Environmental Economics

Notes

David L. Kelly

Department of Economics
University of Miami
Box 248126
Coral Gables, FL 33134
[email protected]

First Version: Fall, 2009

Current Version: Fall, 2011
 INTRODUCTION

I What is Environmental Economics?

Environmental economics is the study of how the economy affects the environment, how the
environment affects the economy, and the appropriate way to regulate economic activity so
as to achieve an optimal balance between competing environmental and economic goals.

1. The economy affects the environment:

• U.S. carbon emissions are forecast to drop by 5% due to the recession.

• In many cases, wealthy countries have lower pollution emissions (despite their
greater GDP), as wealthy countries can afford expensive pollution control tech-
nologies.

2. The environment affects the economy:

• Warming from climate change affects the skiing industry.

• Sulfur dioxide and particulate emissions can increase asthma, increasing sick days,
which reduces GDP.

3. The appropriate way to regulate:

• The Waxman-Martin climate change bill proposed regulating greenhouse gas emis-
sions in part with a cap-and-trade with a safety valve. The government would
issue permits to emit greenhouse gasses, which firms can buy and sell. But if the
trade price gets too high, the safety valve kicks in and more permits are issued,
to keep the price of permits from rising beyond a certain point. Is this the least
expensive way to reduce greenhouse gas emissions?
• The house bill has other provisions. It imposes a technology standard: new build-
ings must meet certain energy efficiency requirements. Is this the least expensive
way to reduce greenhouse gas emissions?
• An effective ban on incandescent light bulbs goes into effect at the end of the year
(see article). Is this the least expensive way to reduce greenhouse gas emissions?

4. Achieving an “optimal balance:”

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 • Nylon production produces nitrous oxide, a greenhouse gas which is much more
warming than carbon dioxide. To eliminate emissions costs about $10-20 million
per factory for scrubbers, plus catalysts that cost $1 million per year. Is the
benefit of reduced nitrous oxide emissions worth the cost?
• In Baltimore, reducing total suspended particulates (TSP) in the air from 115
micrograms per cubic meter to 87 micrograms costs approximately $15 million.
Is the benefit worth the cost?

Although the subject name is often accused of being an oxymoron, in fact the connection
is clear. Environmental economics takes environmental problems identified by scientists and
answers the question “what should we do about it?”

II Topics

Within the above general ideas are many topics to study:

• Can the market economy achieve an optimal balance between nitrous oxide scrubbers
and other things we might care to produce? If not why?

• How do we determine what the optimal balance is?

• What is the least cost way to regulate pollution emissions?

• How do we regulate pollution that originates in one country and lands in another?

• Are environmental side agreements necessary to prevent firms from relocating to coun-
tries with lax pollution regulations? Or are they trade barriers in disguise?

• Are pollution and gas taxes a good way for the government to raise revenue?

• How do optimal greenhouse gas emissions vary over time?

• How much do households value a good environment?

III Approach

A Positive versus Normative

We will examine both positive (why resources are allocated the way they are) and normative
(what is the best resource allocation) questions.

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 Positive question: why is air quality worse in Mexico city than in Chicago?
Normative question: what is the optimal quantity of TSP (close to 87 micrograms)?

B Moral neutrality

Here we use a scientific approach to the environment. If improving the environment is a

moral imperative, then there is no need for this course. Like religion, we simply have faith
that saving the snail darter is an important thing to do. Here, environmental goods here are
little different than other goods. We like clean water just like we like other goods. So the
question becomes which goods, environmental or other goods, do we want to produce?
Related is how we treat households and firms. Polluting firms are not morally challenged,
but instead are responding to their incentives to maximize profits for their shareholders.
Those who buy swordfish in the grocery store are not sinners, but instead are balancing
their (apparently strong) desire for swordfish versus the (probably negligible) effect their
purchase has on the environment.

C Resource and ecological economics

Natural resource economics deals with the production and use of non-renewable resources
such as oil, and renewable resources such as forests. Environmental economics is concerned
with market failures causing excessive pollution or insufficient protection of the natural
world. This distinction is a fine one, and in some cases overlap exists. Rather than discuss
pollution, an environmental topic, one could discuss clean air, which is a renewable resource.
The production of wood from forests sometimes results from insufficient protection of the
natural world. But we will not be talking about oil extraction in this class.
Similarly, ecological economics studies ecological systems rather than resources or pol-
lution. Some ecologists who work on environmental policy adopt different ways of valuing
environmental goods. Economics, however, value goods by observing actual decisions. For
example, if you are willing to travel across the country to go whale watching in the Pacific,
that indicates to economists that whales are valuable. Ecologists sometimes adopt valuations
which are irrelevant, unless they can convince voters to adopt their preferences.

D Going Green

Many firms and households focus on reducing electricity/fuel consumption to reduce energy
costs. This benefits the environment, but is not the focus of this course. If American

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Airlines can reduce fuel consumption by only filling their fuel tanks half way, then by all
means go ahead. A course in economics is not required to solve that problem. If however,
reducing airplane exhaust emissions is costly to American but benefits society, then we have
more interesting questions. Is it worth the enevitable higher ticket prices to reduce airplane
emissions? How should we design airline exhaust regulations?

IV Stylized Facts

A United States

1 US Pollution

Figure 1 is a graph of some major air pollutants in the United States since 1940.

Time Series Behavior of US National Emissions

250 PMx
6*SO2
NOx and CO
Pb
Peak: Pb
4*VOC
200

Peak: NOx+CO
Millions of Short Tons

Peak: SO2
150

Peak: PMx Peak: VOC

100

50

0
1940 1950 1960 1970 1980 1990 2000
year

Figure 1: Air pollution measures in the United States since 1940: particulate matter (PM),
sulfur dioxide (SO2 ), nitrogen oxides (NOx ) and carbon monoxide (CO), lead (Pb), and
volatile organic compounds (VOC). From Bartz and Kelly (2008).

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 • Particulate matter are the large (less than 10 µg, denoted PM10 ) and small (less than
2.5 µg, denoted PM2.5 ) soot and smoke particles. These damaging particles are linked
to heart and lung disease. A principle source is diesel emissions.

• Sulfur dioxide (SO2 ) causes acid rain and is linked to asthma and bronchitis. A primary
source is the burning of coal for electricity.

• Carbon monoxide (CO) is a poisonous gas produced through fuel combustion.

• Nitrous oxide (NO) and nitrogen dioxide (NO2 ), collectively (NOx ) are greenhouse
gasses that also contribute to ground level ozone (smog) problems. Road traffic and
many industrial processes contribute to NOx emissions.

• Hydrocarbons and volatile organic compounds (VOCs) are emitted via fuel combustion
and from evaporation of solvents. Some are carcinogens and others lead to smog.

• Airborne lead is a poison that results primarily from the combustion of leaded gasoline.

Looking at Figure 1 we can see a lot of success: all major air pollutants are in decline,
with most peaking around 1970 and decreasing since the clean air act was passed. Particu-
lates peaked around 1950 and continues to decline. The success is especially striking when
considering that economic output has nearly tripled (256% increase) from 1970-2000. Our
production methods are becoming so much cleaner that overall pollution is falling despite
great increases in output. Figure 2 measures US emissions intensity, that is emissions divided
by GNP, which is falling for all pollutants.

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 United States Emissions Intensity
80

70 PMx
units for PM and NOx are
SO2
tons per million $, units for NOx + CO
SO2 and VOC are tons
60
VOC
per 200K $

50
intensity

40

30

20

10

0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995
year

Figure 2: Air pollution emissions intensity (emissions per unit of GNP).

2 US Environmental Compliance Spending

Figure 3 shows total US spending on compliance with air pollution regulations (also called
pollution abatement expenditures). Estimating such costs are fraught with uncertainty,
nonetheless, it is clear that compliance costs are modest in a $13 trillion dollar economy.

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 Total Spending on Environmental Compliance for Air Pollution, Billions of 2000$
55

50

45

40

35
$

30

25

20

15

10
1975 1980 1985 1990 1995 2000
year

Figure 3: Air pollution compliance costs, calculated using EPA data.

Figure 4 gives total costs as a share of GNP. The US spends about one half of one percent
of income on compliance with air pollution regulations. The total compliance share for all
types of pollution regulation is under 2% of GNP.

Share of GNP Spent on Environmental Compliance for Air Pollution

0.55

0.5

0.45

0.4
percent

0.35

0.3

0.25

0.2
1975 1980 1985 1990 1995 2000
year

Figure 4: Air pollution compliance costs, calculated using EPA data.

The graphs indicate some surprising facts. We have reduced our air pollution emissions

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substantially for only a few billion dollars per year. An interesting question is why we waited
until 1970 to start major emissions reduction, given that reducing emissions is relatively
cheap. The data seems to indicate that we don’t care much about low air pollution, and are
therefore unwilling to spend much on it. Other ideas are possible, though. It could be that
further reductions are more expensive, or that we care a lot about reducing air pollution to
current levels, but don’t care much about reducing it further. Compliance costs could fall
on a relatively small set of industries, leading to more opposition. Nonetheless, the stylized
facts remain that in the US pollution is falling and compliance costs are relatively small.

B Other Countries

1 Pollution

As might be expected, the data is more mixed across countries. Figure 5 shows that China
has experienced small declines in soot (PM) and chemical oxygen demand (COD), a measure
of water pollution. But untreated waste water and SO2 continue to rise. Keep in mind
however, that the increases are far less than the increases in GDP over the same period.

Air and Water Pollution in China

3000
SO2
Soot
Wastewater
2500 COD

2000
10K tons

1500

1000

500

0
1988 1990 1992 1994 1996 1998 2000 2002 2004
year

Figure 5: Air and water pollution in China.

Figure 6 shows that China is producing less and less pollution per unit of GDP.

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 Emissions Intensity of Air and Water Pollutants in China
6

5 SO2
Soot
Wastewater
COD

tons/10K yuan
3

0
1988 1990 1992 1994 1996 1998 2000 2002 2004
year

Figure 6: Air water pollution emissions intensity (tons per 10K yuan of output) in China.

Table 1 compares some countries across the development spectrum.

1980 1990 1995
China
GDP per capita (US$) 907 1783 3072
SO2 concentration (Beijing) 66 107 90
PM concentration (Beijing) 475 413 377
CO2 emissions per capita (tonnes) 0.4 0.6 0.7
Iran
GDP per capita (US$) 5377 4843 5351
SO2 concentration (Tehran) 130 165 209
PM concentration (Tehran) 226 261 248
CO2 emissions per capita (tonnes) 0.8 0.9 1.1
Japan
GDP per capita (US$) 15538 20794 22173
SO2 concentration (Tokyo) 42 19 18
PM concentration (Tokyo) 61 NA 49
CO2 emissions per capita (tonnes) 2.1 2.4 2.5

Table 1: Air pollution indicators for selected cities and countries.

We can see that China is the least developed country, and Japan has the highest GDP
per capita. Among these three countries, SO2 pollution rises and then falls with income.

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Definition 1 THE ENVIRONMENTAL KUZNETS CURVE (EKC) hypothesis states that
pollution first rises and then falls with income.

The EKC hypothesis is controversial. It certainly does not hold for many pollutants,
and it is not clear it even holds for SO2 when more countries are added. Indeed, one could
just as easily hypothesize that China’s large high sulfur coal reserves explain China’s high
SO2 concentrations, whereas Japan’s reliance on nuclear power explains Japan’s low sulfur
concentrations.
Particulates decline with income across countries and across time, as they have in the US.
Carbon dioxide emissions increase with GDP over time and across countries. Carbon dioxide
is unique in that each country contributes very little to global CO2 concentrations in any
given year. Since climate change is based on CO2 concentrations, each country suffers very
little damage as a direct result of their own emissions. Thus, each country has an incentive
not to undertake costly emissions reductions.

2 Compliance spending

Table 2 shows that abatement spending in other developed countries is similar to the US.

Year US France West Germany Netherlands United Kingdom

1981 1.5 0.9 1.5 - 1.6
1982 1.5 0.9 1.5 1.2 -
1983 1.5 0.9 1.4 - -
1984 1.4 0.8 1.4 - -
1985 1.4 0.9 1.5 1.3 1.3
1986 1.4 0.8 1.5 1.5 1.3
1987 1.4 1.0 1.6 1.5 -
1988 1.3 1.0 1.6 - -
1989 1.4 1.0 1.6 1.5 -
1990 1.4 1.0 1.6 - 1.5

Table 2: Pollution abatement expenditures as a percentage of GDP.

V Environmental Regulation

A Command and Control Regulation

Definition 2 COMMAND AND CONTROL REGULATION. The regulator specifies what

steps the polluter must take to reduce pollution, and usually how much pollution must be

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reduced.

Command and control is by far the most common form of regulation. Command and
control regulations typically specify a TECHNOLOGY STANDARD, where the regular spec-
ifies the environmental performance of a particular production technology. Command and
control regulations may go even further and specify in great detail exactly how a good is to
be produced.
Examples:

• CAFE standards: minimum average fuel economy for all cars sold by a given company
in a year (currently 27.5 MPG for cars and 23.5 MPG for trucks).

• Low flush toilets: maximum water use per flush (1.5 gal/flush).

• Coral Gables lawn watering limits (Wednesday and Saturday on the odd side of the
street, and only early in the morning).

• Surface coatings (e.g. furniture manufacture): limits on the types of furniture coatings,
requirements to use a certain type of vent to recapture vapors emitted during painting.

• Renewable energy standard: house climate change bill requires 20% of each utility
company’s power to come from renewable sources by 2020.

• Household appliance standards: the house climate change bill has standards for fluo-
rescent lamps, base lamps, candelabra base lamps, dishwashers, portable spas, faucets,
televisions, buildings, and many other products. The article discusses the energy stan-
dard for light bulbs which effectively bans incandescent bulbs.

B Market based instruments

Definition 3 A MARKET BASED REGULATION provides economic incentives to reduce

pollution.

Market based instruments come in 3 flavors:

1. Taxes. Charge a tax per unit of pollution emitted.

2. Tradeable permits (cap and trade). Limit pollution, but allow the right to pollute to
be traded.

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 3. Liability. Allow pollution victims to pursue compensation from polluters through the
legal system.

Examples:

1. Gasoline taxes (gas tax), gas guzzler car taxes, “by the bag” garbage disposal fees.

2. Cap and trade sulfur dioxide program, NOx cap and trade in the Northeastern states,
proposed cap and trade program in the Waxman-Martin climate change bill.

3. Various lawsuits associated with toxic chemical leaks.

The key difference between command and control and market instruments is that market
based instruments do not proscribe any particular method of reducing pollution. Consider
the gas tax versus CAFE standards. Note that we are implicitly assuming that the goal of
saving fuel is really about reducing car pollution. Many possible responses exist to the gas
tax. Some may drive less, others may buy more fuel efficient cars, some may give their car a
tune up, and some will of course pay the tax because the alternatives are too costly. CAFE
standards cause firms to raise prices on gas guzzlers to induce consumers to buy cars which
meet the standard, but they provide no incentives for tune-ups or reduced driving. Indeed,
CAFE standards create incentives for households to buy less fuel efficient used cars. Thus
we cannot even say for sure that fuel use declines with the CAFE standard.

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