaptation strategies can involve a mix of public and private strategies. I.

II.

Climate change is increasing the frequency and intensity of climate disasters, while at the same time increased exposure (more people living in floodplains or encroaching on fire-prone areas) and vulnerability combine to exacerbate the damages. (Figure 14.2)

Climate Adaptation: Flood Risks—Storms, Sea Level Rise, and Storm Surges A.

In 2021 there were a record 47 weather disasters causing over $1 billion in damages; the top three of those were flooding events in the United States, Central Europe, and China, which caused in total over $150 billion in damages. 1. The year 2021 was the third costliest on record for weather-related disasters, coming in at $329 billion (USD) in damages. 2. The costliest year was 2017, reaching a record $519 billion in damages. 3. Flooding causes more damage and impacts more people worldwide than any other natural disaster. 4. Germany experienced $20 billion in flood damages in 2021 and Belgian floods caused $1.7 billion in damages. 5. Flooding in China caused $30 billion in damages. 6. In the United States in 2021, Hurricane Ida caused an estimated $75 billion in damages. 7. The following year (2022), Hurricane Ian caused $113 billion in damages.

In the ecology literature resilience refers to an ecosystem’s ability to bounce back (recover) from a shock. 1. According to the IPCC, resilience is the “capacity of social, economic, and environmental systems to cope with a hazardous event or trend or disturbance, responding or reorganizing in ways that maintain their essential function, identity, and structure, while also maintaining the capacity for adaptation, learning, and transformation.” 2. According to the National Research Council (2012), “Resilience is the ability to prepare and plan for, absorb, recover from, and more successfully adapt to adverse events.”

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A study conducted by the Multihazard Mitigation Council found that for every dollar spent on pre-disaster investments in resilience to prepare for earthquakes, wind, and flooding, about $4 were saved in post-disaster damages. Flood Insurance in the United States 1. The National Flood Insurance Program (NFIP) was established in 1968 with the passage of The National Flood Insurance Act. a. Frequent flooding of the Mississippi River in the early 1960s led to the perception that floods were uninsurable risks and, as such, there was a lack of availability of private insurance. b. One of the reasons for this is that private insurance companies rely on pooled risk. c. In any population of people, not all are expected to use their insurance, so those people subsidize those who need to file a claim. d. With floods, the entire community is typically affected and as such the insurance company must pay out a significant amount of money, typically more than they took in in premiums. 2. The NFIP is managed by the Federal Emergency Management Administration (FEMA). a. The goals are: i.

To provide flood insurance.

ii.

To improve floodplain management.

iii.

To develop floodplain maps.

3. Example 14.2 discusses resilience and flood insurance. 4. Increased frequency and intensity of storms and flooding have challenged the financial viability of the NFIP. a. The NFIP borrows money from the U.S. Treasury to cover shortfalls, but since 2005, the program has been in financial distress (Figure 14.3). b. With increased frequency and intensity of large storm events, programs such as the NFIP are starting to move from reactive policies to those that are more proactive. E.

Proactive vs. Reactive Adaptation Strategies 1. Rebuilding after a flood or hurricane is a reactive strategy, and subsidized flood insurance actually provides a perverse incentive, meaning it incentivizes an inefficient behavior. 2. If the government pays, people will rebuild. 3. Current rules that require funds to be used to rebuild in the same place exacerbate what is already a moral hazard. a. Recall from introductory economics, a moral hazard is a situation in which there is a lack of incentive to protect against risk. b. In this case, that lack of incentive follows from the fact that subsidized insurance protects policy-holders from its consequences. 4. The extra risks of living in a high-risk area are passed along to taxpayers, and these types of perverse incentives can intensify the risks in the long run.

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a. The NFIP has hit its borrowing ceiling several times and some debt has been forgiven, but the amount of debt the program is carrying is not sustainable. b. The Biggert–Waters Flood Insurance Reform Act of 2012 attempted to make the program more financially and structurally sound by raising flood insurance rates and by no longer subsidizing second homes and repeat-loss homes. c. The Homeowner Flood Insurance Affordability Act of 2014 capped rate increases at 18 percent annually and repealed certain rate increases in order to keep flood insurance affordable. 5. As of 2018 there were nearly 3.6 million flood insurance policies in approximately 1450 communities, and none of these policies prevent building in the flood zones. F.

The National Flood Insurance Program and FEMA take some measures aimed at encouraging adaptation. 1. Federal hazard mitigation grants provide funds for communities to invest in adaptation infrastructure. 2. Another program is the Community Rating System (CRS). a. CRS communities receive flood insurance premium discounts for actions that reduce the damages from flood events. b. Communities that join the CRS program receive a score of 1 to 10. c. A community at high risk with no protections in place would receive a score of 10 and residents and businesses pay full premiums for flood insurance. d. Communities that undertake adaptation measures receive points that can reduce their score. e. For every point a score drops, communities receive a 5 percent discount in flood insurance, for a possible discount of 45 percent for a score of 1. 3. In the most proactive reform, the Disaster Recovery Reform Act (DRRA) was signed into law October 5, 2018, as part of the Federal Aviation Administration Reauthorization Act of 2018. a. The DRRA modifies the Hazards Mitigation Grants Program with a focus on increasing mitigation and improving resilience to hurricanes, floods, and wildfires. b. This program funds public infrastructure projects that increase community resilience before a disaster occurs. c. It allows applicants for flood claims to pursue other resilience options rather than simply rebuilding the same structure in the same place. d. One key feature is that under the DRRA 6 percent of the post-disaster assistance FEMA provides each year will be set aside for FEMA’s Pre-Disaster Mitigation fund. e. By providing more funding for pre-disaster mitigation, damage claims will be lower. 4. In 2021, FEMA announced “Risk Rating 2.0,” an update to its pricing methodology meant to better communicate flood risks and create more equitable pricing. a. The new pricing structure will be based on the value of the home and the unique flood risk of each property.

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b. Previously, homeowners with high-valued homes were paying too little and those with low-valued homes, too much, and this policy is meant to remedy that inequity. G.

Flood Insurance Around the World 1. Flood insurance can differ by who “backs” the insurance (the government or the private sector) as well as whether the flood risk is bundled together with other risks. 2. The possible combinations result in four types of insurance: a. bundled flood insurance backed by private markets; b. bundled flood insurance backed by the government; c. optional flood insurance backed by private markets; and d. optional flood insurance backed by the government. 3. The United States follows the model in the last category; the NFIP is backed by the federal government, and the flood risk is not bundled with any other risks (such as fire). a. Because of the numbers of policies in high-risk areas, this program struggles to be financially viable. 4. Germany, Austria, and South Africa follow a similar model of unbundled flood insurance, but in these cases the insurance is backed by private markets. 5. The opt-in (or optional) model suffers from the same issue as the NFIP, with high numbers of policies in high-risk areas. 6. With private backers, however, prices fluctuate more and it is hard to keep prices low. 7. Optional/non-bundled insurance frequently causes a situation in which most policyholders experience damage, since low-risk policies are not bundled with high-risk. a. One solution to this problem is to bundle different risks together under one insurance policy, thus spreading out the risk. b. If fewer policy-holders are likely to make claims, financial viability is more likely. 8. Maximizing the risk pool helps keep costs low, especially if the insurance is backed by private markets, which is the case in the United Kingdom, Hungary, and China. 9. France and Spain also bundle risks for insurance but use a model that is backed by the government. a. In France, for example, home and building insurance contracts are required by law to protect against natural disasters including floods. b. Private insurers are responsible for a certain amount and after that the government pays the remainder. 10. In many developing countries in Asia where flooding is a huge problem, most residents are unable to afford to pay for flood insurance. a. According to the Geneva Association, in 2014, “only 10 percent of losses from all types of natural disasters in Asia were insured compared with 60 percent in North America.”

Rethinking Flood Insurance 1. In the United States, take-up rates are surprisingly low, despite mandates to purchase flood insurance for those that live in the mapped flood zones, about 49 percent.

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2. Kunreuther (2018) and Meyer and Kunreuther (2017) suggest that individuals tend to underprepare for disasters and other risks for six reasons. a. Myopia – the tendency to focus on overly short future time horizons when appraising immediate costs and the potential benefits of protective investments. b. Amnesia – the tendency to forget too quickly the lessons of past disasters. c. Optimism – the tendency to underestimate the likelihood that losses will occur from future hazards. d. Inertia – the tendency to maintain the status quo or adopt a default option when there is uncertainty about the potential benefits of investing in alternative protective measures. e. Simplification – the tendency to selectively attend to only a subset of the relevant facts to consider when making choices involving risk. f. Herding – the tendency to base choices on the observed actions of others 3. Preventing flood damages in the form of zoning changes and new building codes can save significant amounts of money. a. Given the rising frequency of disaster events and the increasing costs of recovery from those disasters across the United States, strategies aimed at reducing those damages can be very beneficial. The strategies or mitigation actions prevent property loss and loss of life. b. The National Institute of Building Sciences produces an annual report that details the costs and benefits of meeting and exceeding building codes for flood, wind, fire, and earthquake hazards. i.

It also reports the costs and benefits of select utility and transportation infrastructure mitigation and for federal hazard mitigation grants.

ii.

The original study (2005) showed that every $1 spent on mitigation saves an average of $4 in future disaster costs.

iii.

The most recent reports show that the returns are actually higher.

c. Table 14.1 shows benefit-cost ratios for four adaptation strategies. i.

These results find that on average, for every $1 spent on federal grants, $6 in future disaster costs are prevented, a benefit-cost ratio of 6:1.

ii.

Assuring that current model building codes are met returns $11 for every $1 invested, while upgraded codes would result in a 4:1 benefit-cost ratio.

iii.

Finally, upgrading the nation’s utilities and transportation infrastructure would return $4 for every $1 spent on making them more resilient.

d. The highest payoffs vary by the type of risk.

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For riverine floods the biggest bang for the buck can be obtained from improving utilities and transportation infrastructure.

ii.

For wind and hurricanes, it is meeting the 2018 International Building Codes for new buildings.

iii.

For hurricane surges and wildland-urban interface fires, it involves enacting new, stronger codes.

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e. The 2018 report quantifies benefits including future deaths, nonfatal injuries, repair costs for damaged buildings and contents, sheltering costs for displaced persons, loss of revenue to businesses due to interruption, loss of economic activity in the community, loss of services such as those from hospitals and schools that are damaged, insurance costs, and search and rescue costs.

In particular, they find that just implementing the adoption of model codes and mitigating infrastructure would prevent 600 deaths, 1 million nonfatal injuries, and 4000 cases of post-traumatic stress disorder (PTSD).

ii.

They also find that designing buildings to exceed 2015 building codes would result in 87,000 new long-term jobs.

Sea Level Rise and the Role for Adaptation 1. Projections for sea level rise vary by location and emissions scenario, but sea levels are rising and will continue to rise, likely at increasing rates. 2. The NOAA Sea Level Rise Viewer allows users to input different sea level rise scenarios and examine vulnerability and who and what is at risk. 3. Billions of dollars of buildings and critical infrastructure are at risk, and exposure to the risks of sea level rise is high, both globally and in the United States. 4. Presently, about 40 percent of the world’s population (2.4 billion people) lives within 100 kilometers of the coast. a. In the United States, approximately 128 million people live on the coast. b. Forty percent of those live in areas with elevated coastal hazard risk as defined by the NOAA. c. Annually, coastal counties produce more than $8.3 trillion in goods and services, employ 58.3 million people, and pay $3.4 trillion in wages. 5. Adaptation to higher sea levels and increased flood risk can take several forms: hard infrastructure, soft infrastructure, green infrastructure, and simply moving people and infrastructure away from the risks (managed retreat). a. Sea rise adaptation strategies include shoreline stabilization policies. b. Defensive structures harden the shoreline to prevent erosion from waves. These include bulkheads or seawalls. c. Offensive structures dissipate wave energy before it reaches the shoreline, like breakwaters. d. Living shorelines stabilize the shore through enhancement of natural habitat, including sills and marshes.

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Living shorelines are becoming popular stabilization tools because they are the most natural.

ii.

A living shoreline is a protected coastal barrier made of natural materials such as plants, sand, or rock.

iii.

They serve to break waves and protect the marsh or land behind them.

iv.

They are also the most inexpensive, but they do require maintenance.

They take time to establish, but once established work well to prevent flooding.

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e. Example 16.2 discusses shoreline stabilization. J.

Managed Retreat: Buyouts 1. Another flood adaptation strategy involves not rebuilding on vulnerable land. a. After Hurricane Ike hit Texas, FEMA bought back 756 damaged or destroyed homes. b. Those homes were then removed and the land converted to parkland. c. The buyout cost $103 million. 2. Buyouts typically do two important things. a. Move people away from a flood hazard zone, by purchasing the home and mandating that homeowners use the money to buy or build on higher ground. b. Damaged homes are typically either destroyed, with the transformation of the land into the park, or allowed to revert to some natural state. c. These open spaces serve as valuable flood control, as they can now store water during flood events. d. If these open spaces revert to marshlands, which have valuable flood control properties, they can also serve to protect other nearby properties. 3. Between 1989 and 2017, more than 40,000 homes have been bought out by FEMA. a. The program bought homes from eligible homeowners who opted in after Hurricane Sandy, including several Staten Island neighborhoods. b. Residents used the funds to move elsewhere. 4. After Hurricane Harvey, approximately 4000 homeowners in the Houston area volunteered to have their homes purchased. a. Harris County, Texas, has a buyout program that relies on FEMA funds. 5. The buyout program has moved slowly and only a few hundred homes had been purchased within the two years after Harvey hit. (Note that, not mentioned in the text, this is largely because there were many buyouts after Tropical Storm Alison, so we would expect there to be fewer buyouts this time since the easy ones have been done.) 6. Buying out homes after a disaster is partially reactive, in that the homes were damaged by the storm, but proactive in that homeowners cannot rebuild in the same high-risk location. a. Most proactive would be moving people away from the flood risk prior to a major flood event, which is occurring in some places.

Prioritizing among Adaptation Options in the Presence of Ethical Boundaries 1. Benefit-cost analysis is widely known and frequently used, but can be challenging when it confronts basic questions of fairness or gender equity. a. Buyouts which many times rely on benefit-cost analysis to identify which homes are eligible for buyouts, may only define homes in high-valued neighborhoods as eligible. b. Environmental justice considerations could in principle be included with the use of distributional benefit-cost analysis which considers the weights of the benefits and costs (or who is benefiting and who is paying). c. But using that form of analysis requires a conscious political decision to do so.

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Cost-effectiveness can be useful when the benefits, but not the costs, are expressed in physical terms rather than monetary terms. a. A third option, multi-criteria analysis, uses qualitative and quantitative data to prioritize options and is useful when it is not possible to quantify the costs and benefits.

Information as an Adaptive Strategy 1. One strategy for dealing with risks of these sorts is to try to provide specific information to potential victims early enough for them to minimize their risks by taking such actions as leaving the area or fortifying the area where they will take refuge. 2. It may seem that more information earlier is obviously better, but as Example 14.3 points out, this may not always be the case!

III. Climate Adaptation: Wildfire Risk and Management A.

Globally, the risk of large wildfires has increased even in areas previously considered low risk or unaffected by fire. 1. In the western United States, the average annual area burned grew by about 1200 percent between the 1970s and the 2000s. 2. Climate change, combined with increases in the number of people living near high wildfire risk forested zones, has caused the damages from wildfires to rise significantly. 3. In 2020, damages from wildfires in the United States totaled $16.5 billion USD. Wildfire response expenditures reached $2 billion in 2020. 4. The increased prevalence of woodsmoke now causes 25 percent of Americans’ exposure to PM2.5, harmful fine particulate matter, suggesting that the mortality and morbidity costs are not small.

Smoke from fires in the Brazilian Amazon from deforestation has been found to be responsible for the premature death of almost 3,000 people. 1. Estimates suggest that hospital admissions increase by 0.3 percent per unit of smoke, a cost of about $2.2 million. 2. The 2019–2020 Australian fire season is estimated to have increased health care costs by $1.95 billion AUS.

Other damages include runoff and erosion from post-wildfires that can cause water quality and infrastructure damage. 1. Increased sediment can shorten reservoir lifespan and cause water utilities to move to alternate supplies. 2. In an early study, Loomis (2003) found that using prescribed burns to reduce the incidence of more severe fires could save $24 million per year in public infrastructure maintenance costs. 3. Burn scars—the marks made on the land by fires—tend to erode quickly in storms and drinking water can be severely affected. 4. Road closures and bridge collapses also occur.

Policy options for adaptation to increased wildfire risk include; 1. fuel management (prescribed burns and forest thinning);

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2. response preparedness, including increasing firefighting personnel and better information coverage; 3. policies that require power utilities to shut off power when fire danger is high; 4. wildfire insurance; 5. building codes and restricting development in fire-prone areas. E.

Example 14.4 considers the effectiveness of building codes.

IV. Climate Adaptation: Managing Water Shortages A. The Efficient Allocation of Scarce Water 1. In defining the efficient allocation of water, distinguishing whether surface water or groundwater is being tapped is crucial. a. In the absence of storage, the allocation of surface water involves distributing a fixed renewable supply among competing users. b. Intergenerational effects are less important because future supplies depend on natural phenomena (such as precipitation) rather than on current withdrawal practices. c. For groundwater, withdrawing water now does affect the resources available to future generations. 2. An efficient allocation of surface water must a. strike a balance among a host of competing users, and b. supply an acceptable means of handling the year-to-year variability in water flow. B. Figure 14.4 shows the allocation of scarce water. 1. For the optimal allocation, the marginal net benefit is equal for the two users. 2. This allocation maximizes total net benefits or the area under the two demand curves up to their allocation of water. 3. Suppose instead, however, that the state or water authority decides, for equity or political reasons, to simply divide the available water equally between the two users; this allocation would result in different marginal net benefits for each user, and net benefits are not maximized. C. Figure 14.4 mimics the situation on the Colorado River in the Southwest United States. 1. The Colorado River Compact of 1922 allocates river flows between the upper basin states of Colorado, Wyoming, Utah, and New Mexico and the lower basin states of Arizona, California, and Nevada. 2. The Compact commits the upper basin states to deliver an average of 7.5 million acre-feet per year to the lower basin states. 3. At the time of the signing, states thought they were splitting the flows equally while leaving plenty for Mexico. 4. In reality, flows of the river were much lower than thought and more recently the mega drought has led to reservoirs dropping to precipitously low levels. 5. Farmers in Arizona have already been called out, meaning they will receive massively reduced allocations of Colorado River water.

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6. Additionally, the legal doctrine of prior appropriation that governs water allocation in much of the western United States prevents the efficient allocation of water. D. In the earliest days of settlement in the American Southwest and West, the government had a minimal presence. As water was always a significant factor in the development of an area, the first settlements were usually oriented near bodies of water. 1.

The property rights that evolved, called riparian rights, allocated the right to use the water to the owner of the land adjacent to the water.

With population growth and the consequent rise in the demand for land, this allocation system became less appropriate.

As demand increased, the amount of land adjacent to water became scarce, forcing some spillover onto land that was not adjacent to water.

The owners of this land began to seek means of acquiring water to make their land more productive.

E. At about this time, with the discovery of gold in California, mining became an important source of employment. 1. With the advent of mining came a need to divert water away from streams to other sites. 2. Riparian property rights made no provision for water to be diverted to other locations. 3. The rights to the water were tied to the land and could not be separately transferred. 4. The waste resulting from the lack of transferability became so great that it outweighed any transition costs of changing the system of property rights. 5. The evolution that took place in the mining camps became the forerunner of what has become known as the prior appropriation doctrine. a. The miners established the custom that the first person to arrive had the superior (or senior) claim on the water. b. Later claimants hold junior (or subordinate) claims. c. In practice, this severed the relationship that had existed under the riparian doctrine between the rights to land and the rights to water. d. As this new doctrine became adopted in legislation, court rulings, and seven state constitutions, widespread diversion of water based on prior appropriation became possible, but this first-in-time-first-in-right doctrine paid no mind to economic principles. 6. The federal role in water resources originated in the early 1800s, largely out of concern for the nation’s regional development and economic growth. a. Toward these ends, the federal government built a network of inland waterways to provide transportation. b. Since the Reclamation Act of 1902, the federal government has built almost 700 dams to provide water and power to help settle the West. F. Municipal Water Pricing 1. Municipal water utilities must balance the competing goals of revenue stability, providing signals about water scarcity, reasonable prices for commercial users, and equitable prices for homeowners. 2. Water utilities are typically regulated because they have a monopoly in the local area.

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3. One typical requirement for the rate structure of a regulated monopoly is that it earns only a “fair” rate of return. a. The prices charged by water distribution utilities do not promote efficiency of use, either. Both the level of prices and the rate structure are at fault. b. In general, the price level is too low and the rate structure does not adequately reflect the costs of providing service to different types of customers. 4. In general, utilities can simply charge a fee or utilize a volumetric pricing method. (See Figure 14.5.) a. Volume-based price structures require metering, but they send signals about water scarcity, by charging a marginal value per unit of consumption. b. An increasing block structure encourages conservation by ensuring that the marginal cost of consuming additional water is high. c. This type of rate structure is also considered most equitable in that those who need some water, but cannot afford the marginal price paid by more extravagant users, can have access to water without placing their budget in as much jeopardy as would be the case with a uniform price. 5. How many U.S. utilities are using increasing block pricing? a. As Table 14.2 indicates, the number of water utilities using increasing block rates is on the rise, but the increase has been slow. b. However, decreasing block rates have declined dramatically, highlighting a move to pricing that better reflects the availability of water (Figure 14.6). 6. Global Water International’s 2021 tariff survey suggests that worldwide the trend is also moving toward increasing block rates (Table 14.3). a. Since this survey, the number of increasing or inverted block rates increased (from 48 percent to about 58 percent in 2021). b. Just about all the cities that reported have some sort of volumetric pricing, mostly flat and increasing block rates. c. Nine of the 14 declining block rates are in U.S. cities. 7. Efficiency dictates that prices equal the marginal cost of provision (including marginal user cost when appropriate). a. Thus, prices during peak demand periods should exceed prices during off-peak periods. b. Peak water demand is usually during the summer. c. Therefore, seasonal users should pay the extra costs associated with the system expansion by being charged higher rates. d. Few current water pricing systems satisfy this condition in practice, though some cities in the southwest United States (such as Tucson, AZ) are beginning to use seasonal rates. e. In times of drought, seasonal pricing also makes sense, but is rarely politically feasible. f. Under extreme circumstances, such as severe drought, however, cities are more likely to be successful in passing large rate changes that are specifically designed to facilitate coping with that drought.

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8. From 1987 to 1992, Santa Barbara, CA, experienced one of the most severe droughts of the last century. a. To deal with the crisis of excess demand, the city of Santa Barbara changed both its rates and rate structure 10 times between 1987 and 1995. b. In 1987, Santa Barbara utilized a flat rate of $0.89 per ccf. By late 1989, they had moved to an increasing block rate consisting of four blocks with the lowest block at $1.09 per ccf and the highest at $3.01 per ccf. c. Between March and October of 1990, the rate rose to $29.43 per ccf (748 gallons) in the highest block! d. Rates were subsequently lowered, but the higher rates were successful in causing water use to drop almost 50 percent. e. In response to the more recent severe drought in California, Governor Jerry Brown mandated a 25 percent reduction in water use for residential customers. 9. From a utility perspective, however, large reductions in consumer use can risk revenue stability and utilities may have trouble covering their (large) fixed costs. a. Recall that water utilities are natural monopolies with very high fixed costs. b. Example 14.5 compares an alternative price structure focused on revenue stability with increasing block rates. c. In this case, revenue stability can be achieved, but at the expense of equitable pricing. G. Full Cost Recovery Pricing 1. Another available pricing mechanism is to allow water utilities to earn more than a normal rate of return by charging a full cost recovery (FCR) price for water services. 2. Full cost recovery includes both environmental and resource costs. 3. Since allocative efficiency cannot be achieved without users receiving a clear signal regarding the value of water, FCR is a potential solution. 4. Full cost recovery is one of the pillars of the European Union’s Directive on Water Policy. a. This Water Framework Directive states, “Member States shall ensure that water-pricing policies provide adequate incentives for water users to use water resources efficiently, and thereby contribute to the environmental objectives of this objective.” 5. Reynaud (2016) assesses the impact of FCR pricing on European households in nine countries (Austria, Bulgaria, Czechia, Estonia, France, Greece, Italy, Portugal, and Spain). a. Estimates the required price increase resulting from implementing FCR pricing and estimates the price elasticity of demand (responsiveness to price). b. Results vary significantly by country. c. For Estonia and Italy, prices rise significantly and water consumption decreases by 21.2 percent and 33.8 percent respectively. d. For Italy, he measures the largest loss of consumer surplus at 81.2 euros per capita. e. The results are more moderate for Bulgaria, Czechia, and Spain and there is very little effect for the others.

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f. Water affordability is measured as the share of household income that is spent on water and a “water-poor” household is one that spends 3 percent or more of its income on water services. i.

Of the nine countries examined, water affordability only becomes a problem in Bulgaria under FCR pricing.

ii.

Reynaud suggests that efficiency dictates that all households should pay the efficient price.

iii.

Income redistribution schemes could then be utilized to address water affordability.

iv.

In practice, however, such schemes might be difficult to implement, and in the absence of such a scheme, subsidies or social pricing will be second best.

H. Desalination and Wastewater Recycling 1. Desalination technologies, water reuse, and capturing (and storing) rainwater are all helping to make water supplies more reliable. a. Desalination provides only about 1 percent of drinking water worldwide, but is likely to see increased use. b. Until recently, desalinized seawater has been prohibitively expensive and thus not a viable option outside of the Middle East. c. Technological advances in reverse osmosis, nanofiltration, and ultrafiltration methods have reduced the price of desalinized water, making it a potential new source for water-scarce regions. i.

Reverse osmosis works by pumping seawater at high pressure through permeable membranes.

ii.

Approximately 21,000 desalting plants were in operation in 2021.

iii.

Desalination operations can be found in over 150 countries, though nearly half are in the Middle East and North Africa, producing about 25 billion gallons per day.

2. All of the current facilities are in wealthy countries. a. The current technology is energy-intensive and hence very expensive. b. Costs vary considerably, but even the lowest-cost projects ($750 per acre-foot) are more than double the cost of groundwater in most places (Katz, 2014). c. Costs can be as high as $2,000 per acre-foot. Costs are expected to continue to fall by as much as 20 percent over the next five years. d. In the United States, Florida, California, Arizona, and Texas have the largest installed capacity, but actual production has been mixed. e. In China, the choices between moving water or desalting it both prove to be exceptionally expensive (Example 14.6). V.

Roles for Public and Private Institutions A. Research shows that private agents do adapt. 1. One of the most studied sectors, agriculture, reveals clear differences in agricultural practices, such as crop choices, under different climate conditions.

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2. In the longer term, farmers also respond to weather fluctuations by adjusting the size of their farm or moving into non-farm activities. 3. Although few studies examine business investments in adaptation, the fact that households adjust their energy consumption to climatic factors is well documented. a. Both energy demand and the demand for associated products like airconditioning units are found (as expected) to vary both seasonally and across climate zones. b. Further, these private responses have been found to produce substantial social benefits in terms of reduced mortality and enhanced well-being. 2.

But private responses are neither completely effective nor sufficient. 1. To start with, the number of adaptation investment situations that have been studied is very limited. 2. Further, few of those that have been studied focus on adaptation to the kinds of major damages that are expected from a changing climate. 3. There are a number of barriers that inhibit private actions, thereby reducing the effectiveness of a purely private adaptation strategy. 4. Property rights matter. a. Owners have higher incentives to invest in adaptation than renters. In general, ambiguous or compromised property rights can be a barrier to effective private action. b. Effective private action depends on good information on both the nature of risks and options for adapting to them. 5. Much of this information about future risks is a public good, which means that it will be undersupplied unless the government supplies it or participates in its supply. 6. Adaptation choices can also be limited by affordability, including how a low income diminishes the ability to borrow. 7. Much of the adaptation would involve public capital like roads or public transportation systems, and the effectiveness of many private adaptation responses would be affected by those public adaptation responses. 8. This suggests a multifaceted role for governments: a. They should identify circumstances that lead to adaptation market failures and adopt policies that correct or remove the distortions in incentives that lead to the failures. b. They should provide public information on the risks being posed by a changing climate. c. They should provide financial mechanisms for assisting populations facing affordability problems with adaptation. d. They should develop adaptation plans for publicly owned capital such as the transportation infrastructure.

◼ Common Student Difficulties

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This chapter reiterates the principle of equalizing marginal cost and what happens when that is not the case. This may still be confusing to students. Overall, the most confusing thing about this chapter is simply that it deals with a number of issues (floods, wildfires, water scarcity) that all have similar issues overall but different specific solutions. Emphasizing that the same principles apply in all cases is valuable, as it finding local or regional examples to reinforce concepts.

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Suggested Classroom Exercises

Most students do not know where their water comes from, either at college or at home. Where are these water sources? Are they endangered? What issues surround their use? What conservation measures (if any) have been enacted? Students can research these issues outside of class and bring them in for discussion.

Every year, wildfires have become more of an issue. Where are wildfire areas this year? How did these fires start, and why did they become wildfires? How have these fires affected areas within range of smoke (which can be a large distance). For example, at the time of this writing, wildfires continue to rage in eastern Canada, creating health issues all over New England and other parts of the US. Especially when wildfire areas are close to your location, investigating these issues can be meaningful to students and better help them understand how adaptation and mitigation measures may work.

An interesting discussion topic would be natural monopolies and utility regulation giving rise to inefficient pricing. Examples of bills from local utilities and any conservation practices pursued will add to this discussion. This could also be related to municipal water pricing

◼

Essay Questions

How can governments and the private sector best work together to promote adaptation to climate change?

Should people be allowed to build in areas that already have chronic water shortages? For example, should cities like Phoenix, AZ, pass laws to prevent activities that increase water usage? Is this fair, and is it politically feasible?

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Chapter 15 Transportation: Managing Congestion and Pollution Chapter 15 addresses the complexity associated with the management of mobile-source air pollution. Unlike stationary sources, mobile-source pollution is more difficult to predict, and pollution control can be harder to enforce. Mobile sources are also much more numerous than stationary sources. This chapter covers the economics of mobile-source pollution including the associated externalities and implicit subsidies. Policies pursued in both the United States and Europe are discussed. Some alternative policies are also suggested.

◼ Teaching Objectives 1.

Discuss the differences between mobile-source and stationary-source pollution.

Use the concepts of implicit subsidies and externalities to explain why mobile sources emit an inefficiently high level of pollution.

Present a history of pollution control policies, with an emphasis on the United States.

Evaluate the successfulness of policies implemented to control mobile source pollution.

Present alternative possibilities for cost-effective pollution control.

◼

Outline I. Introduction A. There are approximately 27,000 major stationary sources of air pollution. There are more than 250 million registered motor vehicles in the United States. Collectively these mobile sources are responsible for a large proportion of pollution in the form of ozone, carbon monoxide and nitrogen dioxide. Particulate emissions are also a concern. B. It is difficult to predict where a mobile source will end up throughout its lifetime making management of mobile sources more complex than stationary sources. C. Management of mobile-source pollution involves policies aimed at both the manufacturer and the owner. Since there are only a handful of producers, it is easier to control emissions at the point of production.

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D. Given new vehicles make up a small percentage of the total fleet of vehicles, attempting to reduce pollution by regulating how cars are produced will require some number of years to produce a significant reduction in emissions. E. The timing and location of emissions is also important. Clustered emissions cause higher concentration levels. II. Subsidies and Externalities This section focuses on two sources of inefficiency with respect to vehicle pollution: implicit subsidies and external costs. A. Implicit Subsidies 1. Social costs of transportation tend to rise with miles driven. Private costs (insurance) do not reflect these increases. 2. The marginal private cost of driving an additional mile is zero with respect to road construction and maintenance. However, the social cost is greater than zero. 3. Employee parking or other free parking is an implicit subsidy that creates a bias toward automobile travel. B. Externalities 1. Road users fail to bear the full costs of their choices. Marginal private costs diverge from marginal social costs as traffic volume increases. This is illustrated in Figure 15.1. 2.

The social cost of accidents rises with miles driven.

Exhaust from cars causes high levels of pollution inside the cars that follow behind them.

C. Consequences 1. Implicit subsidies and non-internalized external costs result in private transport costs that are too low. This results in too many vehicles using the road, too many trips taken, too many miles driven, and too much pollution. 2. Low transport costs also cause demand for alternative modes of transportation to be inefficiently low. Dispersed settlement patterns may not justify high volume and high fixed cost transportation alternatives. III. The US and EU Policy Approaches A. History 1. The Clean Air Act Amendments of 1965 set national standards for hydrocarbon and carbon monoxide emissions from automobiles. 2. The automobile industry was in favor of federal standards as a way to avoid each state passing different standards. Only California can set its own standards. 3. The Clean Air Act Amendments of 1970 set new emissions standards that would reduce emissions by 90 percent below uncontrolled levels. Many delays and extensions for implementation followed. B. The U.S. Approach 1. The U.S approach to mobile-source pollution control is a combination of controls at the manufacturing end and controls of emissions from vehicles in use. 2. The certification program tests car models from each engine type to ensure they conform to federal standards. 3. An associated enforcement program contains assembly-line testing and a check of warranty provisions. If more than 40 percent of the cars do not conform to the federal

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standards, the certificate may be revoked. The EPA can also order a recall of vehicles that do not conform to federal standards. E.U. regulators pursue a similar testing approach, but E.U. tests tend to be less restrictive and do not include in-use testing, and thus may not always provide the outcomes that they were designed to produce. (Example 15.1)

III. Transportation Pricing A. Fuel Taxes 1. Figure 15.2 shows fuel taxes by country. 2. Parry et al. (2007) estimated how much higher current fuel taxes would have to be in order to internalize the full social cost of road transport. The increases are sizable in most countries. 3. Fuel taxes have no impact on where the emissions occur B. Congestion Pricing 1. Another way to internalize some of the costs and address the temporal and spatial problems would be through congestion pricing. Congestion pricing would involve charging fees or higher prices to use more congested highways and roads. 2. Four different types of congestion pricing mechanisms are in current use: a. cordon (area or zonal) pricing, b. facilities pricing (roads, bridges, tunnels), c. pricing lanes, and d. high occupancy toll (HOT) lanes. 3. Table 15.3 shows congestion charges that have been implemented. 4. Example 15.2 discusses Singapore’s strategy. 5. Anas and Lindsey (2011) note that truly efficient congestion pricing is challenging to implement because the toll not only varies over time, but also varies with lane width, travel speed, and the types of vehicles on the road. a. The amount of information necessary to implement fully efficient tolls may be unrealistically high. b. Finding a congestion charge that is acceptable to drivers can also prove challenging (Example 15.3). 6. Safirova et al. (2007) compare different road pricing instruments all aimed at internalizing the congestion externality. a. Three types of cordon pricing schemes (area-based congestion taxes): a distancebased toll on highways, a distance-based toll on metro roads only, and a fuel tax. b. For the Washington, D.C., metropolitan area in 2000, they model how residential choice (and hence travel time) could be affected by the type of policy instrument employed. c. Find that using “social-cost pricing” (incorporating the social costs of driving) instead of simple congestion pricing affects the outcome of instrument choice. d. When additional social costs are factored in, the vehicle miles traveled (VMT) tax is almost as efficient. e. If, however, the policy goal is solely to reduce congestion, variable time-of-day pricing on the entire road network is the most effective and efficient policy. f. That is easier said than done. (Example 15.4) IV. Fuel-Economy Standards: The U.S. Approach

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A. CAFE Standards 1. Corporate Average Fuel Economy (CAFE) standards were set in 1975. The standards require each automaker to meet miles per gallon targets for all of its cars and trucks, but the standard is based on a fleet average and not per vehicle. The standards took effect in 1978. In 2011 the standard was 27.3, and the standard will rise to 34.1 mpg by 2016. Medium and heavy-duty trucks must meet the same standard. By 2025 the standard will rise to 54.5. 2. The penalty for failing to meet the CAFE standards is $5.50 per tenth of the mpg times the total volume of cars manufactured in that year B. Problems with CAFÉ standards: 1. When Congress instituted the CAFE standards, light trucks were allowed to meet a lower fuel-economy standard because they constituted only 20 percent of the vehicle market and were used primarily as work vehicles. 2. Light truck standards were set at 17.2 mpg for the 1979 model year and went up to 20.7 mpg in 1996 (combined two-wheel and four-wheel drive). a. But with popular SUVs, which are counted as light trucks, trucks now comprise nearly half of the market. b. In addition, intense lobbying by the auto industry resulted in an inability of Congress to raise the standards from 1985 until 2004. 3. As a result of the lower standards for trucks and SUVs, the absence of any offsetting increase in the fuel tax, and the increasing importance of trucks and SUVs in the fleet of on-road vehicles, the average miles per gallon for all vehicles declined, rather than improved. 4. In 2005 the standard for light trucks saw its first increase since 1996 to 21 miles per gallon, an increase of only 0.3 mpg. B. In 2012, the standards rose yet again to a target of 54.5 mpg by 2025. 1. Since new fuel-economy standards only affect new vehicles, overall fuel economy takes a long time to improve—up to 15 years or until all the older cars are off the roads. 2. This, combined with the “rebound effect,” which says that better fuel economy increases miles driven, raises the question of whether fuel taxation is a more efficient policy than a fuel-economy standard (Anderson et al., 2011). 3. Debate 15.1 and Example 15.5 look at the evidence. C. Gas Guzzler Tax 1. The Gas Guzzler Tax is levied on cars that do not meet fuel-economy standards. 2. Congress established this tax as part of the 1978 Energy Tax Act aimed at reducing the production and consumption of fuel-inefficient vehicles. 3. The tax is levied on the manufacturers and is over and above any CAFE fines the manufacturer might have to pay for not meeting its CAFE standard requirement. 4. The tax is based on a formula that weights highway driving at 55 percent and city driving at 45 percent. V. Fuel-Economy Standards in the EU A. The European Union has tackled the externalities from fuel consumption primarily through gas taxes and has some of the highest gas taxes in the world. 1. Fuel-economy standards are also higher than in the United States. B. The European Union standards rise annually from the 2012 standard of 45 miles per gallon (5 L/100 km), and there is also have a carbon dioxide target of 130 grams per kilometer. C. Very high fuel taxes, which creates a larger demand for small cars.

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1. E.U. countries also tax diesel at lower rates than gasoline and as such diesel’s share of passenger cars has grown significantly. D. The Netherlands, Norway, Germany, and Sweden used differential tax rates to encourage consumers to purchase (and manufacturers to produce) low-emitting cars before subsequent regulations required all cars to be low-emitting. E. Tax differentiation confers a tax advantage (and, hence, after-tax price advantage) on cleaner cars. 1. The amount of the tax usually depends on a. (1) the emissions characteristics of the car (heavier taxes being levied on heavily polluting cars), b. (2) the size of the car (in Germany, heavier cars qualify for larger tax advantages to offset the relatively high control requirements placed upon them), and c. (3) the year of purchase (the tax differential is declining since all cars will eventually have to meet the standards). 2. In Sweden, 87 percent of the new cars sold qualified for the tax advantage, while in Germany the comparable figure was more than 90 percent. 3. Europe not only has much higher gasoline prices, but has also developed strategies to make better use of transportation capital. a. Its intercity rail system is better developed than the United States’, and public transit ridership is typically higher within cities. b. Europe was also a pioneer in the use of car-sharing arrangements, an idea that the United States has now begun to mimic (see Example 15.6). VI. External Benefits of Fuel-Economy Standards A. Fuel-economy standards create positive externalities in two ways. 1. First, fuel efficiency lowers emissions. 2. Then, lower carbon dioxide emissions as well as reduced dependence on foreign fuels are both positive externalities that flow from better fuel efficiency. B. Helfand and Wolverton (2011) find that automakers do not build in as much fuel economy as consumers are willing to purchase. 1. Posit that uncertainty, attribute bundling, and the vehicle design process all play a role. 2. If manufacturers are risk-averse and returns to fuel economy are uncertain, they will provide a lower level of fuel economy and will invest more in those attributes for which consumers have already exhibited a strong preference, such as size and performance. 3. Since attributes tend to be bundled, consumers can choose a bundle of attributes including color, features, and so on. 4. Fuel economy is not a bundled attribute so it may not be a priority for manufacturers to vary. 5. New designs take time and, as such, manufacturers may not be as responsive to consumers’ preferences in the short run. VII. Other Transportation Policies A. Private toll roads are an option to avoid having taxpayers bear the burden of paying for new roads. B. Parking cash-outs would have employers compensate employees who do not use a parking space with an increase in income. The provision of free parking spaces by employers creates a bias toward more pollution by making driving to work relatively less expensive than alternatives. C. Bike-sharing programs a. Urban bike-sharing programs have emerged in cities and are growing in popularity. Information Classification: General

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i. Large cities such as Denver, Montreal, Minneapolis, New Orleans, and others have adopted these systems. ii. New York City’s Citibike program logs almost 100,000 riders on some days. D. Common pricing for these bike-share programs involves a membership fee plus pricing based on the rental time used. a. Typically, 30 minutes or less is free and over 30 minutes is priced at an increasing block rate. b. Data suggest that many riders who are approaching the 30-minute mark will return that bike to a stand and take out another. i. That new bike now has 30 minutes for “free.” c. This behavior of docking a bicycle to keep trip length under a time limit is called “daisychaining.” i. Daisy-chaining adds time to a commute since riders might need to go a short distance out of their way to dock the bike and take out another, but the cost savings can be significant depending on the marginal price of the next 30 minutes. E. Pricing Public Transport a. In the absence of congestion, public transportation fees should equal the marginal cost of the service minus a subsidy that reflects the external benefits of taking public transportation. i. If the public transport actually turns out to increase congestion, however, fares should also include a congestion charge. b. The level of the external benefits subsidy should also reflect the local situation. i. Although the subsidy may attract new riders to public transit, the source of these riders is important in structuring the fares. ii. Did they actually come from personal vehicles or were they riders that would not otherwise have taken a trip? iii. Subsidies may also attract riders that use public transport (such as light rail) as a complement, rather than a substitute, for driving. F.

Feebates combine taxes on purchases of new high-emitting vehicles with subsidies for new low-emitting vehicles. a. Some research has found that consumers may undervalue fuel economy. a. One study found that consumers only consider the first three years of fuel savings when choosing a more fuel-efficient vehicle, understating the value of fuel savings by up to 60 percent. b. Feebates combine taxes on purchases of new high-emitting (or high-fuel-consumption) vehicles with subsidies for purchases of new low-emitting/low-fuel-consumption vehicles. i. By raising the relative cost of high-emitting vehicles, feebates encourage consumers to take the environmental effects of those vehicles into account. c. Feebate system structures are based on a boundary that separates vehicles charged a tax from those entitled to rebates.

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i. The simplest feebate structure uses a constant dollar rate per gallon of fuel consumed. ii. The revenue from the taxes can serve as the financing for the subsidies, but previous experience indicates that policies such as this are rarely revenueneutral; the subsidy payouts typically exceed the revenue from the fee. G. Tax credits for electric vehicles can encourage consumers to purchase these vehicles. This helps manufacturers meet the CAFE standards.\ H. Zero-Emission Vehicles and Tax Credits for Electric Vehicles a. Alternative Vehicles a.

In an attempt to foster the development of alternative vehicles and alternative fuels, some jurisdictions have passed legislation requiring their increased use.

California has announced that by 2035, all vehicles sold in California will be zeroemission vehicles (ZEVs).

Under the ZEV regulation, three distinct vehicle designs are considered “zeroemission,” though to varying degrees: i. (1) plug-in hybrid vehicles, which combine a conventional gasoline-powered engine with a battery; ii. (2) battery electric vehicles, which run entirely on electricity; and iii. (3) hydrogen fuel cell vehicles, which run on electricity produced from a fuel cell using hydrogen gas.

The program works by imposing increasingly stringent sales quotas on ZEVs. The quotas are expressed as a percentage of new cars and light trucks sold in the state that must be zero-emission vehicles.

The program assigns each automaker “ZEV credits,” which represent the company’s sales of electric cars and trucks. i. Automakers are then required to maintain ZEV credits equal to a set percentage of non-electric sales. ii. In 2022, the California Air Resources Board (CARB) proposed new rules requiring not just that 100 percent of new-car sales in the state be ZEVs by 2035, but that 35 percent are by 2025 and 70 percent by 2030.12 iii. Selling this number of clean vehicles depends not only on how many are manufactured, but also on whether demand for those vehicles is sufficient. iv. If the demand is not sufficient, manufacturers will have to rely on factory rebates or other strategies to promote sufficient demand. v. According to data as of summer 2016, Californians drive 47 percent of all ZEVs on the road in the United States, while the U.S. comprises about one-third of the world ZEV market.

Electric Vehicles a. Tax credits subsidize the purchase of electric vehicles and can be as high as $7,500 per vehicle in the United States. b. Consumers who purchase electric vehicles not only receive a tax credit but also pay less for fuel and emit fewer greenhouse gases, both of which have external benefits.

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c. However, tax credits lower tax revenue. i. The loss of revenue due to tax credits is estimated to be $7.5 billion through 2019. ii. Since tax credits help manufacturers reduce their miles per gallon average for new cars by increasing the demand for EVs, the sales of electric vehicles help them to meet the CAFE standards. d. The availability of credits for any particular manufacturer’s cars expires after that automaker sells 200,000 qualified vehicles. i. The theory is that this should be enough sales to produce sufficient economies of scale to make their unsubsidized price competitive. e. Sales of EVs have risen sharply (Figure 15.3). f.

Electric vehicles are not pollution-free, however; the environmental externalities associated with lithium mining are significant and lithium is a nonrenewable resource. i. It remains to be seen whether battery alternatives will be discovered.

H. Usage-based Insurance 1. Pay-as-you-drive insurance could also help internalize the externalities associated with driving. 2. Example 15.7 explores this possibility. I.

Accelerated Retirement Strategies 1. Another option is to encourage the retirement of heavily polluting vehicles either by subsidizing retirement or making it more expensive to keep these vehicles with higher registration fees. Under one government program, stationary sources are allowed to claim emissions reduction credits for removing heavily polluting vehicles from service. 2. Example 15.8 discusses the cash for clunkers program adopted in 2009.

Example 15.9 presents a policy for pollution control that turned out to be counterproductive. Mexico City banned each car from driving one day per week, to be determined by the last number on the license plate. Residents responded by purchasing an additional car with a different license plate. Driving and emissions went up in the long run.

◼ Common Student Difficulties The last few chapters have covered a variety of air pollution problems and policies for control. Different types of pollutants and differing geographical impacts will require different management. There is a good chance that some of your students are feeling overwhelmed or confused by the variety of policies discussed. If they are still grappling with the basic theories of environmental economics, this might be a good time to slow down and review some of the principles, which arise again and again. One way to achieve this might be to examine control costs for both mobile and stationary sources together and compare progress and difficulties. Again, using local or timely examples will be helpful and most interesting for your students.

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Suggested Classroom Exercises

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It is usually fairly easy to find a local example of a proposed transportation policy. There may be an upcoming referendum on the addition or expansion of a mass-transit system. There may also be suggestions to impose tolls on certain roads or suggestions to subsidize the use of public transportation. If you find a local issue you can put the students into groups and have them discuss the pros and cons of the proposed policy. In many metropolitan areas it is common to find roads being widened. Many economists argue that increasing capacity will not improve congestion because wider roads make driving easier and therefore traffic will increase. This topic would be interesting for classroom debate. Another interesting option for more advanced students might be to explore options for managing pollution across mobile and stationary sources. An interesting study for the Chesapeake Bay was done by Resources for the Future. This study, Austin, D., A. Krupnick and V. McConnell, Efficiency and Political Economy of Pollution Control with Ancillary Benefits: An Application to NOX Control in the Chesapeake Bay Airshed, RFF paper 97-34, 1997 or Krupnik et al., The Chesapeake Bay and the Control of NOX Emissions: A Policy Analysis, RFF paper 98-46, 1998, can be found at http://www.rff.org. This is a good time to put the students in groups of 3-4 students each and have them work on solving the air pollution problem. Have them identify what they think the most serious problems are, propose policies to solve the problems, and identify potential difficulties. After they have worked with their group (anywhere from 15-30 minutes), bring them all back together and let each group share with the class. The resulting discussion will be very interesting.

Essay Question

Why does a fuel tax reduce oil consumption by more than higher fuel efficiency standards? Should gas taxes be higher?

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Chapter 16 Ecosystem Goods and Services: Nature’s Threatened Bounty Chapter 16 presents many different examples in order to define the concept of ecosystem services. Past chapters have focused on specific resource issues such as how land, water, and energy resources are used in the economy. These earlier chapters also discussed how economic incentives could help promote the efficient use of land, water, and energy resources. Ecosystem services, as defined in this chapter, is a broader concept that attempts to value and identify all of the services provided by a particular ecosystem, such as a coral reef. The chapter discusses the different methods used to place a value on ecosystem services, and then discusses different institutional arrangements that have been used to provide an economic incentive to preserve ecosystem services, particularly in cases where the service may not be commercially valuable.

◼ Teaching Objectives 1. Explain what is meant by the term ecosystem service. 2. Discuss the current state of ecosystem services. 3. Discuss how to quantify the value of ecosystem services. 4. Identify some of the challenges associated with ecosystem valuation. 5. Discuss the different institutional arrangements that have been created to encourage preservation of ecosystem services. ◼

Outline I. Introduction A. Many services supplied by nature are not commercially valuable. When a service provided by an ecosystem benefits at least one person it is called an ecosystem service. B. Ecological functions become services when they create a benefit for humans. An example is nitrogen fixation in the soil. C. Economic analysis can help place a value on these services, and can help design institutions that will help prevent degradation of these services.

II. The State of Ecosystem Services A. The Millennium Ecosystem Assessment, initiated in 2001 by the United Nations, attempts to assess the impact of ecosystem change on human welfare.

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B. The Assessment divides ecosystem services into four categories: provisional services such as water, regulating services such as flood control, supporting services such as soil formation, and cultural services such as aesthetic value. C. The 2005 Assessment finds 15 out of 24 ecosystems evaluated are in decline. III. Economic Analysis of Ecosystem Services A. Economic analysis can be used to measure the economic value foregone by the degradation of a natural asset. B. Economic analysis can also be used to evaluate possible approaches to maintaining or restoring a natural asset, in the form of benefit-cost analysis. IV.

Demonstrating the Value of Ecosystem Services A. B. C.

Quantifying the value of ecosystem services is difficult because many of these services are nonmarket goods. The revealed preference and stated preference methods discussed in Chapter 4 can be used to quantify nonmarket values. Table 16.1 provides data from a 2009 study that measures the value of coral reefs. This study finds that cultural services provide the largest contribution to value. Example 16.1 discusses a 2011 study that estimated the value of coral reefs in the Coral Triangle and Mesoamerica. Damage Assessments: Loss of Ecosystem Services 1. 2.

Ecosystem valuation can be used to measure the damage caused to an ecosystem by humans. A 2013 National Research Council report advocates using a broader approach to assessing damage from oil spills. This broader approach attempts to evaluate the wide array of services provided by an ecosystem rather than simply focusing on direct human loss.

Valuing Supporting Services: Pollination

1. Ecosystem valuation can be used to place a value on important services such as pollination. These pollination services can come from either commercial beekeeping or from wild bees that are a part of the ecosystem. Example 16.2 discusses pollination services. Valuing Supporting Services: Forests and Coastal Ecosystems 1. Several recent studies have attempted to measure the value of forest and coastal ecosystem services in terms of quantifying the benefits of these ecosystems that do not have commercial value. Examples include biodiversity and flood control.

Challenges and Innovation in Ecosystem Valuation 1. 2. 3. 4. 5. 6. 7.

Ecosystem values must be derived from consistent methods if they are to be useful. Nonmarket goods and services have a wide variety of attributes so consistency requires that analysts measure the same set of attributes. Double counting occurs when the same attribute is included in two different services, such as water purification and provision of fresh water. Ecosystem valuation is still evolving. Stated preference methods can be difficult to use when respondents have limited knowledge of the service being valued. Revealed preference methods are only available for a subset of ecosystem services where something is being purchased. Conducting studies that measure ecosystem values can be quite costly.

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Chapter 16

Ecosystem Goods and Services: Nature’s Threathened Bounty

V. Institutional Arrangements and Mechanisms for Protecting Nature’s Services A.

VI.

Payments for Environmental Services 1. If providers of ecosystem services could be compensated for providing this nonmarket service then there would be an incentive to preserve the ecosystem. 2. Costa Rica’s PSA program began as a voluntary agreement where businesses would pay private landowners to conserve forested land. The forested land provides a variety of ecosystem services, including water services. The program evolved to include a water tariff that helps to cover payments to the landowners. 3. Payments for watershed services come from water quality trading markets and in-stream buybacks. Having users pay for services they previously received for free can promote efficient use of resources. 4. Debate 16.1 discusses Yasuni National Park in Ecuador where the government offered to preserve the ecosystem in exchange for payments from the world community. Example 16.3 discusses Amboro National Park in Bolivia where downstream water users paid to preserve native vegetation in the watershed.

Tradable Entitlement Systems A more efficient outcome can be achieved if a landowner who is required to provide environmental services on his land is allowed to instead supply the same amount of environmental services but on a different piece of land with a lower opportunity cost. A. Wetlands Banking 1. To preserve wetlands, and at the same time recognize the economic benefits associated with developing wetlands, a system of wetlands banking can be used. Under this system incentives are provided for creating off-site equivalent wetlands services. B. Carbon Sequestration Credits 1. Given landowners do not have an incentive to consider the external benefits that accrue to others, a system of carbon sequestration credits can be used to give forest owners credit for carbon removed from the atmosphere. These credits can then be sold. Example 16.4 discusses an entitlement system that attempts to reduce emissions from deforestation in developing countries. 2. Debate 16.2 discusses a tradable quota system for whale harvesting to create a market that would balance economic and social interests.

VII. Ecotourism A. Ecotourism attempts to create a revenue stream from an environmental service to create economic value for the environmental service. B. A potential cost of promoting ecotourism is the risk that increasing the number of visitors to the area will damage the ecosystem. C. Debate 16.3 discusses the pros and cons of encouraging people to visit sensitive areas in order to raise funds to preserve these areas. Example 16.5 describes an innovative approach used in Zimbabwe to protect wildlife areas. Example 16.6 discusses wolf recovery in the United States. VIII. Poverty and Debt A. In eastern and southern Africa, positive feedback loops have created a downward cycle in which poverty and deforestation reinforce each other. a. Most natural forests have long since been cut down for timber and fuelwood and for producing crops from the cleared land. b. As forests disappear, the rural poor are forced to divert more time toward locating new sources of fuel.

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c. Once fuelwood is no longer available, dried animal waste is burned, thereby eliminating it as a source of fertilizer to nourish depleted soils. d. Fewer trees lead to more soil erosion and soil depletion leads to diminished nutrition. e. Diminished nutrition reinforces the threats to human health posed by an inability to find or afford enough fuel, wood, or animal waste for cooking and boiling unclean water. f. Degraded health saps energy, increases susceptibility to disease, and reduces productivity. g. Survival strategies may necessarily sacrifice long-term goals simply to ward off starvation or death; the forest is typically an early casualty. B. At the national level, poverty takes the form of staggering levels of debt. a. Repaying this debt and the interest payments flowing from it reduces the capacity of a nation to accumulate foreign exchange earnings to finance imports. C. Debt-for-Nature Swaps a. A debt-for-nature swap involves the purchase (at a discounted value in the secondary debt market) of a developing country’s debt, frequently by an environmental nongovernmental organization (NGO). b. The new holder of the debt, the NGO, offers to cancel the debt in return for an environmentally related action on the part of the debtor nation. c. The first debt-for-nature swap took place in Bolivia in 1987. d. Since then, debt-for-nature swaps have been arranged or explored in many developing countries, including Ecuador, the Philippines, Zambia, Jamaica, Madagascar, Guatemala, Venezuela, Argentina, Honduras, and Brazil. D. Between 1989 and 1996, Conservation International, the Missouri Botanical Garden, and the World Wildlife Fund negotiated nine commercial debt-for-nature swaps in Madagascar. a. $11.7 million in conservation funds. b. Agreements signed by Madagascar’s government and the participating conservation organizations identified the programs to be funded. c. One such program trained over 320 nature protection agents, who focused on involving local communities in forest management. E. Extractive Reserves a. One strategy specifically designed to protect the indigenous people of the forest as well as to prevent deforestation involves the establishment of extractive reserves. b. These areas would be reserved for the indigenous people to engage in their traditional hunting−gathering activities. c. Extractive reserves have already been established in the Acre region of Brazil. Acre’s main activity comes from the thousands of men who tap the rubber trees scattered throughout the forest, a practice dating back 100 years. d. Under the leadership of Chico Mendes, a leader of the tappers who was subsequently assassinated, four extractive reserves were established in June 1988 by the Brazilian government to protect the rubber tappers from encroaching development. F. The World Heritage Convention

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Chapter 16

Ecosystem Goods and Services: Nature’s Threathened Bounty

a. The World Heritage Convention came into being in 1972 with the primary mission of identifying and preserving the cultural and natural heritage of outstanding sites throughout the world, and ensuring their protection through international cooperation. b. Currently, some 178 countries have ratified the convention. c. Ratifying nations have the opportunity to have their natural properties of outstanding universal value added to the World Heritage List. d. The motivation for taking this step is to gain international recognition for this site, using the prestige that comes from this designation to raise awareness for heritage preservation and the likelihood that the site can be preserved. e. A ratifying nation may receive both financial assistance and expert advice from the World Heritage Committee as support for promotional activities for the preservation of its properties as well as for developing educational materials. f. Responsibility for providing adequate protection and management of these sites falls on the host nations, but a key benefit from ratification, particularly for developing countries, is access to the World Heritage Fund. G. Royalty Payments a. Establishing the principle that nations containing these biologically rich resources within their borders would be entitled to a stipulated royalty on any and all products developed from genes obtained from these preserves provides both an incentive to preserve the resources and some revenue to accomplish the preservation. b. Nations harboring rich biological preserves have begun to realize their value and to extract some of that value from the pharmaceutical industry. c. The revenue is in part used for inventorying and learning more about the resource as well as preserving it. d. In 1996, Medichem Research, a pharmaceutical company, entered into a joint venture with the Sarawak government. e. The organization created by this joint venture has the right to file exclusive patents on two compounds that offer some promise as cancer treatments, with a 50–50 split from royalties once the drug is marketed. f. The Sarawak government was given the exclusive right to supply the latex raw material from which the compounds are derived. g. Sarawak scientists are involved in screening and isolating the compounds and Sarawak physicians are involved in the clinical trials. H. Example 16.7 examines whether demand from pharmaceutical companies will yield sufficient biodiversity. Example 16.8 discusses trust funds for habitat preservation. IX.

The Special Problem of Protecting Endangered Species A. To reduce the threat to an endangered species it can be advantageous to prevent their habitat from becoming fragmented. Conservation banking can be used to help preserve the habitat of the endangered species. B. A second strategy to reduce fragmentation is the agglomeration bonus. Under this system, landowners are given incentives to restore habitat across private land. C. Safe harbor agreements guarantee that any landowner who agrees to take steps to protect an endangered species will not be subject to further restrictions. The example given notes that preserving land to protect one species may attract other species and that might then subject the landowner to a new set of regulations. Safe harbor agreements attempt to address this problem.

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Example 16.9 discusses the Gopher Tortoise Conservation Bank. Example 16.10 examines the changing role of monitoring in invasive species management.

◼ Common Student Difficulties Placing a value on ecosystem services is an area of research that is still evolving. This chapter integrates concepts learned in past chapters and in that sense can help students think about how some of the different concepts learned all fit together. Students might need to be reminded about the different methods that can be used to value the environment from Chapter 4. Each of these methods was useful for measuring one part of an ecosystem service. Students can also be reminded of the inefficiencies associated with public goods and common property resources in terms of the reasons why the market does not provide the socially optimal level of these resources. Past chapters have discussed various policies that can be used to encourage economic agents to move towards the socially efficient outcome. This chapter also emphasizes policies and institutional arrangements that can encourage efficient behavior. This chapter does not introduce new and complicated concepts so much as it pulls together concepts from previous chapters. The goal is to think about the ecosystem as a whole rather than in its individual parts.

◼

Suggested Classroom Exercises

As either a class or a group exercise, have students think of a location near where they live that is at risk of being developed. Encourage students to identify the ecosystem services provided by the area and then compare that to the economic benefits of developing the area.

Debate the pros and cons of ecotourism as a means of promoting conservation.

Many areas that provide natural habitats for endangered species are in developing countries. Have a class discussion to debate how best to preserve these areas. Be sure to touch on why the residents of the developing nations might or might not have an incentive to protect these areas in terms of the opportunity costs. Next have a discussion about creative methods that can be used to encourage people in developed countries to help pay to protect these sensitive ecosystems.

4. What value do you place on wildlife? Have students identify the wildlife in their area. Is there any? What is being done to protect it? Should more be done? What are the trade-offs?

◼

Essay Question

Ecosystem services are often not preserved because there is no market value for these services. Describe an institutional arrangement that has been used in an attempt to create economic value for these services.

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Chapter 17 Common-Pool Resources: Commercially Valuable Fisheries Chapter 17 examines renewable resources with biological growth. This chapter focuses on common-pool resources (fisheries) whose movement and lack of well-defined property rights make achieving economic efficiency much more difficult. Commercially valuable species can be exploited beyond recovery if not carefully managed. An economic model is overlayed on a biological model as an example. Efficient levels of harvest are defined and economic incentives for sustainable harvests are discussed. [These models tend to be difficult for students. Take time to set up the biological models and emphasize what is being measured on the axes.]

◼ Teaching Objectives 1.

Present the Schaefer model.

Define static-efficient sustainable yield.

Discuss the difference between maximum sustainable yield and static-efficient sustainable yield.

Discuss the difference between the open-access and static-efficient outcome.

Present and discuss dynamic efficiency and the effect of the discount rate.

Discuss the two types of externalities created with free-access.

Present public policy options for fisheries management and the pros and cons of each option.

◼

Outline I. Efficient Allocations This section presents a simple biological fisheries model and defines the concept of a static-efficient sustained yield from a fishery. Emphasis is placed on the fact that the maximum sustained yield is not the efficient allocation unless the marginal cost of effort is zero. The dynamic efficient sustainable yield model is then presented. A. Biological Dimension—The Schaefer model 1. The Schaefer model posits an average relationship between the growth of the fish population and the size of the fish population.

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Chapter 17

5. 6.

Common-Pool Resources: Fisheries and Other Commercially Valuable Species

The graphical relationship is represented with the size of the population on the horizontal axis and the growth of the population on the vertical axis (Figure 17.1). The shape of the graph shows that population growth first increases as population increases, and then decreases as population continues to increase. The two points of intersection of the growth function with the horizontal axis represent equilibria. Only the second intersection represents a natural equilibrium. This is the population size that would persist without outside influences. Reductions in the stock (deaths for example) are exactly matched by increases in the stock (births for example). Thus, this is also a stable equilibrium. It is also the carrying capacity of the habitat. The other equilibrium point is called the minimum viable population and is the level of population below which growth in population becomes negative. Thus, this is an unstable equilibrium. A change in the stock in either direction would lead to either positive or negative growth. Sustainable yield refers to a catch rate that is equal to the growth rate. As long as the population size remains constant, then the growth rate and catch rate will remain constant. The peak of the function on this graph is called the maximum sustainable yield. This is the population size that yields the maximum growth and thus the largest sustainable catch. Catch rates higher than the maximum sustainable yield would lead to extinction. For any fish stock, the sustainable yield can be found by locating the intersection of a line from the stock size to the function and then determining what growth rate (catch rate) it is associated with based on the vertical axis.

B. Static-Efficient Sustainable Yield 1. The static-efficient sustainable yield is the catch level that, if maintained perpetually, would produce the largest annual net benefit. The dynamic-efficient sustainable yield incorporates discounting. 2. Assumptions of the economic model are: a. The price of fish is constant and does not depend on the amount sold. b. The marginal cost of a unit of fishing effort is constant. c. The amount of fish caught per unit of effort expended is proportional to the size of the fish population. 3. The static-efficient sustainable yield allocation maximizes the constant net benefit (catches, population, effort levels, and net benefits are constant over time). 4. The function illustrated in Figure 17.1 can be used to derive a graph that represents benefits (total revenue) as a function of fishing effort. a. Harvest-effort functions are added to the population function as shown in Figure 17.2. As effort increases, the harvest-effort function will rotate upwards. b. The sustained yield associated with each level of effort is where the harvest-effort function intersects the population function. c. Figure 17.3 graphs the relationship between effort (on the horizontal axis) and the sustainable catch on the vertical axis. This is the sustainable yield function defined in terms of effort instead of population. d. The sustainable yield function is multiplied by the price to get total revenue. Since the price of the fish is constant, the total revenue function will take the same shape, as illustrated in Figure 17.4. [Remind your students that increasing effort will reduce the fish population.] e. The peak of this function again represents the maximum sustainable yield. 5. Since marginal costs are assumed constant, total cost is a straight line from the origin. Net benefit is the vertical distance between benefits and costs. Maximum net benefit is at point Information Classification: General

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E e where the vertical distance is maximized and where the marginal benefit (slope of the total benefit function) equals marginal cost (slope of the total cost function). 6. The maximum sustainable yield is not equal to the static efficient yield unless the marginal cost of additional effort is zero. The efficient level of effort is less than that necessary to harvest the maximum sustainable yield and thus is associated with higher population sizes. 7. A change in the marginal cost of effort (due to a change in technology, or a regulation, for example) would cause the total cost curve to rotate. Lower marginal costs would cause a rotation to the right. Higher marginal costs would cause a rotation to the left. C. Dynamic Efficient Sustainable Yield 1. The dynamic efficient sustainable yield will equal the static efficient sustainable yield if the discount rate equals zero. 2. Higher discount rates mean higher costs (foregone current income) to the resource owner of maintaining the stock. 3. With positive discount rates, the efficient level of effort increases and equilibrium populations decrease. 4. With an infinite discount rate, the level of effort would rise to E c (Figure 17.4) where net benefits equal zero. With an infinite discount rate the marginal user cost is zero since the value of the future is zero. 5. Under the dynamic efficient management scheme, extinction could occur if the growth rate is lower than the discount rate and if the costs of extracting the last unit are sufficiently low. 6. Actual fisheries differ from the standard model discussed above in two ways: (1) marginal costs are typically not constant, but rather increase as the remaining stock size decreases, and (2) since the price of fish is not constant, the size of the harvest can affect price. II. Appropriability and Market Solutions This section compares and contrasts the typical market allocation to the efficient allocation and discusses the externalities associated with unrestricted fisheries that lead to these differences. A. A sole owner of a fishery would have a well-defined property right to the fish and would want to maximize his or her profits. Profit maximization will lead to the static-efficient sustainable yield. A sole owner can increase profit by increasing fishing effort until marginal revenue equals marginal cost (Figure 17.5). B. Ocean fisheries, however, are typically open-access resources. Thus, no single fisherman can keep others from exploiting the fishery. C. Open-access creates two kinds of external costs: 1. Contemporaneous external costs are the costs imposed on the current generation from overfishing. Too many resources (boats, fishermen, etc.) are committed to fishing. 2. Intergenerational external costs are the costs imposed on the future generation from the exploitation of the stock today. Overfishing reduces stocks and thus future profits. D. Unlimited access creates property rights that are not well-defined. Efficiency would create profit equal to the scarcity rents. Rents encourage entry into the fishery. Entry will occur until the rents are gone and will result in overexploitation of the fish stock. (Figure 17.5 exhibits this situation also.) E. With free-access, individual fishermen have no incentive to “save” the resource. The asset value disappears. Individuals have incentives to increase effort until profits are zero. This is the case for many ocean fisheries.

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Chapter 17

Common-Pool Resources: Fisheries and Other Commercially Valuable Species

Whether or not free-access poses the threat of species extinction must be determined on a case-by-case basis.

G. Open-access and common-pool resources are not synonymous. Open access generally violates both the efficiency and sustainability criteria (Example 17.1). III. Public Policy Toward Fisheries This section presents a variety of public policy responses to the problems outlined above. A. Raising the Real Cost of Fishing 1. Raising the marginal cost of effort results in a lower harvest and higher stock sizes. 2. Regulations such as gear restrictions or equipment bans will raise the cost of fishing. Examples include restrictions on the size and type of traps, net restrictions, turtle exclusion devices, etc. 3. Limitations on fishing seasons and times will also raise the cost of fishing. 4. While these policies may result in an efficient catch, they are inefficient because the efficient level of catch is not caught at the lowest possible cost. Fishermen will overcapitalize. With time restrictions, fishermen will invest in more equipment than is necessary in order to capture the fish in the limited season. Raising the cost of fishing uses resources that could have been used elsewhere. Net benefits are lost because excessively expensive means are used to catch the fish. 5. These policies have led to substantial losses in the net benefits received by the fishery. The problem is further exacerbated if the incomes of fishermen suffer. Lower incomes lead to incentives to violate regulations, and further conservation efforts become difficult to implement. 6. Technological innovations have lowered the cost of fishing, offsetting the increases imposed by regulations. B. Taxes 1. A tax on effort would also cause the total cost curve to rotate (higher total cost) and will lead to lower catches and higher population levels (Figure 17.6). 2. Unlike regulations, the tax can lead to the static-efficient sustainable yield allocation because the tax revenues represent transfer costs and not real-resource costs. 3. Transfer costs involve the transfer of resources from one part of society to another. Regulations cause resources to be used up or wasted. Taxes cause resources to be moved around. Thus from society’s perspective, transfer costs are retained as part of the net benefit. 4. For the individual fisherman, however, a tax still represents an increase in costs. C. Catch Share Programs 1. A properly designed individual transferable quota (ITQ) system is another policy option for obtaining an efficient allocation. An efficient quota system will have the following characteristics: a. The quotas entitle the holder to catch a specified volume of a specified type of fish. b. The total amount of fish authorized by the quotas should be equal to the efficient catch level for that fishery. (A quota defined in terms of the right to own and use a fishing boat would not be efficient since there would still be incentives to overcapitalize.) c. The quotas should be freely transferable among fishermen and markets should send appropriate price signals about the value of the fishery.

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2. Since quotas are valuable, transferable quotas will command a positive price. Fishermen who own quotas, but have high costs, can make more money by selling their quotas to fishermen with lower costs and vice versa. Transferable quotas also encourage technological progress. 3. Thus, both the tax system and the ITQ system encourage lower harvest rates in an efficient manner. 4. The distribution of rent from a quota system depends on how the quotas are initially allocated. 5. If the government auctions off the quotas, the government appropriates all the rent and the outcome is similar to that of a tax. 6. If the government gives the quotas away, the fishermen can then trade among themselves and the rent goes to the current generation of fishermen. 7. New entrants would have to purchase quotas from existing fishermen. The price of the transferable quotas will rise to the point at which it equals the discounted market value of future rents. 8. Future generations see little difference between a quota system and a tax system. In both cases, they have to pay to enter the industry. 9. Examples of existing or proposed ITQ programs are numerous. (Table 17.1 lists some examples.) 10. The ITQ system established in New Zealand to protect the deepwater trawl fishery is highlighted and discussed in this section. This is an excellent class case study. (Example 17.2 examines restrictions and quotas for Atlantic Sea Scallops.) 11. Problems with ITQ programs can include bycatch and high-grading which both result in high mortality rates. When quotas specify the catch in terms of the weight of the species, the value of the catch is affected by the size of the fish. Fishermen thus have incentives to throw back the less valuable fish. This is called high-grading. As with by-catch, the fish that are thrown back rarely survive, resulting in wasted harvests and smaller stocks. 12. Territorial Use Rights Fisheries (TURFs) are an alternative to ITQ systems where the right to fish for certain species in a certain area is allocated. These are access rights and not ownership rights. By assigning property rights, TURFs create an incentive to protect the future value of the resource. Debate 17.1 discusses how TURFs and ITQs can be combined to create an even more efficient system. D. Aquaculture 1. Allowing some fisheries to be privately held is one solution to the common-property problem. 2. This solution can work when fish are not very mobile (e.g., lobsters), or can be confined, or when they return to areas to spawn. 3. Aquaculture is the controlled raising and harvesting of fish. Fish farming involves cultivating fish over their lifetime. Fish ranching involves holding fish in captivity for the first few years of their lives. 4. Privately owned fisheries encourage owners to invest in resources that increase the yield of the fishery. 5. Oysters and mussels are examples of species that have been successfully raised through aquaculture. 6. By 2008, about 46% of fish consumed around the world were raised on farms. About 2/3 of the seafood consumed in China comes from fish farms. 7. Some governments, such as in Japan, have created private property rights for waters that were formerly held in common.

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Chapter 17

Common-Pool Resources: Fisheries and Other Commercially Valuable Species

Fish farming can create environmental problems from pollution and from the destruction of ecologically valuable sites.

E. Subsidies and Buybacks 1.

Subsidies that reduce the cost of fishing, such as fuel subsidies and tax exemptions, encourage overfishing.

Payments used to buy out excess fishing capacity (buybacks) are useful in that they reduce overcapacity. However, they can induce fishermen to acquire more vessels than otherwise.

Marine Protected Areas and Marine Reserves 1. Marine reserves protect individual species by preventing harvests within the reserve boundaries. Marine reserves also reduce habitat damage from fishing gear. 2. Marine protected areas can promote ecosystem balance unlike single species harvesting quotas. The removal of sensitive species in the form of by-catch is prevented. 3. Marine protected areas do not always create win-win situations. Local harvesters may have to sacrifice in the short run in order to benefit in the long run. Policies must recognize these costs. G. The 200-Mile Limit 1. As an attempt to reduce the common-pool and open-access issues associated with ocean fisheries, countries bordering the sea now have ownership rights that extend 200 miles offshore. Within the 200-mile limit, the countries have exclusive jurisdiction. This ruling protects coastal fisheries, but not the open ocean. H. Preventing Poaching 1. Poaching presents another threat to commercially valuable species. Poaching can be discouraged by raising the relative cost of this illegal activity. 2. Providing incentives to protect the species is another possible solution. I.

Debate 17.2 discusses the costs and benefits of aquaculture.

◼ Common Student Difficulties The jump from the biological model of a fishery to the economic model will be difficult for some students. Emphasize the different axes and how an increase in effort represents a move from right to left in one graph, and a move from left to right in the other. I have found it useful to make enlarged photocopy handouts of these graphs for class so that the students can focus on the concepts and add notes to the graphs instead of worrying about drawing the graph. Additionally, the assumptions of the economic model are extremely restrictive, and I doubt you will be able to finish a presentation of the theoretical model without a challenge to these assumptions. Remind the students that these assumptions allow us to set up the problem and isolate the open access problem and outcome. Then you can show them what happens when one of these assumptions is relaxed or how a price change might affect the incentives to comply with regulations and the like. Finally, social costs could be added to this model to examine optimal levels of fishing effort. For some species, social costs could be so high that the optimal level of effort is zero.

◼

Suggested Classroom Exercises

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A version of the game below was presented in Chapter 2, but I find it is more fun to incorporate when discussing fisheries. My environmental studies students have, in the past, been horrified to find that not only are the fish they caught worth nothing because they flooded the market, but also that they have completely extinguished the species. They are most distraught by the latter point. This game is simple and does a nice job of illustrating the open-access problem. One extension of this game is to try to create a situation that exhibits the differences between free-access and common-property resources. One way to achieve this is to play the game again, but allow the students to communicate and attempt to “manage” the “fish” before the fishing begins. I have done this by completing the first version of the game at the beginning of a class before lecturing on Chapter 17. I then lecture on fisheries models and talk about management options. At the beginning of the next class, I then ask the students if they would like to try the game again, but this time I let them communicate and they are playing for problem set points instead of money. They will usually form some sort of agreement as to how many fish to pick up. (Once, after an agreement was reached, one student then picked up all the fish and the class received no problem set points!) Another extension could be the addition of regulations and noncompliance penalties that could be imperfect. A role of a die or dice could determine the probability of getting caught. Adding a reproduction rate for the “fish” could also work.

Fish Game A simple game that is fun and illustrates the common pool resource issue is called “the carmel game” or the “fish game” as I like to call it. This game is a demonstration of free access goods and is an adaption of a game used by James Alm in his microeconomics course. The “fish” (caramels or other candy) are placed around the room and anyone can catch a fish. You can use fewer caramels than students if cost is a factor, but it probably will not matter if you use more—some students are bound to grab as many as they can. However, the price of fish depends on the number caught; the more caught, the lower the price. If all the fish are caught, then the price is $0.00. (This way you are only out the price of the candy because invariably all will be caught. This shows how free access causes inefficient markets, i.e., some level of harvest less than complete harvest would maximize “profits.” Since the marginal cost of catching fish is zero in this game, maximum profits occur at maximum total revenue.)

Directions Stage 1 Place 50 (or number of students) fish around the room. Student directions: At the signal, you will have one minute to pick up the “fish.” Anyone can play by picking up as many fish as they want. Come to the front of the classroom to redeem fish. Any fish picked up must be redeemed in the next stage. No talking during the game. Stage 2 Count the total number of caramels that were collected. Find the price based on the total number. Exchange caramels for cash.

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Chapter 17

Common-Pool Resources: Fisheries and Other Commercially Valuable Species

(Price is based on the following market demand curve. See below. Stage 3: (optional) Gather the remaining caramels and play the game again. In the optional two-harvest period game, the “fish” are randomly thrown about the classroom. If the fish are harvested (i.e., picked up) in the first period (i.e., first 30 seconds), the price for their return is low. If the fish are harvested in the second period, then the price is higher. No one in the class is allowed to communicate. This prevents those who are near a fish from agreeing to wait until the second period. Naturally, every fish is immediately picked up. Both of these games are variations of the prisoner’s dilemma, which characterizes many types of open-access resources. Inverse Market Demand P = 1.00 − 0.02Q P

PQ

$1.00 $0.98 $0.96 $0.94 $0.92 $0.90 $0.88 $0.86 $0.84 $0.82 $0.80 $0.78 $0.76 $0.74 $0.72 $0.70 $0.68 $0.66 $0.64 $0.62 $0.60 $0.58 $0.56 $0.54 $0.52 $0.50 $0.48 $0.46 $0.44 $0.42

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29

$ 0.00 $ 0.98 $ 1.92 $ 2.82 $ 3.68 $ 4.50 $ 5.28 $ 6.02 $ 6.72 $ 7.38 $ 8.00 $ 8.58 $ 9.12 $ 9.62 $10.08 $10.50 $10.88 $11.22 $11.52 $11.78 $12.00 $12.18 $12.32 $12.42 $12.48 $12.50 $12.48 $12.42 $12.32 $12.18

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• Environmental and Natural Resource Economics, Twelfth Edition

$0.40 $0.38 $0.36 $0.34 $0.32 $0.30 $0.28 $0.26 $0.24 $0.22 $0.20 $0.18 $0.16 $0.14 $0.12 $0.10 $0.08 $0.06 $0.04 $0.02 $0.00

30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50

$12.00 $11.78 $11.52 $11.22 $10.88 $10.50 $10.08 $ 9.62 $ 9.12 $ 8.58 $ 8.00 $ 7.38 $ 6.72 $ 6.02 $ 5.28 $ 4.50 $ 3.68 $ 2.82 $ 1.92 $ 0.98 $ 0.00

In the book, National Research Council, 1999, Sharing the Fish: Toward a National Policy on Individual Fishing Quotas, National Academy Press, Washington, D.C., numerous case studies of ITQs are explored. These are great in-class discussion tools. There are numerous examples that can be used for small group discussions. I have asked groups to analyze different ITQ programs and then report back to the larger class their opinions as to the pros and cons (or successes and failures) of their particular program.

◼

Essay Question

Would the establishment of a marine reserve maximize the present value of net benefits for fisherman? Using your knowledge of discounting, how could reduced harvests in the short run be offset by increases in the long run?

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Chapter 18 Forests: Storable, Renewable Resources Chapter 18 covers forests, forest management and sustainable forestry. Efficient allocations of the forest resource are defined and examples of how economic incentives can be used to protect biodiversity are presented. Both single-use and multiple-use management are presented using a basic growth model. The calculation of optimal rotations is presented. Timber values as well as biodiversity values of the forest are highlighted. The problem of deforestation and its potential solutions are also emphasized.

◼ Teaching Objectives 1. Present the concept of a forest as a capital asset. Discuss the difference between harvest value and asset value. 2. Discuss the biology of forest growth. 3. Present the difference between the biological decision rule for forest management and the profit maximization rule. 4. Illustrate the calculation of the present value of net benefits from timber harvesting for a finite time horizon. 5. Discuss the effect of the discount rate on the harvest decision. 6. Present the infinite time horizon (multiple harvest) model. 7. Discuss the sources of inefficiency in forest management. 8. Discuss how policies have led to inefficient management and over harvesting. 9. Discuss global externalities that encourage over harvesting. 10. Present a history of U.S. forest policy. 11. Present economic strategies for dealing with global inefficiencies.

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◼

Outline

• Environmental and Natural Resource Economics, Twelfth Edition

I. Characterizing Forest Harvesting Decisions This section presents the economics of forest harvesting for timber. A simple biological model is presented and the optimal time for harvesting based on profit-maximization is overviewed. Both single-harvest and a more complicated multiple-harvest model are covered. Biological growth rates and the discount rate will help determine the optimal rotation time. A. Timber is both an output and a capital good. B. The harvest decision involves how much timber to harvest, how often to harvest it and whether to replant after harvesting. C. Standing trees are a capital asset. Tree growth increases the harvestable volume and standing trees provide watershed protection and wildlife habitat. D. Forest managers will decide between harvesting today and waiting to harvest. Unlike many other harvestable resources, harvest rotations are typically 25 years or more. E. Tree growth is measured on a volume basis. Young trees will grow tall quickly, but volume growth is slow. Medium aged trees increase in volume quite rapidly while mature trees grow very slowly and eventually stop growing or reverse growth. Growth will also be affected by weather, soil fertility, disease, forest fires, etc. F.

The optimal time to harvest from a profit maximization perspective would be the age that maximizes the present value of net benefits from the wood.

G. The size of the net benefits depends on whether there is a single planting and harvest or whether the land is perpetually harvested. For simplicity we start by assuming a single harvest. H. Benefits are measured using the potential volume of wood given the growth rate and the price of the lumber. The annual incremental growth represents the marginal growth. I.

Costs, in this example, are of two types—planting costs and harvesting costs. Planting costs are immediate and thus are not discounted while harvesting costs are discounted because they are paid in the future.

Net benefits are calculated by subtracting the present value of costs from the value of the timber at harvest age.

K. The discount rate will affect the harvest decision. Any positive discount rate will shorten the optimal rotation length. Thus, higher discount rates yield shorter optimal harvesting times. The relevant comparison is between additional tree growth from waiting one more year to harvest and returns on the revenue should the trees be harvested today when the timber revenues are invested at a rate of r. As long as the discount rate is positive, the trees should be harvested as soon as the growth rate slows to a point at which more can be earned elsewhere (than in the tree asset). A simple numerical example illustrates these points. (See Table 18.1.) L. Since planting costs are immediate and not discounted, the optimal harvest age is that age which maximizes the difference between the present value of timber and the present value of the planting cost. M. Harvesting costs are discounted and are proportional to the amount of timber harvested. N. The net benefit of a unit of wood harvested at any age is the price of the wood minus the marginal cost of that unit. These values are constants. As long as the marginal harvesting cost is less than the price, an increase in marginal harvest cost will not affect the optimal harvesting age. O. A tax levied on each cubic foot of wood harvested would simply raise the marginal cost of harvesting by the amount of the tax. The tax would leave the optimal harvesting age unchanged.

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Chapter 18

Storable, Renewable Resources: Forests

High discount rates and high replanting costs could make replanting prohibitively expensive.

Q. The infinite-planning model is different from the single-harvest model in that it recognizes the interdependencies between periods. Decisions to delay harvests impose costs on the next harvest period. For this case, the opportunity cost of delaying the next rotation must be outweighed by the gain in tree growth. R. All else the same, the optimal rotation in the infinite-planning case is shorter than in the singleharvest case. The marginal cost of delay is higher since there is now an opportunity cost of starting the next cycle later. Thus, the optimal rotation is shorter. S.

If harvest costs or planting costs rise, the optimal rotation is lengthened. A per unit harvest tax would have the same effect.

T. Rising prices would also increase rotation time. U. If the amenity value of standing trees is added to the infinite horizon model, the optimal rotation time would lengthen because the marginal benefit of delay would rise. Large enough amenity values would lead to leaving the forest as wilderness. II. Sources of Inefficiency This section illustrates how inefficiencies can lead to deforestation. Some inefficiencies are due to externalities. Others can be categorized as either perverse incentives for landowners or perverse incentives for nations. Forestry provides numerous examples and situations where perverse incentives have produced inefficient and unsustainable outcomes. A. Perverse incentives create inefficient and unsustainable outcomes especially with respect to privately owned forests. B. The value of a standing forest as wildlife habitat or ecosystem function is an external cost. Failure to recognize social values will result in inefficiencies. C. External costs of timber harvesting, such as loss of watershed protection or biodiversity, may not be adequately considered by the private landowner. D. Government policies can also create perverse incentives. In Brazil, for example, the government reduced taxes on income from agriculture, thus making it more profitable for land conversion to take place. This policy and other inefficient policies, such as cattle subsidies were later abandoned. E. Government resettlement programs have also encouraged deforestation by facilitating the movement of migrants into agriculture. F.

Concession agreements are another source of inefficiency. Concession agreements define the terms under which public forests can be harvested.

G. Deforestation involves transboundary or global externalities. Deforestation contributes to species loss and to global warming. Loss of biodiversity (and thus genetic material) and global warming have widespread effects, but harvesting decisions are made on an individual or local scale. The global social value of standing trees for species diversity and for carbon absorption will not be taken into account by a private landowner or a single country and will lead to overharvesting. 1. Biodiversity: deforestation is a major source of species loss. Many benefits of species preservation are external to the country with the forest. 2. Climate change: deforestation contributes to climate change, but the benefits of leaving the trees standing are largely external. The costs, however, are largely internal. (Debate 18.1 considers whether firewood is a carbon-neutral fuel.)

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• Environmental and Natural Resource Economics, Twelfth Edition

Sustainable Forestry A. Profit-maximizing decisions may not be efficient due to externalities. B. Efficiency and sustainable forestry are not necessarily compatible. C. Practices aimed at sustainable forestry that is also economically sustainable had led to a focus on rapidly growing trees and plantation forestry. D. Plantation forestry is controversial because it typically involves a single species, resulting in many externalities including runoff contaminated with pesticides and reduced quality of wildlife habitat. E. Public Policy

V. Public Policy A. Restoring efficient incentives for the management of the forest could be achieved by: 1. Charging concessionaires the full cost of rights to the land including damages. 2. The magnitude of land transferred to squatters should be controlled. 3. The rights of indigenous people should be respected. 4. Developing standards for sustainable forestry and ensuring compliance with those standards. (Example 18.1 provides an example using certification.)

◼ Common Student Difficulties I have found that this chapter is one of the most difficult for students. In particular, the spreadsheet example of optimal harvest rotation can be very confusing. Students are still trying to grasp discount rate concepts and the addition of, and comparison to, biological growth models can be very confusing. However, this is a great time to really nail down these points by letting the students experiment with these concepts by developing a spreadsheet based on this model or another similar model. Learning by doing will facilitate these concepts. I have also found that while a potentially painful exercise, the students are extremely enthusiastic when they have suddenly mastered both spreadsheets and the discounted profit maximization problem. Using graphs, combined with the spreadsheets and mathematics, will facilitate this process. The appendix to this chapter presents the mathematics.

◼

Suggested Classroom Exercises

As mentioned above in the Common Student Difficulties section, your students may have trouble with the discounting concepts and with spreadsheets. If you teach in a computer lab or have access to one, you (or a TA) could work through an example during class. Another option would be to assign such an exercise as a problem set. Ideally you could do both if class time permits. I have usually found that there is not sufficient class time and simply assign a problem set and have the TA hold a review session. One example of an in class problem or homework assignment would be to give them a growth function for Douglas fir, such as Q = e[5.52 − (95.3/t)] Assume a real rate of interest of 4%, a price per thousand board feet of $200, and a replanting cost of $200 per acre. Differentiating that equation with respect to t with yield the instantaneous growth function. Using this equation, students can create a spreadsheet with volume, marginal growth, the growth rate, and average growth. You can ask them to calculate the present value of the first rotation and for multiple

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Chapter 18

Storable, Renewable Resources: Forests

rotations. They can then figure out the optimal rotation and compare that to maximum sustained yield. Allowing the discount rate to change is another alternative question. If you are teaching continuous rate discounting for biological growth models, this is a good chapter to utilize. It is also interesting to have your students compare the results when using both continuous and fixed interval discounting.

For the more advanced student See if your students can figure out the multiple-harvest model with the addition of the standing forest amenity value.

◼

Essay Question

The trade-off between economic development and preservation has been discussed in several chapters thus far. Deforestation may lead to short run economic benefits for cash poor developing countries, but may lead to losses later on if the practices are not sustainable. How can economic incentives be used to promote sustainable forestry practices? (Note that these concepts are also covered in Chapter 16.)

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Chapter 19 A Locationally Fixed, Multipurpose Resource: Land Chapter 19 examines how the market allocates land and how market allocation complies with the social criteria. In addition, this chapter studies the policy instruments that help to reduce the gap between market and socially desirable outcomes. Finally, the chapter carefully analyzes the effectiveness of these policy instruments and how they restore conformance between goals and outcomes. Several examples are developed to understand and discuss the tradeoff between conservation and market use of the land.

◼ Teaching Objectives 1. Discuss and highlight the concept of land use and land use conversion. 2. Analyze graphically land allocation. 3. Identify the variables that can shift up or down the bid rent functions. 4. Present the sources of inefficient use and conversion. 5. Discuss the negative and positive externalities that can affect the land value. 6. Present and discuss the influence of taxes on land use conversion. 7. Discuss how the market power can affect the ability of the market to achieve efficiency by preventing transfers that would increase social value. 8. Analyze the problems that developing countries face when determining land uses. 9. Discuss the market-based policy remedies that help to overcome the market failures in the allocation of land. 10. Present and discuss the different approaches to protect land, such as Conservation Easements or Land Trusts.

◼

Outline I. Introduction

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Chapter 19

A Locationally Fixed, Multipurpose Resource: Land

The introduction outlines the main questions that this chapter attempts to answer. It also highlights the importance that land has as a resource and how its location affects its value and the value of its neighbors. II. The Economics of Land Allocation This section presents and discusses the concepts of land use and land use conversion. Specifically, it graphically analyzes the allocation of land and determines how markets allocate land to its highest valued use. A. Figure 19.1 describes the process of allocation of land. This graph will be extremely useful to explain other concepts in the next sections. B. The bid rent function describes the relationship between the distance to the center of the town or urban area and the net benefit per acre received from each type of land use. C. The types of land use identified in Figure 19.1 are residential development, agriculture, and wilderness. Other land uses could be introduced into the graph. The bid rent functions are negatively sloped due to the fact that the cost of transporting both goods and people reduces net benefit per acre as the distance from the center increases. D. Land use conversion can occur whenever the underlying bid rent functions shift. E. The residential development function can shift upwards if there is an increase in urbanization and industrialization of society. F.

The bid rent function for agriculture increases: 1. as domestic population grows. 2. if export markets open for agriculture. 3. as there is a shift from subsistence crops to cash crops for exports. 4. with new planting or harvesting technologies. 5. with lower agricultural transportation costs.

G. The wilderness function shifts upwards if the demand for wilderness-based recreation increases or public knowledge about the many functions wilderness performs increases. H. The allocation of agricultural land between different types of crops is discussed, with reference to the use of corn for producing ethanol. III. Sources of Inefficient Use and Conversion A. Sprawl and Leapfrogging 1. 2. 3. 4.

Sprawl occurs when land uses in a particular area are inefficiently dispersed, rather than efficiently concentrated. Leapfrogging occurs when a new development continues not on the very edge of the current development, but farther out. Dispersed development produces environmental problems resulting from the time and distance spent driving from place to place. The fact that public infrastructure is subsidized by all taxpayers can result in potential buyers finding living farther out to be artificially cheap. This reduced cost of developing farther out increases the likelihood of leapfrogging. Examples of inefficiently low transportation costs are pollution externalities and parking subsidies.

B. Incompatible Land Uses

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1. 2.

• Environmental and Natural Resource Economics, Twelfth Edition

Another source of inefficiency is the existence of interdependence between the neighboring lands. Negative externalities are common in land transactions. Zoning is a traditional remedy for the problem of incompatible land uses. It involves land use restrictions enacted via an ordinance by the local government to create districts or zones that establish permitted and special land uses within those zones. Zoning can eliminate or reduce negative externalities. However, it could promote urban sprawl.

C. Undervaluing Environmental Amenities 1.

2. 3.

Positive externalities, such as environmental amenities, may not accrue exclusively to the landowner. The owner of land that contains vast open spaces, wildlife areas, or wetlands is not likely to consider the value of this resource to other people in society. The land will be undervalued. One possible remedy for positive externalities is direct protection of those assets by regulation or statute. Debate 19.1 discusses compensation for landowners.

D. The Influence of Taxes on Land-Use Conversion 1. 2.

3. 4.

Taxes can affect incentives to convert land from one use to another, even when such conversion would not be efficient. Property taxes in the U.S. are imposed on land and the facilities on the land. Property tax has two components: (1) the tax rate and (2) the tax base. The tax base is determined by the market value or by a professional estimator called an assessor. The property tax system can create a bias against land intensive activities. The inheritance tax can be a significant factor in land conversion since land may have to be sold to pay the taxes.

E. Market Power 1.

4. F.

Market power can frustrate the ability of the market to achieve efficiency by preventing transfers that would increase social value. To capitalize on the opportunity to become a monopolist, the landowner could become a holdout until such time as the public sector paid him monopoly profits for the land. Eminent domain is the main traditional device for controlling the “frustration of public purpose” problem. The government can legally acquire private property for a public purpose by condemnation as long as the landowner is paid “just compensation.” The main differences between an eminent domain condemnation and a market transaction are the following: (1) the transfer under eminent domain is mandatory, and (2) the compensation to the landowner in an eminent domain proceeding is determined by a legal determination of a fair price (not by agreement of both parties). Debate 19.2 considers the issue of what a “public purpose” is.

Special Problems in Developing Countries 1.

2. 3.

In many developing countries land uses may be determined on a first-come, first-served basis. Squatters, the occupiers of the land, do not hold title to the land. The lack of clear property rights can produce efficiency and equity problems. The degradation of the land can dominate sustainable use, simply as a matter of survival. A government failure defines the situation in which public policies have the effect of distorting land use allocation, for example, building roads into previously preserved land, rendering that land suitable for a number of new land uses.

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Chapter 19

A Locationally Fixed, Multipurpose Resource: Land

IV. Innovative Market-Based Policy Remedies A. The establishment of property right systems can mitigate the problem of overexploitation that can occur when land is merely allocated on a first-come, first-served basis. Adequate property right systems can encourage efficient transfers and efficient maintenance of the value of the property, since in both cases the seller would benefit directly. B. Transferable development rights (TDR) are a method for shifting residential development from one portion of a community to another. Local units of government identify sending areas and receiving areas. You can only develop in a receiving area. To develop you must buy rights from those in the sending area. (Example 19.1 gives a New Jersey case study.) C. The Taylor Grazing Act of 1934 attempted to prevent overgrazing by assuring that the amount of grazing was consistent with the carrying capacity of the land. D. A conservation easement is a legal agreement between a landowner and private or public agency that limits use of the land in order to protect its conservation values. 1.

An advantage of the conservation easement is that property taxes will fall (since the assessed value is now lower) and the landowner will either get a substantial income tax break (in the case of a charitable donation of the easement) or the revenue (in the case of a sale of the easement). Easements can also introduce problems: (1) there can be legal costs to enforce compliance with the agreement, and (2) the perpetual nature of conservation easements could become a problem if and when development became the universally preferred use.

E. A conservation land trust is a nonprofit organization that actively works to conserve land using a variety of means. It can purchase land for permanent protection or accept donations of either land or the funds to purchase land. F.

Development impact fees are charges imposed on a developer to offset the additional publicservice cost of new development.

G. Property tax adjustments can be used to ensure land is used in a socially desirable way.

◼ Common Student Difficulties The concept of bid rent functions is crucial in this chapter. It is important to explain why these functions have a negative slope and to carefully analyze the variables that cause them to shift upwards or downwards. Students will find it interesting to analyze the causes of positive and negative externalities in the land value. Some students may have problems understanding how taxes influence land use conservation. Have them think about land use in their local area in terms of competing uses and development.

◼

Suggested Classroom Exercises

Ask your students to identify real life examples where positive or negative externalities have clear consequences in the land value.

Discuss how ecotourism can promote conservation. Introduce the concept of opportunity cost and develop a graph similar to Figure 19.1.

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Tietenberg/Lewis

One useful exercise is to ask students to identify the main problems that developing countries face at the moment in choosing land uses. Real examples will help them to better understand these problems and to apply the concepts introduced in this chapter.

◼

Essay Question

What policy instruments are available to address the problems related to the inefficient use of land? What are the problems of undervaluing environmental amenities? Is it moral to allow the deterioration of land in the case of poor countries?

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Chapter 20 Sustainable Development: Meeting the Challenge Chapter 20 discusses the concept of sustainable development and its usefulness as a guide to the future. Sustainable development - development that meets the needs of the present without compromising the needs of the future – is vague enough in its definition that it appeals to many but may be so vague that it serves no useful purpose. This concept can generate some interesting class discussion, and it allows the students to brainstorm about the direction the economy should take in the future. The second section of the chapter discusses the relationship between trade and the environment. Students often have strong feeling about trade so this could lead to some interesting discussion. The last section of the chapter discusses how to measure economic growth and economic well-being. Students should find some of these measurement issues interesting.

◼ Teaching Objectives 1.

Provide a definition of sustainable development.

Discuss whether the achievement of sustainability is possible.

Discuss efficiency versus sustainability in terms of the compatibility between the two concepts.

Discuss the relationship between international trade and sustainable development.

Discuss the relationship between economic growth and the welfare of the population.

Review traditional measures of economic growth and present several alternative measures that might better measure the welfare of the population.

◼

Outline I. The Basic Elements of Sustainable Development After discussing four different scenarios regarding the achievement of sustainable development, this section discusses efficiency and sustainability, and whether the two concepts are compatible. Some of the discussion is quite abstract and several different articles from the literature are briefly reviewed. One approach is to present the four scenarios, and then review the models learned in previous chapters, making reference to sustainability. If you are going to spend time discussing any

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of the journal articles that are cited from the literature, you might wish to look the articles up and provide more detail to the students. A.

Delegations from 178 countries met in Rio de Janeiro during the first 2 weeks of June 1992 to begin the process of charting a sustainable development course for the future global economy.

According to the World Commission on Environment and Development, which is widely credited with initiating this concept, “Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs”.

Current generations can affect the sustainable welfare levels of future generations both positively and negatively. a. On the positive front we can use our resources to accumulate a larger capital stock, providing future generations with shelter, productivity, and transportation. i. Another positive contribution would come from what economists call human capital—investments in people. ii. Human creativity can endure by serving as a foundation for subsequent new ideas. b. Although current generations can lay the groundwork for a more hospitable future, they can also have the opposite impact. i. Climate change ii. The imperfect storage of radioactive wastes iii. Emissions of gases such as chlorofluorocarbons and hydrochlorofluorocarbons can raise the incidence of skin cancer. iv. The ongoing reduction of genetic diversity in the stock of plants and animals could well jeopardize future biodiversity.

The concept of sustainable development asks us to replace our short-term thinking, which focuses mainly or exclusively on what is good for our generation, with a perspective that also considers how our actions affect the world our children, grandchildren, and great-grandchildren will inhabit.

II. The Sufficiency of Market Allocations in Attaining Just, Sustainable Outcomes A. Market imperfections can promote unsustainable outcomes. 1. Free or open access to resources promotes unsustainable harvesting. 2. Intertemporal externalities result in excessive emissions of greenhouse gases, which imposes costs on the future. B. Restoring or ensuring efficiency will not necessarily lead to sustainability. C. Even when market outcomes benefit current generations at the expense of future generations, the market can, in the right circumstances, limit the damage by promoting innovation that makes substitutes available. a. Falling costs of solar panels, electric vehicles, and electrical storage batteries show that market innovation can increase the speed and reduce the cost of the transition to an electrical system that is based upon renewable resources. b. The flexibility and responsiveness of markets to scarcity can be an important component of the transition to sustainability, but the notion that markets would, if left to their own devices, automatically provide for a sustainable future is a false hope.

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Chapter 20

Sustainable Development: Meeting the Challenge

115

III. The Evolution of the Sustainable Development Concept A. The original concept of sustainable development focused mainly on achieving a just intergenerational allocation of resources. 1. Setting goals to assure that the resource base on which economic activity depends would be sustained, not exhausted, or degraded. 2. Depletable resources can, in fact, be depleted, and supplies of resources that might be crucial for key sectors in the economy are not unlimited. 3. Renewable resources have the distinct advantage that in principle they regenerate, but are not immune from becoming scarce. B. Our planet, on which we all depend, has a limited capacity for life-sustaining services and our economy does not by itself prevent that capacity from being exceeded. A partnership between government and the economy would be essential. C. The United Nations Conference on Environment and Development (UNCED), known popularly as the Earth Summit, was convened in Rio de Janeiro in 1992. 1. Addressed strategies for controlling toxic substances, for controlling climate risks by developing strategies for mitigating GHG emissions, for protecting biodiversity, and for dealing with anticipated shortages of water supplies. 2. It initiated the United Nations Framework Convention on Climate Change (UNFCCC). 3. Signed by 154 states, it laid the groundwork for periodic follow-up meetings of signatory countries known as the UNFCCC Conference of Parties. 4. With respect to protecting biodiversity the Convention on Biological Diversity was opened for signatures at the Earth Summit and received enough signatures to enter into force in 1993. 5. This international treaty was designed to develop cooperative national strategies for the conservation and sustainable use of biological diversity. 6. Issued Agenda 21, a comprehensive plan of action to build a global partnership for sustainable development, seeking to improve human lives while protecting the planetary basis on which development depends. D. In 2000 the United Nations enlarged the concept of sustainable development by establishing the Millennium Development Goals (MDGs), which focused on assuring that ALL citizens, including those in the developing world, would have access to the necessities of life. 1. The MDGs established objectives for tackling extreme poverty and hunger, preventing deadly diseases, and expanding primary education to all children, among other development priorities. E. Finally in 2015 the United Nations General Assembly established a more detailed and comprehensive collection of 17 interlinked global Sustainable Development Goals (SDGs) to “achieve a better and more sustainable future for all.” 1. These were designed to be a set of universal, measurable objectives that could motivate and track progress in meeting the urgent environmental, political, and economic social justice challenges facing the world. IV. The Current Sustainable Development Vision in Practice A.

The climate goal seeks to reduce global greenhouse gas emissions to a net-zero level by 2050.

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1. This would be achieved mainly by decarbonizing the energy sector via a transition from high-carbon, depletable fossil fuels to zero-carbon renewable resources such as solar and wind, with possible complementary roles for hydrogen and nuclear power. 2. This transition would be accompanied by an expanded role for beneficial electrification in transportation (electric vehicles) and heating and cooling (heat pumps), as well as investments in energy efficiency to reduce energy waste. 3. Due to its higher global warming potential, scientists believe that curbing methane emissions would be a priority near-term way to put the planet on a more sustainable temperature trajectory. B.

Focusing future decarbonization efforts primarily on substantially increasing electric generation from renewables like wind and solar presents some related challenges. 1. Beneficial electrification will require more electricity to be generated and transmitted in the future, while maintaining system reliability. 2. Further, electric utilities must provide reliable power whenever and wherever it is needed by their customers. 3. Unlike fossil fuel plants, which can normally generate power as needed, solar and wind plants run only intermittently. 4. Solar farms produce no power at night, little on cloudy days, and less during the winter than the summer. 5. Wind generators produce power only when the wind is blowing. 6. Studies that compare the demand for electric power over time with the amount supplied by solar and wind would reveal a gap of unfulfilled power needs during those times when wind and solar are not producing enough to meet demand. 7. Therefore, enabling wind and solar to be the foundation of the future electrical power system requires some means to seamlessly fill the power gap when the renewables are not producing. 8. The two main current contenders are battery storage and nuclear. i. Battery storage works by drawing and storing power from the grid at those times when current electricity generation exceeds demand and supplying it to the grid when demand would otherwise exceed supply. ii. Nuclear is an alternative generation source that does not produce any carbon emissions. iii. Establishing the proper role for nuclear, however, is controversial. (Debate 20.1)

In 2021 an influential and comprehensive document (Dasgupta, 2021) argued that to close a significant gap between what we may demand from nature in the future and what it can supply to us, we must recognize that humanity is embedded in nature, not external to it. 1. The implication that flows from that insight is that more attention and resources must be focused on protecting, enhancing, and maintaining the ecosystems on which we depend. 2. Major renewable food sources such as fisheries and agriculture can be degraded and/or depleted if not managed carefully and can be limited by climate change as it intensifies droughts, floods, temperatures to inhospitable levels, and fires. 3. Economic forces are powerful, and we have seen how they can either promote sustainability or degrade it, depending on the circumstances.

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4. Fortunately, well-designed policies can help to align those forces, when necessary, thereby facilitating the outcomes we seek. D.

A useful complementary framing vision, known as The Circular Economy, is still evolving, but is playing an increasing role, especially in Europe. 1. Seeks to replace the old linear production cycle of make–use–discard with a more restorative and regenerative circular design for the economy. 2. Some examples of key components offer suggestive pathways for affecting both supply and demand. i. Examples involve reducing the demand for natural resources by limiting or eliminating waste in the production and use of new products, as well as by increasing the useful life of products so they have to be replaced less often. ii. Others involve designing products so that when they reach the end of their useful life, they can easily become inputs in the production of new products rather than waste, thus completing the circle. iii. Food supply can be enhanced by encouraging regenerative agriculture practices that retain, rather than deplete, valuable natural nutrients in the soil.

Both intergenerational and intragenerational justice must be a part of not only generational outcomes, but the processes to reach them as well. 1. A just process would assure meaningful involvement of all people regardless of race, color, national origin, or income, with respect to the development, implementation, and enforcement of sustainability laws, regulations, and policies. 2. Sustainable development should also produce fair outcomes for all with respect to the consequences from the implementation and enforcement of sustainability laws, regulations, and policies.

V. The Evolution of Sustainable Development Metrics A. Modifying Conventional Income Measures 1. A true measure of development focuses on welfare measures—those that attempt to answer the question of whether or not we are better off. 2. Conventional measures are measures of output, which tell us how many goods and services have been produced, but do not tell us how well off we are. GDP was never intended to be a welfare measure, but it is a readily available statistic calculated by most countries. 3. Gross domestic product (GDP) is the most commonly used measure of output. GDP is the sum of the output of goods and services produced in any year by an economy (or country). Prices weigh the relative importance of goods and services in GDP. GDP can be thought of as the sum of the value added at each stage of production. 4. Net domestic product (NDP) is gross domestic product minus depreciation of the capital stock. GDP includes the value of newly purchased capital that is simply replacing worn out capital. Replacing worn out capital does not enlarge the capital stock. 5. Constant-dollar GDP and constant-dollar NDP adjust GDP and NDP for the effect of general increases in the price level. 6. Not all components of GDP contribute equally to welfare. The consumption component is arguably the most important for measuring welfare. Real consumption per capita is the best readily available welfare-oriented output measure.

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None of these measures account for depreciation in natural capital. While net domestic product accounts for depreciation in man-made capital, it does not account for depreciation of the natural capital. Natural capital includes soil, forests, oil and mineral resources, water, wildlife, etc. 8. Hicksian income is defined as “the maximum value a man can consume in a week and still be as well off at the end of the week as he was at the beginning.” University endowments are used as an analogy. You can use the proceeds of the endowment but are not expected to touch the principal. 9. Since the GDP measure does not account for the depreciation of natural capital, economic growth can occur at the expense of the environment. Drawing down oil reserves will result in an increase in income. An oil spill that ruins a coast will result in an increase in income because money will be spent to clean it up. 10. The impact of an adjustment for natural capital would be the largest for the developing world whose endowment of capital is primarily in the form of natural capital. 11. A number of industrialized countries have set up a system of adjusted accounts. Whether or not a complete revision of the standard accounts will take place is the subject of some controversy. B. Donut Economics 1. In economist Kate Raworth’s book Donut Economics: 7 Ways to Think Like a 21st Century Economist she presents this visualization, which has three main components: (1) a safe and just place in the middle, shaped like a donut; (Figure 20.1) (2) the outer edge of the donut depicts the ecological ceiling, with nine categories of possible exceedances of the ceiling; and (3) the inside edge of the donut depicts possible shortfalls in meeting 12 social foundations that identify the basic rights and services that all of humanity should have. a. The sustainable development goal is achieved when all the world’s people attain their place in the donut “safe and just space” with no violations either of the planetary boundary or the social foundations boundary. b. The categories that make up the 12 social foundations are based upon the 19 internationally agreed-upon United Nations SDGs. a. Represent the basic human rights and quality of life that it was felt all humans in the sustainable society should enjoy. c. The actual metrics used to measure the current status of efforts to provide these basic human rights and services are commonly the percentage of the population that has yet to meet the goals. a. The deadline for meeting the 12 social foundation goals is 2030.5 b. Annual progress on the SDGs is monitored by the United Nations, and the reports are posted on the web, making this aspect of the donut metric relatively easy to track. c. The Donut Economic categories that make up the planetary boundaries came from an international team of scientists. 1. Used scientific evidence to propose nine specific categories of planetary boundaries that could be violated by human perturbations: climate change, ocean acidification, chemical pollution, nitrogen and phosphorus loading, freshwater withdrawals, land conversion, biodiversity loss, air pollution, and ozone layer depletion.

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2. For seven of the categories the study also proposes thresholds below which the risk of destabilization is likely to remain low enough to provide a “safe operating space” for global development, but other two categories (air pollution and chemical pollution) no safe levels of perturbation were yet determined. d. Figure 20.2 shows the donut economics graph when these progress measurements are applied. a. Each planetary ceiling category experiencing overshooting is depicted by a bar radiating out from the outer edge of that planetary ceiling category. b. Shortcomings in meeting the social foundation goals are depicted by an area radiating toward the center from the inner boundary of the donut. c. Success would be depicted as the absence of any violations of either boundary; the unencumbered donut would depict a situation in which the basic needs of all planetary inhabitants would be met without violating any planetary boundaries 6. The donut economics concept not only identifies specific challenges the development process faces in achieving a just and safe outcome, but it also provides the basis for a “one-glance” visual depiction of where we stand in terms of achievement of the internationally established goals. a. By identifying both where current actions have fallen short and the degree of the shortfall, it provides a more comprehensive and inclusive guidance for directing future efforts in a way that previous metrics could not. b. Raworth suggests that everyone should become a growth agnostic. i. Growth can be helpful or harmful to the achievement of the goals. ii. The key is to focus rather on creating an economy that is regenerative and fair, letting economic growth’s role be defined by how well it helps to achieve that goal. VI. Meeting the Challenges A. The economic evidence is clear that in the absence of action to mitigate the emissions of greenhouse gases, the increasing damages resulting from climate change will make future societies collectively worse off. B. Markets are not only good at providing innovation, but they are also good at achieving the necessary change cost-effectively. 1. Market-induced innovation has already helped by substantially lowering the costs of renewable energy sources like solar, wind, and energy storage. 2. However, due to market imperfections such as fuel-choice externalities (where carbon damages are understated in fuel choices) and free-rider effects associated with research and development choices (where innovators receive only a portion of the benefits they create), by themselves markets are not likely to result in both sufficient emissions reductions and sufficient research and development investment by the time they are needed. C. Governments can play a major role by correcting these imperfections, either by filling in the gaps or by redirecting the incentives. 1. Can also help by incentivizing early adoptions by the pioneers to move the markets to scale more quickly and by assisting in financing where necessary to assure that affordability constraints don’t inhibit fair treatment. 2. Economics can facilitate the partnership by providing insights on the likely consequences of various policy strategies that might be considered by it.

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D. Enacting optimal policies requires specific government actions, including setting the right price on carbon. 1. Economics can help to identify the required prices, but enacting legislation that produces the right prices is up to the government. 2. Carbon pricing is spreading to new geographic areas and being applied to new types of applications (Example 20.1). E. The global aggregate emissions reductions achieved or pledged by governments are not yet sufficient to meet the established climate goals in terms of the amount of emission reductions or their timing. 1. The current array of implemented carbon prices is too low to generate the necessary emissions reductions in time. 2. Existing policies are not comprehensive enough in terms of the scope of their coverage, both geographically and across economic sectors. 3. While basic economic principles and empirical studies can establish what the optimal price paths and coverage should be, that is little comfort if governments prove politically incapable of putting those components into effect. F. Economic research may even be able to help to build the political will to enact the necessary actions. 1. Studies have made clear, for example, that mitigating greenhouse gas emissions helps to achieve multiple planetary boundary goals, not merely the climate goal. 2. Reducing the burning of fossil fuels simultaneously reduces several associated pollutants that lead to early death, heart attacks, respiratory disorders, stroke, and the exacerbation of asthma, among others. 3. These climate action co-benefits increase the net benefits from the transition away from fossil fuels without requiring additional air pollution control policies that would increase the costs. 4. Note that since these pollutant concentrations are reduced in the areas where the emissions are reduced (not globally), they are not subject to free-rider barriers to political action. 5. The more carbon emissions an area reduces, the more health co-benefits the residents of that area receive. G. Additionally, carbon pricing programs can be designed to respond to unexpected outcomes as time passes, a characteristic that is rare among emissions mitigation strategies. 1. If the emissions reductions fall below expectations, automatic price adjustment mechanisms would be triggered by these circumstances. Waiting for additional enabling legislation would not be necessary. H. Finally, delay in action raises the ultimate cost and exposes younger generations to much higher risks. I. Partnerships can also play a role in managing planetary overshoot risks in addition to climate change. 1. In protecting biodiversity, for example, market-based policy instruments are increasingly being enlisted to allow the commonly understated social benefits of biodiversity to get their due. i. By placing an additional cost on the use of the natural resource or the emission of a pollutant, to reflect the negative environmental externalities that they generate, they provide incentives for both producers and consumers to behave in a more environmentally sustainable way.

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J. Public discussions have focused on the importance of a partnership of the market and “the government,” but climate change is a global problem requiring international cooperation. Freerider problems hinder the creation and durability of the requisite international agreements. 1. The intragenerational sustainability dimension envisions a transition that is fair to all within each generation as well as among generations. K. As one of its monitoring steps, the UN calculates an SDG index for each country for which adequate data are available. 1. The first step is to produce a score for each of its goals, using the arithmetic mean of indicators associated with that goal. 2. These goal scores are then averaged across all 17 SDGs to obtain the country’s SDG Index score. 3. The score can be interpreted as a percentage of SDG achievement by that country. 4. In its Sustainable Development Report 2021: The Decade of Action for the Sustainable Development Goals the U.N. had enough data to calculate index scores for 165 countries. For those 165 countries the scores ranged from a high of 85.90 (Finland) to a low of 38.25 (Central African Republic). i. The highest scores were achieved in European countries and the lowest in Africa. 5. Africa has emerged as the continent that would face the most difficulties in reaching its goals and be the most helped by the SDGs being globally achieved. i. For that reason, it has become the focus of additional attention. The 2020 Africa SDG Index and Dashboards Report provides some context for that focus. ii. Nine out of ten extremely poor people in the world are found in Africa. iii. The consequences of COVID-19 have posed additional challenges for achieving SDG 1 (end poverty) in Africa by 2030. iv. Evidence indicated that 135 million people globally were found to be food insecure in 2020 with the majority, about 73 million, living in Africa. v. Inadequate basic services and access to clean water have been a great challenge for the continent. vi. In Sub-Saharan Africa, about 63 percent of people have difficulties in accessing basic water services. vii. Extreme inequality persists within African countries and cities as well as between countries. viii. Evidence from African countries shows that children in the poorest quintile of the population are up to three times more likely to die before their fifth birthday than children in the richest quintiles. L. In 2019 the International Monetary Fund (IMF) estimated that the low-income developing countries (LIDCs) would have to increase their SDG outlays by roughly 12 percent of GDP to achieve the 2030 targets. 1. LIDCs are a group of 59 IMF member countries with income per capita below a threshold level. 2. LIDCs contain one-fifth of the world’s population—1.5 billion people—but account for only 4 percent of global output. 3. This required level of incremental spending was estimated to be beyond the means of these countries, leading to an SDG financing gap on the order of $300 to $500 billion per year. M. The 2022 Financing for Sustainable Development Report: Bridging the Finance Divide finds that while rich countries were able to support their pandemic recovery with record sums borrowed at

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ultra-low interest rates, the poorest countries spent billions servicing their debt, money that could have supported investments in sustainable development. 1. The pandemic shock plunged 77 million more people into extreme poverty in 2021, and by the end of the year many economies remained below pre-2019 levels. i. During this period the LIDCs fell even further behind. 2. The negative effects from extreme poverty and the loss of basic empowering services such as health care, adequate nutrition, and education can even have intergenerational consequences. N. Several funding measures have been launched to address climate issues, including the UN’s Green Climate Fund and Adaptation Fund. 1. The Green Climate Fund, established under the framework of the UNFCCC, aims to assist developing countries in investing in low-emission and climate-resilient development. 2. The Adaptation Fund supports financing projects and programs to help developing countries become more resilient to reduce the impacts of climate change that no longer can be avoided. O. Another method for easing the transition for lower-income households involves the use of progressive pricing and tax structures. 1. Pricing water to households via an increasing block system is a common example. 2. Financing just transitions at least partially from taxation is usually much more progressive than asking each project to be completely self-financed or completely locally financed. 3. Government financing can also provide economic incentives to help low-income households make their homes more energy-efficient. 4. The up-front costs of some investment options can preclude lower-income households from investing due to their lack of access to the necessary loans. Since some governments already provide public funds to help low-income households pay for high heating costs in colder climates, investing in sealing energy leaks is frequently a cheaper way over the long run to help these households. 5. Investments that achieve financial sustainability by providing the services needed to correct the problem (health, education, sanitation) can have a longer and deeper impact than simply helping to finance the resulting consequences of underinvestment in these services (sickness, skill deficits, etc.) year after year. P. Other opportunities for government financial support involve helping displaced workers and the communities that are hard hit by the transition. 1. In the United States some states, such as Wyoming, North Dakota, Alaska, New Mexico, and West Virginia, are heavily dependent on fossil fuel-related revenues to support public services. 2. Using stylized scenarios of future energy use, one study estimates that through 2050, nationwide revenues in these communities decline 16, 50, and 80 percent respectively under business-as-usual, 2ºC temperature target, and 1.5ºC temperature target scenarios. i. Although more jobs are expected to be created during the energy transition, the new jobs will generally match neither the geographic location of displaced workers nor the existing skills they offer. ii. Grants can help to support workers by helping them develop necessary skills for the job market of the future. 3. In Virginia, West Virginia, and Pennsylvania some abandoned U.S. coal mines are being transformed into solar farms, but that is not the norm.

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4. The European Union has created a “Just Transition Fund” that will focus on the European regions and sectors that are most affected by the transition due to their dependence on fossil fuels. i. Support provided through the Just Transition Fund is focused on the economic diversification of the territories most affected by the climate transition as well as on the reskilling and active inclusion of their workers and jobseekers. 5. New kinds of financial institutions are also being developed to increase the flow of capital investments into green activities. i. Green banks have been established specifically to facilitate the flow of investment capital into low-carbon, climate-resilient infrastructure, as well as into other green sectors such as water and waste. 6. In some cases, sustainable development presents new business opportunities arising from new technologies. i. Rural parts of the world have previously not had access to electricity because extending the grid to these areas would not have been economically viable, but with the transition to renewables, however, access to electricity in these communities is now not only possible but spreading. ii. In developing countries, bank branches and fixed-line telecommunications are scarce, whereas mobile phones are plentiful. 1. Typically, low-income users buy airtime by the minute. Due to its liquidity, airtime became a form of “mobile money.” 2. Cash can be used to purchase minutes, and unused minutes can then be converted back into money. 3. Mobile phone entrepreneurs then simplified the process by skipping the airtime connection aspect of these transactions and they began directly selling fungible credits that customers could use as financial accounts. iii. The economic impact of making these low-cost financial services available is significant. (Example 20.2) Q. The Evolving Roles of Technology, the Business Community, and NGOs 1. A worldwide system of NGOs are also playing a complementary role in assuring a just form of sustainable development can be achieved. i. Many of these, including GiveDirectly, are funded by private donations from individuals or foundations who care. ii. According to the Worldwide NGO Directory some 449 NGOs are operating in southern Africa, with 157 of those focusing on education. R. Efforts designed to enhance the effectiveness of the complementary roles of governments, markets, businesses, and nongovernmental organizations are under way. 1. Specific sustainable development strategies that would offer pathways for meeting both the intergenerational and intragenerational components of sustainable development have been created and are evolving as new experience is gained. 2. These strategies in turn are driving the emergence of complementary new technologies that are facilitating the transition by lowering costs, expanding the array of options, and hastening the transition to scale. 3. New organizations are springing up to help with any remaining gaps that emerge.

◼ Common Student Difficulties

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The section of the chapter on sustainability is difficult, because it covers a lot of abstract material, and many of the programs instituted are yet to have clear results. While many of the terms should be familiar at this point, the breadth of topics and the complicated nature of the subject could possibly seem daunting to your students. However, many of the examples refer to topics in other chapters, making it a nice summary. Some proposals for sustainability are outlined. These may be controversial and worthy of class discussion. Students have by this time learned enough to be able to start to integrate the material from previous chapters and seriously discuss strategies for achieving growth and sustainability. If your students have not had macroeconomics recently you may wish to take some time and review GDP.

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Suggested Classroom Exercises

Put the students in groups and have them brainstorm about the policies that should be adopted to achieve sustainable growth. Have them integrate material from past chapters. Have them share their thoughts with the class.

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Essay Question

How well does GDP measure economic wellbeing? Should traditional GDP measures be abandoned for an alternative measure? If so, how would you determine which measure is most appropriate? What are the pros and cons of such a change?

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