This week we discuss an application of externalities that is widely debated currently: climate policy.

The goal is to review the main economic-instruments that can be used to internalize this externality,
and to briefly review the main applied issues in doing so. If you find any inaccuracies in the
assignment, please let me know (h.vrijburg@law.leidenuniv.nl). Answers will be provided during the
lecture.

Topic 1 – Measuring the externality

Figure 1 below describes both the marginal abatement costs (MAC) and the marginal social benefit
(MSB) of emission reduction. The current emissions are given by e0. Section 5.5.2 in chapter 5 of the
Mirrlees Review discusses the desired level of Carbon Taxation, Figure 1 is an abstract representation
of this discussion. Please answer the following questions.

1. Explain the two approaches that can be taken to infer the “optimal” Carbon-price

Answer: Given an abatement cost curve, one can either try to measure the marginal damage curve,
or try to set a clear target directly.

1) Marginal damage curve (p. 452): “build up a picture of the economic costs of climate change”
• Regional changes in agricultural productivity
• Raising sealevels will make it more costly to life in certain areas (for example the Hague)
• Assigning values to unpredictable catastrophes, including the value of human lives lost
• Taking into account that these benefits occur in the future, so intergenerational altruism is
involved.

Then use the abatement cost curve to compute the desired equilibrium. A wide range of esitmates
result.

2) Stern Review of the Economics of Climate Change (Stern, 2006).

• Assessment of the target that should be adopted to stabilize the CO2-concentration:
maximum 550 part per million carbon dioxide equivalent.
• Given this goal, the Stern review analyzes which price per Carbon is needed to reach this goal
 using the estimated abatement cost curve.

So: the goal in emission levels is the implicit estimate of the marginal damage curve.

The relationship with figure 1 is insightfull. The marginal abatement curve is known in both cases.
However, estimating the marginal damage curve is very difficult. Many complexities play a role. From
todays perspective we get an impression of today’s valuation of climate change, still we have to
translate this into a valuation in the future to find the marginal value that society wants to pay for
emission abatement.

The other solution is to hypothesize that in the end we want small changes in climate only, implying a
certain emission reduction goal based on our current models. The goal then is an implicit
measurement of the marginal damage curve.

The difference in approaches becomes relevant for applied policy when one wants to prevent to
stimulate firms and civilians now to invest in very expensive emission abatement equipment. The
trick is then to compute a lower bound for the price needed to prevent a deemed problematic
change in temperatures.

2. What is the range of “optimal” CO2-prices suggested in the literature?

Answer: 0.3 – 0.7 dollar per ton CO2. (0.82 – 1.64 pound, Pearce) till 30 dollar per ton CO2 (Stern).

The current social cost of carbon is estimated at 300 doller per ton CO2

In addition some more general questions on valuing environmental damage

3. Outline and discuss some of the limitations of the contingent valuation methodology.
[Question 1, Chapter 10, Nas]

Answer: (p. 109 Nas). The contingent valuation method is used when actual observations of
individuals are absent. The researcher uses surveys to study the willingness-to-pay and willingness-
to-accept of certain policy outcomes. Limitations: respondents understate their true preference
when asked for their willingness-to-pay (maybe for strategic reasons). In addition, outliers and the
embedding effect might be observed if individuals do not understand the question posted, or
reluctance to respond if respondents fear some consequences. Another important criticism is that
the responses are hypothetical (chapter 15).

4. What are the advantages of the discrete choice experiment method over the contingent
valuation method? [Question 2, Chapter 10, Nas]

Answer: the options are now not open ended anymore. Respondents have to choose. The researcher
can model and restrain the answers more, such that those can be better interpreted.
 5. Can the contingent valuation method be used to elicit information on nonuse values? Use an
example to discuss some of the issues with regard to the appropriateness of these values.
[Question 3, Chapter 10, Nas]

Answer: nonuse value is the value assigned to certain goods that are not explicitly consumed by the
actor, but that could be enjoyed in the future, or some goods that the actor enjoys indirect utility
from simply due to their existence. Such as endangered species.

The contingent valuation method can be used to measure a nonuse value: the actor can reveal a
valuation.

See for example chapter 15 the discussion on measuring the existence value of the striped shiner in
Wisconsin. The researchers wondered whether the citizens of Wisconsin really felt 12 million poorer
due to the striped shiner disappearing. That is: does the willingness-to-pay reflect a true loss in
utility?

Revealed Preference methods do not estimate the nonuse value, as the methods only focus on the
revealed valuation of goods that are used. The stated preference methods do value the nonuse part,
but do so with considerable noise.

6. Outline and discuss some of the suggested methods for placing a value on human life. Is it
possible to apply the Pareto principle to set a value on one’s own life? Discuss. [Question 4,
Chapter 10, Nas]

Answer, see p. 112, Nas.

One can compute the productivity loss, so computing the loss in lifetime earnings. But this misses out
on the valuation of the life of the person next to his or her productivity.

“Mishan (1971) defines the value of life by referring to the the Pareto principle. Accordingly, the
worth of an individual’s life is viewed as the minimum sum of compensation necessary to offset the
individual’s involuntary exposure to an increased probability of death.” According to Mishan this is
the only sensible way to look at the issue. Note that the probability of death is stressed, not certain
death.

To measure the valuation of an increased probability of death one can use revealed preference
methods where people have been observed making choices over varying degrees of risk of death.

7. What does the concept of a statistical life mean? [Question 5, Chapter 10, Nas]

Answer: This captures the willingness-to-accept a larger probability of dying. It is distinctly different
from a certain death. It just reflects a risk-money tradeoff.

Topic 2 – Taxes versus Permits

[Question 17, Gruber (2013)] Firm A and B each produce 80 units of pollution. The federal
government wants to reduce pollution levels. The marginal cost associated with pollution reduction
are MCa = 50 +3Qa for firm A and MCb = 20 + 6Qb for firm B, where Qa and Qb are the quantities of
pollution reduced by each firm. Society’s marginal benefit from pollution reduction is given by MB =
590 – 3Qt where Qt is the total reduction in pollution.

1. What is the socially optimal level of each firm’s pollution reduction?

2. How much total pollution is there in the social optimum?

3. Explain why it is inefficient to give each firm an equal number of pollution permits (f they are
not allowed to trade them).

4. Explain how the social optimum can be achieved if firms are given equal numbers of
pollution permits but are allowed to trade them. [relate your answer to the equimarginal
rule]

5. Can the social optimum be achieved using a tax on pollution?

[Field and Field, chapter 12] Opponents of emission charge policies sometimes assert that they are
simply a way of letting firms buy the right to pollute.

6. Is the efficient solution fair? [Tip: think about who in the end feels the cost of buying
emission charges in their purchasing power]

Answer: This is indeed exactly what emission charges and permits do. By making firms pay a price,
they feel the cost of using a normally “unpriced” input, giving them incentives to reduce the use of
this input. So, this is an advantage of the policy instrument, not a drawback.

Instead of being critical about the policy instrument itself, these opponents might be “elasticity
pessimists,” referring to the slope of the abatement cost curve. When the abatement cost curve is
steep, putting a price on pollution will yield only a small reduction in pollution. But is it socially
desirable to press for larger reductions..?
Topic 3 – Uncertainty and instrument choice

As both Hepburn and chapter 5 of the Mirrlees Review indicate, climate policies have to be
formulated within a large degree of uncertainty. The implications of uncertainty for policy setting are
therefore an important topic to discuss. The exact shape of the marginal social cost (or marginal
damage) and abatement cost curves is often not known.

We assume that the government is uncertain about the Marginal Abatement Cost (MAC) curve. The
government and industry lobbyists agree that marginal abatement costs will most likely be a linear
function of the quantity of pollution reduced (Q). However, industry lobbyists believe the abatement
cost curve to be twice as steep as government officials. So, MAC1 = Q (government’s estimate) and
MAC2 = 2Q (industry’s estimate). The social valuation of pollution reduction is given by the marginal
damage (MD) curve, MD = 200 – 5Q.

1. Which curve (MAC or MD) describes firm behavior?

Answer: the MAC curve. It describes the costs of abatement for the firm, and therefore
allows the firm to compare between the costs of the policy and the abatement.

2. The government wants to base its policy on MAC1, draw the MAC and MD-curves, and
indicate the efficient abatement level and the marginal abatement cost in equilibrium if
the governments assessment of the abatement costs is correct.

Answer: see the slides.

3. However, the lobbyists caused some doubt in the minds of the policymakers. Suppose
the Lobbyists are right, what would be the efficient abatement level and the associated
marginal abatement costs? Explain the difference.

Answer: see the slides.

4. The government wonders whether a tax or a cap-and-trade program (CAP) is the best
policy instrument given these circumstances. What do you think?

Answer: the cap-and-trade program is the best policy in this case. In case the lobbyists are
right, either policy will cause a welfare loss. We can draw the welfare loss caused by both
policies in this case, as a triangle in the figure (see the slides). The triangle for the cap-and-
trade program is in this case the smallest.

5. Without drawing: consider a marginal damage curve that is flat. Can you give an example
of damages that might follow such a pattern? What would now be the best policy?
Explain.

Answer: if the marginal damage curve becomes flat, this implies that irrespective of the
number of emissions reduced, the marginal damage is relatively constant. The optimal tax
will therefore not vary much depending on the assumed MAC curve. The tax is therefore
more attractive with a flat marginal damage curve.
 6. Without drawing: what happens in the opposite case when the marginal damage curve is
very steep. What is intuitively the best policy instrument?

Answer: this is the opposite case. Now some extra emissions will cause a relative stark
increase in the marginal damage. This implies that additional emissions are potentially very
painfull for society. The quantity becomes more important, and it is harder to predict which
value should be attached to the tax. So: a cap-and-trade system works better.

Topic 4 – Applied Climate Policy

1. Define the main features of the EU ETS and explain what might happen when the
Netherlands introduces a carbon-tax of 50 euro’s upon all carbon emissions.

Answer: see the slides. The EU ETS is a EU wide cap-and-trade system for CO2-permits. Under the EU
ETS each year CO2-permits are handed out (either sold or grandfathered). These permits can be
saved and used later in time by firms. The number of permits handed out decreases over time until it
reaches zero around 2057. A market stability reserve has recently been introduced to stabilize and
increase the permit price.

2. Various policy proposals have been suggested in the Netherlands to achieve a 49 % reduction
in CO2-emissions in 2030 relative to 1990. One of the proposals is to reduce the emissions of
industry through a combination of industry specific plans, fines and subsidies (see details
below). How does this policy proposal compare to the incentives that follow from taxes and
pollution-permits?

A (simplified) summary of the proposal:

• Each firm proposes a set of abatement options in a firms specific CO2-reduction plan
that has to be submitted to government.
• Government evaluates and adjusts the firm-specific plans such that the aggregate
plans achieve the CO2-reduction target set for industry. This yields a firm-specific
CO2-reduction schedule for the period 2020-2030.
• Firms can receive a subsidy for the abatement options that they mention in their
firm-specific plans.
• If firms do not follow the imposed firm-specific CO2-reducion schedule, they are
fined.

Answer: will be discussed next week.

3. We skipped the text concerning revenue implications in the Mirrlees Review. There is a
whole literature on how revenues can or should be rebated to citizens to minimize economic
distortions. Can you from the perspective of SCBA explain why the revenues in itself do not
matter for the discussion of instrument choice?

Answer: tax revenues are in principle a transferred or pecuniary effect. The main focus of
climate policy are the climate benefits. The revenues should be spend such as to achieve the
largest social gain. But this is always true, also without the climate policy the government can
raise money to spend on matters it deems socially desirable.