I. Liability Law

• An example of how the Coase Theorem applies to environmental policy is liability law.
• If a firm will be held liable for the damages from its pollution, it has incentive to avoid pollution when the marginal abatement cost is less than the marginal damage.
• By avoiding damage, the firm lowers its liability.
• Note that the government does not need to know the marginal costs of the firm in order to achieve the desired level of pollution.
• Complications
• The burden of proof may be difficult in court.
• Need to know both who causes the harm and what the damages are.
• Will courts be willing to hold polluters liable for damages that they cannot pay?
• Litigation is costly.

II.    Command and Control (CAC) Regulation

• Command and control regulation uses the setting of standards.
• A standard is a mandated level of performance that is enforced in law.
• A standard simply makes excessive amounts of pollution illegal.
• In principle, the government can set the standard to yield the efficient level of pollution control.

III. Types of Standards

• Ambient Standards
• Regulates the amount of pollutant present in the surrounding (ambient) environment.
• Examples:
• Parts per million (ppm) of dissolved oxygen in a river
• Sulfur dioxide (SO2) in an airshed
• Ground level ozone levels (ppm)
• Measures are often an average (e.g. over a 24 hour period, or per year)
• This is important, as concentrations vary by time of day and by season (e.g. due to changes in weather)
• Note that the level itself cannot be directly enforced.
• Rather, the sources of the pollution must be found and regulated to be sure that the ambient standard is met.
• A good example is the U.S. Clean Air Act.
• The federal government sets ambient standards for six criteria pollutants in a region.
• If a region is in violation, they must come up with a plan to attain compliance.
• Emission standards
• Regulates the level of emissions allowed
• Examples
• Emissions rates (pounds of SO2 per hour)
• Concentration (ppm of biochemical oxygen demand (BOD) in wastewater)
• Total quantity of a pollutant
• Residuals per unit of output (SO2 per kWh of electricity)
• Residual content per unit of output (sulfur content of coal)
• Percentage removal of pollutant (90% of SO2 scrubbed)
• Note that emissions standards do not guarantee a specific ambient level of pollution
• Weather conditions affect the concentrations
• Human behavior affects pollution levels
• Technology standards
• Require polluters to use certain technologies, practices, or techniques.
• Whereas emissions standards require polluters to meet a goal for the level of pollution, but give the polluter freedom to choose the technology used, technology standards require a specific technology.
• Examples
• Until 1990, electric utilities were required to install scrubbers with 90% efficiency ratings.
• U.S. requires catalytic converters in autos
• The 1972 Water Pollution Control Act Amendments set a goal of zero discharges by 1985.
• Used technology based effluent standards (TBES)
• EPA determines the “best practicable technology” and sets standards assuming that firms are using that standard.
• For enforcement, polluters must have a discharge permit issued by an EPA-backed state permitting program.
• Often, as in the Clean Air Act, the government mandates that the Best Available Control Technology (BACT) be used.
• However, BACT is often not clearly defined.

IV.  Economic Analysis of Standards

• Setting the standard
• The first question, of course, is deciding at what level to set the standard.
• Efficiency calls for setting the standard where MAC = MD
• In practice, it is difficult for the regulator to know MAC and MD
• Alternative guides to setting regulation:
• Zero-risk
• Requires protecting everyone, no matter how sensitive, from damage.
• Appropriate for cases in which there is a threshold.
• Allow “reasonably small” damages
• Raises the question of how to decide what is reasonable.
• Should abatement costs be considered?
• The recent Supreme Court case (American Trucking Company v. Browner) raises this question.
• Should standards be applied uniformly?
• Federal standards apply throughout the U.S.  Is it appropriate to have uniform standards across regions?
• Are the needs of rural and urban areas similar?
• If marginal damages differ across regions, a uniform standard cannot be efficient in both jurisdictions.
• However, having different standards increases costs to the government.
• Note in this case the issue is variation in the marginal damage function.
• Should standards be the same across firms?
• Efficiency is achieved when MAC is equal across firms, which won’t happen with uniform standards unless the MAC curves are the same.
• By efficiency, we mean that any given abatement level is achieved at the lowest cost possible.

• Vintage differentiated regulation can help address differences in MAC from command and control.  However, it raises additional issues, particularly with dynamic investment decisions.

  • With vintage differentiated regulation (VDR), standards depend on the entry date of each unit.

    • Newer units face more restrictive regulations.

    • Older units are often exempt (“grandfathering”)

  • Examples

    • Clean Air Act New Source Review

    • Emissions standards for automobiles

    • Clean Water Act effluent limits for water treatment plants

  • Why use VDR?

    • Efficiency

      • Costs are lower for newer units

      • Relates to equimarginal principle

        • Holding all plants to the same standard is not cost effective

        • In principle, CAC could mimic an efficient standard if each plant’s regulations varied depending on MAC.

        • However, this is hard to observe.

        • If MAC correlates with vintage, using vintage (which is easily observed) to differentiate regulations makes CAC more efficient.
    • Equity
      • Rules aren't changed in midstream
    • Politics
      • Easier to pass regulations if don't harm existing firms
      • Potential for economic rent for existing firms if VDR makes entry into the market harder.

  • Effect on investment

    • Firms invest if NPV of benefits (net of O&M costs) > cost of investment

      • VDR makes investment more costly

        • Both initial costs and O&M costs higher

      • As a result, investment falls, and capital is kept longer

      • In extreme cases, VDR could lead to more emissions in the short run, as older, less efficient equipment is kept longer than before.

    • Note that market structure matters

      • The effects will be largest in competitive markets.

      • Plants facing rate of return regulation find it easier to pass costs on to customers.

        • For example, studying the effect of NOX trading markets, Fowlie (2007) finds that plants in deregulated markets are less likely to invest in capital intensive equipment.

  • Evidence: Automobiles

    • VDR for automobiles:

      • Emission standards

      • Safety standards

      • Fuel economy regulations

    • Note that retrofitting older vehicles would be very expensive and hard to enforce.  Thus VDR makes sense for automobiles.

    • Evidence from 1981 emissions standards increase

      • Using price elasticities and estimates of cost increases from new emission standards, Gruenspecht found that VDR led to a 2-4% decrease in sales in the first 5 years after new standards

      • Effect on emissions

        • CO emissions up 1%/year for first 4 years

        • HC emissions up 2%/year for first 5 years

        • NOX emissions fell immediately

      • Note that, by 1990, CO emissions down 5.3%, and HC emissions down 16%

    • Alternatives:

      • Pay people to scrap old vehicles.  Greunspecht suggests a $250 bounty for scrapping cars more than 15 years old.

      • Gas taxes instead of fuel economy standards

  • Evidence: New Source Review

    • New Source Review (NSR) is part of the Clean Air Act

      • Regulations apply only to new sources

      • However, existing sources that make major modifications must also comply.

    • Several studies find that NSR lowers investment, thus extending the life of power plants.

    • NSR can also raise the cost of operating newer plants.

      •  As a result, newer plants may be idled first.

      • Stanton (1993) found that plants with weaker regulations were used more intensely. 

    • NSR can discourage investment at older plants.

      • However, Wolfram and Bushnell (2008) find that this effect is small.

      • They find that NSR reduces capital expenditures at existing plants, but they find no change in operating costs, fuel efficiency, or emissions.

• Incentive to do innovation
• Command and control provides little incentive to innovate
• There are incentives to avoid the costs of regulation.  However, there are no incentives to exceed the level of regulation.
• For example, even after costs are lower, firms have no need to control more pollution.  Additional regulation would be needed.
• Enforcement
(We didn't get to this in class, but I've put this here for completeness.  The details are covered in the text.)
• In the U.S., self-monitoring is often used.
• Firms keep their own records on emissions, and are subject to surprise audits.
• Even when regulations are set at the federal level, enforcement is often left to local governments.
• For example, water discharge permits are given out by state agencies with EPA backing.
• Enforceability helps determine which types of standards are appropriate.
• For non-point sources, technology standards (e.g. requiring or prohibiting certain methods) is easier to enforce than direct monitoring of emissions.