Environmental Economics: Theory and Policy in Equilibrium

Springer Texts in Business and Economics For further volumes: http://www.springer.com/series/10099 Hans Wiesmeth En...

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Springer Texts in Business and Economics

For further volumes: http://www.springer.com/series/10099

Hans Wiesmeth

Environmental Economics Theory and Policy in Equilibrium With Contributions by Judith Marquardt

Prof. Dr. Hans Wiesmeth TU Dresden Faculty of Business and Economics Chair of Economics, esp. Allocation Theory 01062 Dresden Germany [email protected]

ISSN 2192-4333 e-ISSN 2192-4341 ISBN 978-3-642-24513-8 e-ISBN 978-3-642-24514-5 DOI 10.1007/978-3-642-24514-5 Springer Heidelberg Dordrecht London New York Library of Congress Control Number: 2011940769 © Springer-Verlag Berlin Heidelberg 2012 This work is subject to copyright. All rights are reserved, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilm or in any other way, and storage in data banks. Duplication of this publication or parts thereof is permitted only under the provisions of the German Copyright Law of September 9, 1965, in its current version, and permission for use must always be obtained from Springer. Violations are liable to prosecution under the German Copyright Law. The use of general descriptive names, registered names, trademarks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. Printed on acid-free paper Springer is part of Springer Science+Business Media (www.springer.com)

Preface

This monograph is an “offspring” of an earlier textbook on Environmental Economics which was published in 2002. It is, however, not just an update or a simple translation of the former German version. Rather, this book includes topics, which played no signiﬁcant role in public opinion some 10 years ago. Climate change is one of the cross-border environmental issues which has substantially gained importance and public attention over the last decade. From a theoretical point of view, tackling this issue amounts to solving the allocation problems for a global environmental commodity. As long as there are no straightforward and functioning “global” allocation mechanisms, this will remain a challenge for international environmental policy. The text addresses this issue in various chapters and sections, which each have a different focus. Of course, international efforts to curb greenhouse gas emissions, the various cap and trade policies, for example, are included in this analysis together with critical assessments. Overﬁshing has been on the agenda of national and international organizations for decades. However, the increasing globalization accompanied by technological innovations and rising demand seems to exacerbate the alarmingly poor state of the world’s marine stocks. As is the case for climate change, there is no promising multinational policy on the horizon to date. The text therefore retains this issue from the former book with some additional information and analysis related to the international context. Integrated approaches to environmental policy such as integrated waste management in general and policies for waste electrical and electronic equipment in particular consider “waste” as part of the allocation problems. Therefore, the three “R”s, reducing waste, reusing or recycling discarded commodities, have to be reasonably implemented in a practical context. This requires a holistic approach, integrating appropriate signals from all stages of a product’s life span, including design and the post-consumption phase. Extended producer responsibility is meant to provide incentives for a design for environment, and is introduced into the text together with integrated waste management and policies for waste electrical and electronic equipment.

v

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Preface

Holistic environmental policy is also used for promoting renewable energy sources. These approaches rely upon appropriate framework conditions by opening investment opportunities for private business – a special public-private partnership with the public authorities establishing the required framework conditions. The book addresses this issue and discusses examples of this kind of a Private Finance Initiative. Of course, the monograph presents and analyzes the standard theoretical tools which are required for environmental economics, although resource economics is not included in the text, beyond the issue of overﬁshing. Classical instruments of environmental policy are also discussed, always with a link to theory. It is, generally speaking, one of the characteristics of this monograph to thoroughly analyze practical environmental issues with theoretical tools which are often taken from equilibrium analysis, although in various situations, especially in an international context, the market mechanism has to be replaced by some other allocation mechanism – negotiations, for example. These two hallmarks then justify the title of the monograph: “Environmental Economics – Theory and Policy in Equilibrium”, and the text was written with this concept in mind. This textbook is suitable for undergraduate and graduate courses on theoretical and applied environmental economics. The material in Part II and Part IV is, however, more demanding from a formal point of view, and addresses readers, who are familiar with microeconomics on at least an intermediate level. The various cases included in the text provide sufﬁcient material for discussions in class. This textbook owes a great deal to many people. Undergraduate and graduate students, and research associates at Dresden University of Technology, Hanoi University of Science and International School of Economics at Tbilisi State University have played an important part in the development and further development of this text. I am indebted to my colleagues Bernd Bilitewski from Dresden University of Technology and Martin Wittmaier from Bremen University of Applied Sciences, who introduced me to the exciting world of waste management and drew my interest to many policy issues in this area. The editors at Springer, Barbara Fess and Marion Kreisel, were quite helpful in providing technical assistance. Finally, I am very grateful to my former colleague, Judith Marquardt, who, as native speaker, proofread and provided further helpful advice regarding international aspects. Dresden, September 2011

Hans Wiesmeth

Contents

1

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1 Ecology and Economy: Unequal Partners? . . . . . . . . . . . . . . . . . . . . . . 1.1.1 Environmental Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1.2 Why is Theory Needed for Environmental Policy? . . . . . . . . 1.2 Survey of the Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1 1 3 4 5 9

Part I The Environmental Movement 2

Differing Views on the Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1 The Europeans and the Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1.1 Environmental Awareness in Europe . . . . . . . . . . . . . . . . . . . . 2.1.2 Conclusions for Environmental Economics . . . . . . . . . . . . . . . 2.2 The Environmental Movement in the US . . . . . . . . . . . . . . . . . . . . . . . 2.3 The Developing World and the Environment . . . . . . . . . . . . . . . . . . . . 2.3.1 China and the Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.2 India and the Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.4 Attitudes Towards the Environment: A Summary . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

13 13 14 15 17 20 20 22 23 24

3

The International Dimension of the Environment . . . . . . . . . . . . . . . . . . 3.1 International Environmental Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1.1 Global Environmental Commodities . . . . . . . . . . . . . . . . . . . . 3.1.2 Consequences of Globalization . . . . . . . . . . . . . . . . . . . . . . . . . 3.1.3 The Environment and International Trade . . . . . . . . . . . . . . . . 3.2 International Conferences and Environmental Agreements . . . . . . . . 3.2.1 The United Nations Conference on Environment and Development (UNCED) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.2 The United Nations Framework Convention on Climate Change (UNFCCC) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.3 The Kyoto Protocol . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

27 27 27 29 30 31 31 36 37

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3.2.4 Copenhagen, Cancun, Durban and Rio? . . . . . . . . . . . . . . . . . 39 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 Part II Theoretical Environmental Economics 4

Basics of Environmental Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1 Fundamental Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1.1 Environmental Awareness and Perceived Scarcity . . . . . . . . . 4.1.2 Environmental Commodities and Allocation Problems . . . . . 4.2 Efﬁciency as a Normative Criterion for Environmental Economics . 4.2.1 Economic Efﬁciency and the Environment: Theory . . . . . . . . 4.2.2 Economic Efﬁciency and the Environment: Applications . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

45 45 45 47 48 49 50 52

5

Allocation Problems in a Market Economy . . . . . . . . . . . . . . . . . . . . . . . . 5.1 Efﬁcient Equilibrium Allocations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.1.1 The Model Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.1.2 Market Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.2 Environmental Effects in a Market Economy . . . . . . . . . . . . . . . . . . . . 5.2.1 The Concept of an External Effect . . . . . . . . . . . . . . . . . . . . . . 5.2.2 Analysis of an Externality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.2.3 Market Equilibrium with External Effects . . . . . . . . . . . . . . . . 5.3 Public Commodities in Environmental Economics . . . . . . . . . . . . . . . 5.3.1 The Prisoners’ Dilemma in an Environmental Context . . . . . 5.3.2 The Prisoners’ Dilemma and the Kyoto Protocol . . . . . . . . . . 5.3.3 The Tragedy of the Commons . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

53 53 53 56 59 59 61 63 66 67 70 74 75

6

The Internalization of External Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 6.1 External Effects and Missing Markets . . . . . . . . . . . . . . . . . . . . . . . . . 77 6.1.1 Supplementing the Market System . . . . . . . . . . . . . . . . . . . . . . 79 6.2 The Pigou Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 6.3 Firm-Speciﬁc Prices for an Environmental Commodity . . . . . . . . . . . 87 6.4 Tradeable Emission Certiﬁcates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 6.5 Pollution Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91 6.6 The Coase Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

7

Public Goods in Environmental Economics . . . . . . . . . . . . . . . . . . . . . . . . 103 7.1 The Lindahl Mechanism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103 7.1.1 The Concept of a Lindahl Equilibrium . . . . . . . . . . . . . . . . . . . 103 7.1.2 Lindahl Equilibrium and Incentive Compatibility . . . . . . . . . 106 7.2 Core Equivalence in a Public Goods Economy . . . . . . . . . . . . . . . . . . 108 7.2.1 The Core of an Economy with a Public Good . . . . . . . . . . . . . 108 7.2.2 The Cost-Share Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . 111 7.2.3 Core Equivalence and Cost-Share Equilibria . . . . . . . . . . . . . . 114

Contents

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7.3 Implications for the Kyoto Protocol . . . . . . . . . . . . . . . . . . . . . . . . . . . 117 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122 Part III Environmental Policy 8

From Theory to Policy: Information Deﬁcits . . . . . . . . . . . . . . . . . . . . . . 127 8.1 Informational Requirements Regarding the Structure of the Markets 127 8.1.1 The Competition-Price Mechanism . . . . . . . . . . . . . . . . . . . . . 129 8.2 Information Deﬁcits in International Environmental Policy . . . . . . . . 131 8.3 Information Deﬁcits Regarding Hazardous Materials and Processes 132 8.4 Consequences for Environmental Policy . . . . . . . . . . . . . . . . . . . . . . . 134 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136

9

Command-and-Control Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139 9.1 Environmental Standards and Framework Conditions . . . . . . . . . . . . 139 9.1.1 Standards in Economic Systems . . . . . . . . . . . . . . . . . . . . . . . . 140 9.1.2 Ecological Efﬁciency of Standards: Examples . . . . . . . . . . . . 141 9.1.3 Framework Conditions, Standards and the Private Finance Initiative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142 9.2 The Reﬁllables Quota Issue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143 9.2.1 Facts and Developments Regarding Reﬁllable Packaging . . . 144 9.2.2 The Reﬁllables Quota Issue and the German Packaging Ordinance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147 9.3 Economic Feasibility of an Environmental Policy . . . . . . . . . . . . . . . . 149 9.3.1 The Concept of Economic Feasibility . . . . . . . . . . . . . . . . . . . 149 9.3.2 Economic Feasibility: A Formal Analysis . . . . . . . . . . . . . . . . 150 9.3.3 Economic Feasibility in a Practical Context . . . . . . . . . . . . . . 156 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157

10

Integrated Approaches to Environmental Policy . . . . . . . . . . . . . . . . . . . 159 10.1 Extended Producer Responsibility (EPR) . . . . . . . . . . . . . . . . . . . . . . . 159 10.1.1 General Aspects of Waste Electrical and Electronic Equipment (WEEE) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160 10.1.2 EPR Approach to WEEE in Germany . . . . . . . . . . . . . . . . . . . 163 10.1.3 EPR Approach to WEEE in Japan . . . . . . . . . . . . . . . . . . . . . . 165 10.2 Integrated Waste Management (IWM) . . . . . . . . . . . . . . . . . . . . . . . . . 167 10.2.1 The Concept of IWM in Environmental Economics . . . . . . . . 168 10.2.2 The Implementation of IWM . . . . . . . . . . . . . . . . . . . . . . . . . . 169 10.2.3 IWM in Germany . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173 10.3 Renewable Energy Sources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175 10.3.1 The German Renewable Energy Sources Act (EEG) . . . . . . . 176 10.3.2 The EEG in Practice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177 10.4 Integrated Approaches: A Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . 179 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180

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11

The Price-Standard Approach to Environmental Policy . . . . . . . . . . . . 183 11.1 Market-Oriented Environmental Policies . . . . . . . . . . . . . . . . . . . . . . . 183 11.2 Pollution Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185 11.2.1 Relevant Features of the Pollution Tax . . . . . . . . . . . . . . . . . . . 185 11.2.2 Cost Efﬁciency of the Pollution Tax . . . . . . . . . . . . . . . . . . . . . 187 11.2.3 Cost Efﬁciency with Spatial Differentiation . . . . . . . . . . . . . . 189 11.3 Ecotaxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191 11.3.1 Aspects of an Ecotax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191 11.3.2 Theoretical Considerations Regarding an Ecotax . . . . . . . . . . 192 11.3.3 The Ecological Tax Reform in Germany . . . . . . . . . . . . . . . . . 193 11.4 Tradeable Emission Certiﬁcates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195 11.4.1 Relevant Features of Markets for Tradeable Certiﬁcates . . . . 195 11.4.2 Emission-Oriented and Immission-Oriented Trading Schemes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196 11.5 Experiences with Markets for Tradeable Certiﬁcates . . . . . . . . . . . . . 199 11.5.1 The EU Emission Trading System (EU ETS) . . . . . . . . . . . . . 199 11.5.2 A Critical Assessment of the EU ETS . . . . . . . . . . . . . . . . . . . 202 11.5.3 The US Cap and Trade Policy . . . . . . . . . . . . . . . . . . . . . . . . . . 203 11.5.4 Cap and Trade Policies in Other Parts of the World . . . . . . . . 207 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208

12

The Allocation of International Environmental Commodities . . . . . . . . 211 12.1 International Environmental Agreements . . . . . . . . . . . . . . . . . . . . . . . 211 12.2 The Principal-Agent Problem in Environmental Policy . . . . . . . . . . . 213 12.2.1 Stability and Efﬁcient Mitigation Strategies . . . . . . . . . . . . . . 214 12.2.2 The Role of Adaptation Strategies . . . . . . . . . . . . . . . . . . . . . . 219 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225

Part IV The Environment in the Globalized World 13

Trade and the Environment: The Legal Context . . . . . . . . . . . . . . . . . . . 229 13.1 The Framework Conditions for International Trade . . . . . . . . . . . . . . 229 13.2 Environmental Aspects of the GATT and the WTO . . . . . . . . . . . . . . 231 13.3 Regional Trade Agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235 13.3.1 The Environmental Policy of the EU . . . . . . . . . . . . . . . . . . . . 235 13.3.2 The North American Free Trade Agreement (NAFTA) . . . . . 237 13.4 Consequences for the Integration of Trade and the Environment . . . . 240 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242

14

Overﬁshing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245 14.1 The State of Fishery Resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245 14.2 Short-Run Supply of the Fisheries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247 14.2.1 Interdependence of Fisheries . . . . . . . . . . . . . . . . . . . . . . . . . . . 248 14.2.2 Short-Run Supply and Fixed-Stock Equilibrium . . . . . . . . . . 250 14.3 Integration of Economical and Biological Aspects . . . . . . . . . . . . . . . 254 14.3.1 A Biological Growth Process . . . . . . . . . . . . . . . . . . . . . . . . . . 254

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14.3.2 The Bioeconomic Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . 255 14.4 The Market Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259 14.5 Conclusions from the Formal Analysis . . . . . . . . . . . . . . . . . . . . . . . . . 262 14.5.1 An Analysis of Externalities in the Fishing Industry . . . . . . . 263 14.5.2 Attempts to Internalize Externalities in Fisheries . . . . . . . . . . 264 14.5.3 Quota Management Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . 265 14.6 Fisheries Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268 14.6.1 Subsidies and Overcapacity in the Fishing Industry . . . . . . . . 268 14.6.2 Evaluating the Common Fisheries Policy of the EU . . . . . . . . 271 14.6.3 A Glance at the US Fisheries Policy . . . . . . . . . . . . . . . . . . . . 274 14.7 Overﬁshing: A Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278 15

Integration of Trade and the Environment . . . . . . . . . . . . . . . . . . . . . . . . 281 15.1 Bhagwati’s “Genuine Problems” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281 15.2 Trade and the Environment: A Formal Approach . . . . . . . . . . . . . . . . 283 15.2.1 The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283 15.2.2 Autarky Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287 15.2.3 Free Trade Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289 15.3 Trade and the Environment: The Formal Integration . . . . . . . . . . . . . . 292 15.3.1 From Autarky to Free Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . 292 15.3.2 Harmonizing Environmental Standards . . . . . . . . . . . . . . . . . . 293 15.4 Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295 15.5 Stackelberg Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297 15.6 Integrating Trade and the Environment: A Summary . . . . . . . . . . . . . 300 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303

List of Figures

5.1 5.2 5.3 5.4

(Theory) Aggregate supply set without external effects . . . . . . . . . . . . (Theory) Market equilibrium without external effects . . . . . . . . . . . . . (Theory) Market equilibrium with external effects – Example A . . . . (Theory) Market equilibrium with external effects – Example B . . . .

54 58 62 62

6.1 6.2 6.3 6.4

(Theory) Marginal social cost of pollution – Example A . . . . . . . . . . . (Theory) Marginal social cost of pollution – Example B . . . . . . . . . . . (Theory) Property rights assigned to one sector – Example A . . . . . . (Theory) Property rights assigned to one sector – Example B . . . . . .

85 86 93 96

7.1

(Theory) Core equivalence for cost-share equilibria . . . . . . . . . . . . . . 115

8.1

(Policy) The competition-price mechanism . . . . . . . . . . . . . . . . . . . . . . 129

9.1 9.2

(Economic Viability of Recycling) Case without recycling . . . . . . . . . 151 (Economic Viability of Recycling) Case with recycling . . . . . . . . . . . 153

11.1 (Policy) Offset system with several control points and emission sources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198 12.1 (Principal-Agent Approach) Raising environmental awareness . . . . . 217 12.2 (Principal-Agent Approach) Effect of adaptation . . . . . . . . . . . . . . . . . 223 12.3 (Principal-Agent Approach) Effect of adaptation (details) . . . . . . . . . 224 14.1 14.2 14.3 14.4 14.5 14.6 14.7

(Fishery) Global trends in the state of world marine stocks . . . . . . . . 246 (Fishery) Reaction curves and ﬁxed-stock equilibrium . . . . . . . . . . . . 250 (Fishery) Equilibrium output and the efﬁciency parameters . . . . . . . . 252 (Fishery) Sustainable catch for various levels of the resource stock . . 255 (Fishery) Bioeconomic equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256 (Fishery) Stability of the bioeconomic equilibrium . . . . . . . . . . . . . . . 257 (Fishery) Efﬁciency parameters affecting the bioeconomic equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258

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List of Figures

14.8 (Fishery) Efﬁciency parameters affecting aggregate supply, case 1 . . 259 14.9 (Fishery) Efﬁciency parameters affecting aggregate supply, case 2 . . 260 14.10 (Fishery) Increasing market demand affecting equilibrium . . . . . . . . . 261 14.11 (Fishery) Efﬁciency parameters affecting equilibrium . . . . . . . . . . . . . 262 14.12 (Fishery) Optimal allocation of quota . . . . . . . . . . . . . . . . . . . . . . . . . . 267 15.1 (Nash Equilibrium) Structure of a game – simultaneous decisions . . . 285 15.2 (Trade and Environment) Autarky equilibrium with international environmental effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288 15.3 (Trade and Environment) Free trade equilibrium with regional environmental effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290 15.4 (Trade and Environment) Free trade equilibrium with international environmental effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291 15.5 (Harmonization) Free trade and regional environmental effects . . . . . 294 15.6 (Harmonization) Free trade and international environmental effects . 295 15.7 (Nash Equilibrium) Structure of a game – sequential decisions . . . . . 297 15.8 (Stackelberg Equilibrium) Autarky with international environmental effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298 15.9 (Stackelberg Equilibrium) Free trade with international environmental effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299

List of Tables

5.1 5.2

(Theory) Example of a Prisoners’ Dilemma situation . . . . . . . . . . . . . . 69 (Kyoto Protocol) Target reductions and 2008 reductions of CO2 emissions according to IEA and UNFCCC reports . . . . . . . . . . . . . . . . 71

9.1

(Waste Management) Quota of reusable and ecologically advantageous one-way drinks packaging in Germany (2007-2009) . . 144 (Waste Management) Container mix for soft drinks in the US (1947-1998) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145 (Waste Management) Quota of reusable drinks packaging in Germany (1991-2009) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147

9.2 9.3

10.1 (Waste Management) Packaging consumption in Germany (1991-2006) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174 11.1 (EU ETS) Carbon allowances for various member states of the EU . . 201

xv

Acronyms

APS CAA CAIR CCS CEE CER CFC CFP COP CO2 CPRS CTE DfE DIW DM EAP EC ECSC EEC EEG EEZ EFF ElektroG EPA EPR EPS ERU EU EU ETS FCMA FDA

Ambient Permit System US Clean Air Act US Clean Air Interstate Rule Carbon Capture and Storage Central and Eastern Europe Certiﬁed Emission Reduction Chloroﬂuorocarbon EU Common Fisheries Policy Conference of the Parties Carbon Dioxide Australian Carbon Pollution Reduction Scheme Committee on Trade and Environment Design for Environment German Institute for Economic Research Deutsche Mark European Community Environment Action Programme European Commission European Coal and Steel Community European Economic Community German Renewable Energy Sources Act Exclusive Economic Zone European Fisheries Fund German Electrical and Electronic Equipment Act US Environmental Protection Agency Extended Producer Responsibility Emissions Permit System Emission Reduction Unit European Union European Union Greenhouse Gas Emission Trading System US Fishery Conservation and Management Act US Food and Drug Administration

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xviii

FIFG FRG GATT GATS GDP GDR GIZ GNP GTZ GW HARL IARI IEA IMF IPA IPCC IWM IUU kWh MEA MERC MRS MRT MSW MWh NAFTA NMFS NOAA OECD PFI PPP RAC RTA SEA SO2 TAC TRIPS UBA UNCED UNECE UNEP UNFCCC US USAID USDA

Acronyms

EU Financial Instrument for Fisheries Guidance Federal Republic of Germany General Agreement on Tariffs and Trade General Agreement on Trade in Services Gross Domestic Product German Democratic Republic German Agency for International Cooperation Gross National Product German Technical Cooperation Agency Gigawatt Japanese Home Appliance Recycling Law Indian Agricultural Research Institute International Energy Agency International Monetary Fund EU Instrument for Pre-Accession Assistance Intergovernmental Panel on Climate Change Integrated Waste Management Illegal, Unreported and Unregulated Fishing Kilowatthour Multilateral Environmental Agreement USAID Middle East Regional Cooperation Program Marginal Rate of Substitution Marginal Rate of Transformation Municipal Solid Waste Megawatthour North American Free Trade Agreement US National Marine Fisheries Service US National Oceanic and Atmospheric Administration Organization for Economic Cooperation and Development The Private Finance Initiative Public-Private Partnership EU Regional Advisory Council Regional Trade Agreement EU Single European Act Sulfur Dioxide Fisheries: Total Allowable Catch Agreement on Trade-Related Aspects of Intellectual Property Rights German Federal Environmental Agency United Nations Conference on Environment and Development United Nations Economic Commission for Europe United Nations Environment Programme United Nations Framework Convention on Climate Change United States of America United States Agency for International Development US Department of Agriculture

Acronyms

WEEE WTO WWF

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Waste Electrical and Electronic Equipment World Trade Organization World Wildlife Fund

Chapter 1

Introduction

Abstract This introductory chapter raises ﬁrst the seemingly delicate issue of addressing environmental issues with economic tools and instruments. After all, environmental degradations are to some extent the result of economic activities, and a contradiction between economy and ecology seems to be obvious. Thereafter, the role of economic theory is explained together with a deeper analysis of the equilibrium approach to environmental economics. The need for appropriate allocation mechanisms, both on a national and an international level, to tackle environmental problems, will be discussed before a survey reveals the structure of this monograph.

1.1 Ecology and Economy: Unequal Partners? An economic imperative in the form of a potential loss of international competitiveness with ensuing higher unemployment rates has often been cited by well-known representatives of the private sector to argue against the implementation of higher environmental standards. Conversely, rigorous environmentalists point to the increasing scarcity of environmental resources, which are of utmost importance for practically all economic activities. Therefore, the protection of the environment has to take absolute precedence over further economic progress. This apparent dichotomy between ecology and economy is, without doubt, of substantial relevance for the further economic and social development of all parts of the world. Unfortunately, as the above statements make clear, ecology and economy are not independent of each other. On the contrary, they are closely linked and intertwined. This fact has been recognized and clearly stated by the Brundtland Commission, formally the World Commission on Environment and Development, which was established by the UN in 1983 in view of the increasing role of global environmental issues. The commission is named after its chairperson Gro Harlem Brundtland, a longtime Prime Minister of Norway. In her foreword to the famous report of the commission, also called the Brundtland Report and published in 1987,

H. Wiesmeth, Environmental Economics: Theory and Policy in Equilibrium, Springer Texts in Business and Economics, DOI 10.1007/978-3-642-24514-5_1, © Springer-Verlag Berlin Heidelberg 2012

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1 Introduction

Gro Harlem Brundtland points to this inseparable relationship between environment and development:

Our Common Future Report of the World Commission on Environment and Development (excerpt from [1], Chairman’s Foreword) When the terms of reference of our Commission were originally being discussed in 1982, there were those who wanted its considerations to be limited to “environmental issues” only. This would have been a grave mistake. The environment does not exist as a sphere separate from human actions, ambitions, and needs, and attempts to defend it in isolation from human concerns have given the very word “environment” a connotation of naivety in some political circles. The word “development” has also been narrowed by some into a very limited focus, along the lines of “what poor nations should do to become richer”, and thus again is automatically dismissed by many in the international arena as being a concern of specialists, of those involved in questions of “development assistance”. But the “environment” is where we all live; and “development” is what we all do in attempting to improve our lot within that abode. The two are inseparable. Further, development issues must be seen as crucial by the political leaders who feel that their countries have reached a plateau towards which other nations must strive. Many of the development paths of the industrialized nations are clearly unsustainable. And the development decisions of these countries, because of their great economic and political power, will have a profound effect upon the ability of all peoples to sustain human progress for generations to come.

Later in this report, the commission introduced the concept of sustainable development, which thereafter gained widespread acceptance and was introduced into the economic and environmental literature:

Our Common Future Report of the World Commission on Environment and Development (excerpt from [1], Ch. 2) Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs. It contains within it two key concepts: • the concept of ‘needs’, in particular the essential needs of the world’s poor, to which overriding priority should be given; and

1.1 Ecology and Economy: Unequal Partners?

3

• the idea of limitations imposed by the state of technology and social organization on the environment’s ability to meet present and future needs. Thus the goals of economic and social development must be deﬁned in terms of sustainability in all countries – developed or developing, marketoriented or centrally planned. Interpretations will vary, but must share certain general features and must ﬂow from a consensus on the basic concept of sustainable development and on a broad strategic framework for achieving it. Therefore, ecology and economy are integrated and should not be torn apart. It remains true, of course, that what could be called environmental awareness is of different relevance in different countries. Developing countries with high growth rates seem to be less interested in environmental issues than industrialized countries. On the other hand, the ecological footprint of a citizen of an industrialized country exceeds that of a citizen of a developing country by far. But then again, a richer society has the means to address pollution of the environment and, even more important, to prevent or reduce further pollution. What is then the role of environmental economics in this context? The answer to this question will be explored in the following subsection.

1.1.1 Environmental Economics Once the intrinsic relationship between the economy and the environment is accepted, the role of environmental economics is (almost) straightforwardly determined by the concept of environmental commodities, which helps to “embed” environmental issues into the economic framework. The term “commodity” refers to the fact that the environment with its multitude of characteristics affects the wellbeing of mankind directly and indirectly, similarly to “regular” commodities. This together with the perceived scarcity of many environmental commodities implies a consideration of these commodities in the allocation problems, the basic problems of each economic system regarding what and how many units, how and for whom to produce. From an economic point of view the ultimate goal of environmental economics is then to attain an optimal solution of the allocation problems with environmental commodities taken into account. In principle, this can be achieved by applying appropriate allocation mechanisms. The market mechanism, however, has to be augmented in this context due to missing markets resulting from externalities. Nevertheless, the equilibrium approach to environmental economics provides the tools to cope with most of these externalities, at least in a theoretical context. Thus, the theory of environmental economics consists to a great extent of framework conditions which allow an integration of the environmental commodities into the market mechanism to attain an optimal allocation with respect to all commodities. In an

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1 Introduction

international context, however, the market mechanism has to be replaced by other allocation mechanisms, such as the core together with international negotiations. Consequently, from a theoretical point of view, there seems to be no dichotomy between ecology and economy. In particular, there is no subordination of ecology to economy. Thus, the question arises, where does this dichotomy, which evidently does exist, come from? More precisely, what are the reasons for this “gap” between environmental and economical issues? In a practical context, informational deﬁcits regarding optimal allocations require the introduction of standards such as a maximum permissible concentration of certain air pollutants. To achieve these standards, which are, of course, environmental standards, economic resources have to be deployed. The fact that there are concurrent employment possibilities for these resources contributes then to the dichotomy: more economic growth and higher environmental standards can become ﬁerce competitors for these resources. Given these informational deﬁcits, which limit the direct application of theoretical environmental economics to practical problems, what is then the role of theory for environmental policy? The next subsection will brieﬂy elaborate on this aspect.

1.1.2 Why is Theory Needed for Environmental Policy? A quick survey of current environmental policies across the world reveals a colorful mixture of environmental regulations, instruments and tools, and of negotiations, both on a national and an international level. Direct links to theory in the form of markets for emission certiﬁcates, for example, are scarcely visible. However, a thorough understanding of theory can help to structure and design environmental policies, which are needed to effectively reach a standard or a certain environmental goal. Thus, environmental policy is about constructing, designing and applying allocation mechanisms for special tasks. To illustrate this important point, a few examples shall be given: Tragedy of the Commons: Familiarity with this simple but powerful mechanism helps to understand why it generally takes a long time to “motivate” a vast majority of consumers and/or producers to adopt environmentally friendly behavior, if there is no immediate and direct beneﬁt “perceived” with such behavior. Theory recommends addressing each individual agent in such a case. Pollution Taxes: Usually a pollution tax is considered to be a “punishment” for a polluter. Theory, however, demonstrates that a pollution tax, which is the applied form of a Pigou Tax, is the equilibrium price on an artiﬁcial market, which has to be established to internalize an external effect. In general, consumers and producers will have various options to react to this “new” market. Not every alternative will be environmentally friendly, and a thorough “market analysis” is required to understand reaction strategies of individual agents.

1.2 Survey of the Book

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Integrated Environmental Policies: Policies such as integrated waste management or extended producer responsibility target environmental aspects in all stages of the life cycle of particular commodities in order to reduce waste and promote recycling. It is easier to design such a policy if one understands that an integrated approach is based on the reduction of waste, or rather the integration of waste into the economic allocation problems. International Negotiations: The international climate negotiations, for example, can be interpreted as an allocation mechanism for a global environmental commodity, the reduction of greenhouse gas emissions. Again, familiarity with the relevant concepts from economic theory can help to identify certain negotiation strategies to attain a desired outcome. These examples serve to indicate that many environmental policies do have “theory content”, even if this may not be evident at ﬁrst glance. Thus, theory helps to understand the functioning of environmental policies, and knowledge of theory is required to design effective environmental policies. As a conclusion to this section, ecology and economy, as well as theory and policy in environmental economics should be considered “equal” partners. They depend on each other, they complement each other and they need each other.

1.2 Survey of the Book The following survey will help to understand the structure of this monograph and the relations between the various parts and chapters.

Part I: The Environmental Movement The ﬁrst part of the book is devoted to the environmental movement, if not “revolution”, which has penetrated and conquered most industrialized countries and a number of developing countries since the 1970s. Nevertheless, there are differences in the perception of the environment and environmental pollution, which are explored in Chapter 2. More precisely, differences regarding “attitudes towards the environment” of citizens of the European Union, of the United States of America, of China and of India provide some challenges for internationally coordinated environmental policies. However, there are also similarities pointing in particular to the persistence of certain environmental problems such as “pollution in towns and cities”. Also, environmental issues seem less urgent, once citizens are asked to pay for cleaning up the environment. These differences in the perception of environmental issues gain particular importance in the case of international environmental pollution. Therefore, Chapter 3

6

1 Introduction

investigates global environmental commodities, addresses environmental effects of increasing globalization, and studies trade-related environmental issues. The ﬁnal section in this chapter then presents the international activities regarding sustainable development, which originated with the Brundtland Report in 1987 (cf. Section 1.1), and which culminated with the “United Nations Conference on Environment and Development” (UNCED) in 1992. The “United Nations Framework Convention on Climate Change” (UNFCCC) is an offspring of the “Earth Summit” together with the “Kyoto Protocol”. This section also highlights the various international negotiations with the goal of establishing a second commitment period for the reduction of greenhouse gas emissions in the context of the Kyoto Protocol. The results of these chapters are important as they point to some observations which are of relevance for theory and policy in environmental economics. In this sense, this ﬁrst part of the book prepares the ground for a more detailed analysis later.

Part II: Theoretical Environmental Economics The second part of the book provides the theoretical framework, the tools and instruments of environmental economics. The basics include the concepts of environmental commodities, allocation problems, and economic efﬁciency, which are of relevance in any economic system. Among the issues addressed in Chapter 4, environmental awareness in its relation to the state of the economy plays a special role. Again, this will be of importance in an international framework. Chapter 5 introduces a simple model of a market economy with the market mechanism leading to an efﬁcient market equilibrium. Thereafter, environmental or external effects lead to inefﬁcient equilibrium allocations, sometimes referred to as “market failure”. Public commodities, which are also relevant in environmental economics, are characterized by mutual externalities. Without interference, the allocation of public commodities is affected by the Prisoners’ Dilemma and the Tragedy of the Commons. These are mechanisms which are responsible for a variety of environmental problems, including difﬁcult “climate change negotiations”. Chapter 6 addresses the key issue of an internalization of the environmental effects. First considerations point to “missing markets” as a reason for externalities. Therefore, the market system has to be “completed” in an appropriate way. An immediate procedure is based on certiﬁcates or emission certiﬁcates. These are scarce artiﬁcial commodities, which are linked to environmental commodities. Alternatively, the Pigou Tax can be interpreted as the equilibrium price on such an initially missing market. Another interpretation of the Pigou Tax refers to “closing the gap” between marginal private costs and marginal social costs of an economic activity. Unfortunately, considering this equilibrium price as a “tax” implies a connotation which is negative in some countries, although it is not a tax in the sense of a regular ﬁscal tax. Instead of introducing a Pigou Tax, personal prices for an environmental commodity can also be applied to internalize the external effect. This points to missing

1.2 Survey of the Book

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property rights as a source for environmental effects, an issue which is related to the Coase Theorem as an alternative approach to internalizing externalities. This approach, which reduces the inﬂuence of the government in contrast to the Pigou Tax, is brieﬂy discussed in the context of pollution rights. These “rights”, which allow the emission of a certain pollutant, are based on a prior assignment of property rights regarding an environmental commodity. Chapter 7 considers the allocation of public commodities from a theoretical point of view. The Lindahl mechanism is characterized by incentive-compatibility problems, and is, in general, not suitable for practical applications. The core of the economy, constituting an alternative allocation mechanism, is closely related to the concept of a cost-share equilibrium in the sense of core equivalence. Therefore, certain cost sharing agreements, such as the Kyoto Protocol in the context of reducing greenhouse gas emissions, are likely characterized by some stability property, which renders them useful and interesting for practical purposes. This application-oriented analysis of the Kyoto Protocol prepares the ground for environmental policy in the third part of the book.

Part III: Environmental Policy Applied environmental economics has to deal with information deﬁcits, which prevent an immediate implementation of the tools and instruments discussed and evaluated in Part II. These information deﬁcits, analyzed in Chapter 8, refer in particular to details of market structures, insufﬁcient knowledge on hazardous substances and processes, and various aspects of international environmental policy. One of the consequences of this incomplete information is the ubiquitous presence of environmental standards, which replace economic efﬁciency in the environmental context. After these standards have been introduced, they have to be achieved with appropriate regulations. All this requires government institutions which contribute towards the establishment of an ofﬁcial environmental policy with its own budgetary needs and its own policy goals. One of the reasons for the dichotomy observed between ecology and economy is this development based on information deﬁcits. In order to achieve these standards, command-and-control policies play a dominant role in applied environmental economics (cf. Chapter 9). Problems with this kind of policy are mainly associated with incentive-compatibility issues, leaving unexpected “loopholes” for households or companies. The “reﬁllables quota issue” in Germany provides a good example in this context. Moreover, again as a result of the information deﬁcits mentioned above, command-and-control policies have to rely upon the application of the best available technique, for example for the reduction of the emission of pollutants, or the economic reasonableness of certain activities, for example recycling activities. Section 9.3 investigates economically reasonable activities in the environmental context. Chapter 10 addresses integrated approaches to environmental policy. They constitute holistic policies which integrate signals along the product chain into environmental policy. Prominent examples are given by extended producer responsibility,

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1 Introduction

regulations for waste electrical and electronic equipment (WEEE), and integrated waste management. Concrete examples of these policy areas from various countries are analyzed with respect to their incentive structure. The German approach to integrated waste management provides a good example for regulatory framework conditions, which open investment opportunities for private business. The promotion of renewable energy sources in Germany constitutes another interesting example in this context. Market-oriented environmental policies are considered in Chapter 11. These policies make more use of the information which is available in the economy in a decentralized way. Environmental caps, pollution taxes and markets for emission certiﬁcates are the relevant examples. The discussion of the pollution tax in Section 11.2 shows that environmentally friendly avoidance strategies are required for a well-functioning pollution tax, pointing to an important difference between an environmental tax and a ﬁscal tax. This aspect is considered in more detail in the discussion of the ecotax in Section 11.3. Thereafter, the analysis of markets for emission certiﬁcates is followed by an investigation of various practical examples, among them the EU Emission Trading System (EU ETS), and the US Cap and Trade Policy, which has not yet been implemented. The chapter concludes with examples of cap and trade policies from other parts of the world. The ﬁnal chapter of Part III, Chapter 12, addresses the allocation of international environmental commodities, in particular reductions of greenhouse gas emissions, from a practical and theoretical point of view. The chapter ﬁrst discusses brieﬂy some international environmental agreements, thereafter the principal-agent problem is applied to the context of an international environmental commodity. A theoretical investigation illustrates stable and efﬁcient mitigation strategies for countries differing with respect to environmental awareness and costs for the provision of the public commodity. These considerations shed some light on the question which strategy yields the highest “return” regarding the public commodity. The current climate change negotiations, which can be interpreted as an allocation mechanism for a global public commodity, are immediately related to this analysis.

Part IV: The Environment in the Globalized World The last part of the book provides further insights into challenges of international environmental economics, especially international environmental policy, in the globalized world. Chapter 13 directs the reader’s attention ﬁrst to the existing legal context, which is of relevance for international environmental issues. Beyond cross-border environmental problems, many regional environmental issues acquire an international dimension through international trade. Therefore, environmental aspects of the framework conditions for international trade are mainly addressed in this chapter. Besides the World Trade Organization it includes an analysis of regional trade agreements such as the European Union and the North American Free

References

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Trade Agreement (NAFTA). The key question in this context refers to the extent of an integration of trade and the environment in these agreements. Overﬁshing has been on the agenda of national and international organizations for at least 30 years, without much success so far. Chapter 14 ﬁrst develops a model which integrates the biological system with the economic system and reveals various externalities. The theoretical analysis is complemented with a study of various policy alternatives and a review of ﬁsheries policies, in particular the Common Fishery Policy of the EU and the US Fisheries Policy. The key issue of this chapter refers to the inﬂuence of globalization on overﬁshing and the resulting policy alternatives. The ﬁnal chapter reconsiders the integration of trade and the environment and addresses ﬁrst the issues of unfair trade with different environmental standards affecting trade, the race towards the bottom with competitive pressure through trade on environmental standards, ethical preferences leading to trade restrictions, and welfare losses associated with environmental degradation through increasing trade. With the exemption of ethical preferences, these issues are investigated in a theoretical model which provides some insight into the interaction of trade and the environment. The analysis also extends to questions of harmonizing environmental standards and leadership in environmental issues, and it discusses various policy measures in the sense of a principal-agent approach adapted to this context.

References 1. UN (1987) Our common future. Report of the World Commission on Environment and Development http://www.un-documents.net/ocf-02.htm. Cited June 2011

Part I

The Environmental Movement

Environmental degradation of all kinds can be observed around the globe and receives differing degrees of attention. The ecological revolution, which has conquered the industrialized world since the 1970s, has not yet had much of an effect on many parts of the developing world. On the contrary, globalization is often blamed for placing additional burdens on these countries in the form of polluting industries, urbanization and rapidly increasing quantities of often hazardous waste. This ﬁrst part of this monograph will therefore document the state of the environment in various parts of the world: the EU, the USA, China and India. The factors and the circumstances leading to environmental pollution will be investigated, and the perception of environmental problems or the attitudes towards the environment will be addressed. Clearly, besides the environmental degradation itself, the way this pollution is perceived in a particular country is an important factor inﬂuencing any environmental policy. In particular, international environmental policies, such as the efforts to reduce global greenhouse gas emissions, are challenged, among other things, with these differing perceptions. Nevertheless, the growing international dimension of a number of environmental issues has raised environmental awareness since the early 1990s. In particular, with the United Nations Conference on Environment and Development (UNCED) in Rio de Janeiro in 1992 a process was started, which – thanks to the Kyoto Protocol and the current international negotiations on a global reduction of greenhouse gas emissions – is still gaining increasing worldwide importance.

Chapter 2

Differing Views on the Environment

Abstract Environmental degradations occurred and are occurring everywhere, although they tend to vary with the economic system, the state of the economy, the geographic area, the climatic conditions, and the growth of the population – to cite just a few relevant factors. Moreover, the perception of environmental problems and the attitude towards the environment seem to depend critically on the state of the economy with consequences for tackling cross-border environmental issues. In this context, this chapter attempts to “take stock” of the environmental situation in various parts of the developed and the developing world. The survey includes the actions, or rather the reactions, regarding a more or less rigorous environmental regulation. In view of differing attitudes towards the environment, the challenges arising from a growing number of global environmental problems still have to be mastered.

2.1 The Europeans and the Environment After the ecological revolution had reached the industrialized countries in the 1960s and the early 1970s, the European Community enacted the First Community Environment Action Programme (1st EAP) in 1973. In the period till 2012, the 6th EAP provides the framework for environmental policy-making in the EU. The four priority areas identiﬁed are climate change, nature and biodiversity, environment and health, natural resources and waste. According to the preamble, the 6th EAP “should promote the process of integration of environmental concerns into all Community policies and activities . . . in order to reduce the pressures on the environment from various sources” ([3], preamble, paragraph 13). These priority areas were already relevant for the 5th EAP (1993-2000), which, with the title “Towards Sustainability”, focused on longer term objectives and on a more global approach – in comparison to the earlier EAPs. To what extent were the citizens of the European Union, or rather the former European Community, concerned about environmental issues? This will be brieﬂy H. Wiesmeth, Environmental Economics: Theory and Policy in Equilibrium, Springer Texts in Business and Economics, DOI 10.1007/978-3-642-24514-5_2, © Springer-Verlag Berlin Heidelberg 2012

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analyzed in the following subsection by means of the Eurobarometer, which has been employed by the European Commission to monitor the “evolution of public opinion” in the member states since 1973 (cf. [4]).

2.1.1 Environmental Awareness in Europe The Environment Directorate-General of the EU commissions public opinion surveys to measure the attitudes and the behavior of Europeans towards the environment. The surveys address the general attitude towards the environment, the personal relationship with the environment, opinions on environment policies and questions regarding information on the environment.1 One key question usually refers to the “ranking” of the concept of environment in Europeans’ minds: what are the ﬁrst associations they tend to make with the word “environment” and which environmental issues worry them the most. The answers given vary, of course, over time, but “protecting nature”, “the state of the environment our children will inherit” and “pollution in towns and cities” have always been among the priorities. “Climate change”, which has only been offered as an alternative in recent years, declined surprisingly from 19% in 2007 to only 13% in 2011. People seem to be losing interest in this issue, for whatever reason. “Man-made disasters (oil spills and industrial accidents)” increased only slightly from 8% in 2007 to 9% in 2011, despite of the Deepwater Horizon Catastrophe in April 2010 and the Fukushima Nuclear Catastrophe in March 2011.2 However, if people are allowed to pick the ﬁve main environmental issues that they are worried about, then “man-made disasters” rank top. According to the latest Eurobarometer survey EB75.2 in 2011 (cf. the Summary and the Factsheet in [5]), the top three priorities (in percentages) for the citizens to protect the environment are (max. 3 answers): Sort waste so that it can be recycled:

2011: 59%, 2007: 55%

Reduce your home energy consumption (lighting, heating, household appliances):

2011: 48%, 2007: 47%

Use public transport as much as possible instead of using your own car:

2011: 37%, 2007: 38%

Thus, only the issue of “sorting waste” gained increasing attention between 2007 and 2011. Of interest are also the answers (in percentages) to the following two questions, which touch on the issue of the “willingness to pay” for the environment: 1 Cf. [6], the website for the “Special Eurobarometer”, which also covers the “attitudes towards the environment”. 2 The ﬁeldwork for this latest survey was carried out between April 13 and May 8, 2011, thus after the Fukushima Nuclear Catastrophe (cf. [5]).

2.1 The Europeans and the Environment

How important is protecting the environment to you personally? Percentage of answers for “totally important”:

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2011: 95%, 2007: 96%

Are you wiling to buy environmentally friendly products even if they cost a little bit more? Percentage of answers for “totally agree”: 2011: 72%, 2007: 75% The answers to the question regarding the “most effective ways of tackling environmental problems” prioritize the “introduction of heavier ﬁnes for offenders”, which is with an acceptance rate of 36% in 2011 far ahead of “providing more information on environmental issues”, which gained only 26%. Only 15% of those asked favor “introducing or increasing taxation on environmentally damaging activities”. 91% of those interviewed “agree totally” that “the big polluters (corporations and industry) should be mainly responsible for protecting the environment”, whereas only 56% consider “protecting the environment” as a “very important” personal duty, and for an additional 36% it constitutes a “fairly important” personal duty. Moreover, 69% of the citizens believe that they themselves are not doing enough “to use natural resources efﬁciently”. And, ﬁnally, “economic factors” (to the extent of 85%), the “state of the environment” (to the extent of 77%) and “social factors” (to the extent of 75%) inﬂuence “quality of life” substantially. What does all these mean? What conclusions can be derived from these surveys?3 What can one learn for “environmental economics”?

2.1.2 Conclusions for Environmental Economics First of all, it is important to mention that “economic factors”, the “state of the environment” and “social factors” are dependent on each other. Economic growth obviously affects the social situation. Moreover, the environment can be further polluted through economic activities, or economic resources can be used to clean up the environment or prevent further environmental pollution. In many countries environmental degradation and social factors such as poverty are strongly correlated. Thus, and this is a ﬁrst lesson for “environmental economics”, the economical and the ecological conditions should not be separated when investigating environmental issues. Given the existing, persistent dichotomy between ecology and economy, this is not an easy thing to accomplish. In fact, this dichotomy results from information deﬁcits, which tend to increase the “gap” between economical and environmental is3

Observe that answers to some of the questions in the Eurobarometer surveys are not only provided in aggregate form, but also for the individual member states of the EU. This allows, in principle, an interesting analysis of the differences in attitudes among the citizens of the member states, which shall, however, not be further pursued in the context considered here (cf., for example, [5]).

16

2 Differing Views on the Environment

sues (cf. the discussions in the introductory chapter (Section 1.1), but also in Part III, in particular Subsection 9.1.1). Some environmental concerns such as “protecting nature”, “the state of the environment our children will inherit” and “pollution in towns and cities” have occupied high ranks and even top ranks in the surveys for at least ten years. This is, ﬁrstly, a clear indication that it is difﬁcult to tackle some environmental problems successfully and once and for all. Of course, in the context of “environmental economics” this immediately entails the question, why is this the case? A hint for an answer is provided by the fact that the three issues cited result from individual decisions and activities. So, it is in the hands of the economic agents to continue polluting the environment or to prevent future pollution, at least to a large extent. It is not too difﬁcult to keep the streets clean, to not dump waste in the forests, to use one’s own car less, or to prevent water pollution. Therefore, the question should be reformulated as follows: why do people disapprove of the pollution in towns and cities on the one hand, and contribute towards exactly this pollution on the other? Man-made disasters, however, seem to have only a short-lived effect. They are usually soon forgotten, till the next disaster starts to worry people. Similarly, environmental issues which extend over some period of time rarely receive the attention they deserve and should receive if it is difﬁcult to experience personally severe and direct consequences. This is, for example, true for “climate change”, especially, if long and hard winters seem to contradict the forecast of “global warming”. The question regarding the “top three environmental priorities” reveal activities, which are comparatively easy to carry out (sorting waste for recycling purposes), or they help to save money (reducing home energy consumption), or are difﬁcult to monitor on an individual level (using public transport). Therefore, it seems to be easy to award them high priority. The question regarding the “personal importance” of the environment in combination with the “willingness to pay” for environmentally friendly products demonstrates the dilemma: when people are asked to contribute personally towards the protection of the environment, they seem to lose interest and their enthusiasm wanes. This is clearly also an aspect which is relevant for “environmental economics”. A somewhat related situation can be observed with the answers to the question regarding the “most effective ways of tackling environmental problems”. The prioritized answer of an “introduction of heavier ﬁnes for offenders” points again to “the others” – the “polluters” should be penalized. However, as soon as there is a slight chance that one might oneself be affected by an environmental tax, this instrument suddenly becomes much less interesting. So, people tend to blame others for environmental degradation and, therefore, consider policies with a potential effect on their own economic situation less appropriate. Finally, the fact that 91% “agree totally” that the big polluters should be mainly responsible for protecting the environment, and the fact that only 56% consider the protection of the environment a “very personal” duty points again in the same direction: “the others” are always more responsible for all issues related to environmental problems than oneself. This “attitude” is important and relevant for a number of cases of environmental degradation.

2.2 The Environmental Movement in the US

17

In summary, this brief analysis of the “attitudes of European citizens towards the environment” helps to explain, among other things, the persistence of certain environmental issues, such as the highly ranked “pollution of towns and cities”. If it is mainly the “others”, who are blamed for polluting the environment, then this attitude should be changed. It is one of the tasks of “environmental economics” to provide appropriate incentives. The following section investigates environmental issues in the US. Although environmental awareness in the US is supposedly as high as in the EU, differences in the perception of the environment and of environmental problems lead to different attitudes towards the environment. These differences can hinder negotiations on cross-border environmental problems. The current international negotiations on the reduction of greenhouse gas emissions demonstrate the different positions among industrialized countries and between industrialized and developing countries regarding this issue.

2.2 The Environmental Movement in the US On April 22, 1970, the US celebrated Earth Day. This is, probably, the birthday of the environmental movement in the US. The following excerpt from an article published in the EPA Journal in 1988, provides some background information.

John C. Whitaker:4 “Earth Day Recollections: What It Was Like When The Movement Took Off” (excerpt from [16], EPA Journal July/August 1988) When President Nixon and his staff walked into the White House on January 20, 1969, we were totally unprepared for the tidal wave of public opinion in favor of cleaning the nation’s environment that was about to engulf us. If Hubert Humphrey had become President, the result would have been the same. During the 1968 presidential campaign, neither the Nixon nor Humphrey campaign gave more than lip service to environmental issues. Rather, their thoughts focused on 4

such issues as Vietnam, prosperity, the rising crime rate, and inﬂation. Nixon made one radio speech on natural resources and the quality of the environment, which seemed adequate to cover an issue that stirred little interest among the electorate. ... Yet only 17 months after the election, on April 22, 1970, the country celebrated Earth Day, with a national outpouring of concern for cleaning up the environment. Politicians of both parties jumped on the issue. So

John C. Whitaker was Cabinet Secretary in the Nixon administration in 1969 and a member of the Domestic Council staff from 1969 to 1973. As a member of the Domestic Council, Mr. Whitaker had responsibility for environmental and natural resources policies.

18

many politicians were on the stump on Earth Day that Congress was forced to close down. The oratory, one of the wire services observed, was “as thick as smog at rush hour”. A comparison of White House polls (done by Opinion Research of Princeton, New Jersey) taken in May 1969, and just two years later in May 1971, showed that concern for the environment had leaped to the forefront of our national psyche. In May 1971, fully a quarter of the public thought that protecting the environment was important, yet only 1 percent had thought so just two years earlier. In the Gallup polls, public concern over air and water pollution jumped from tenth place in the summer of 1969 to ﬁfth place in the summer of 1970, and was perceived as more important than “race”, “crime”, and “teenage” problems, but not as important as the perennial poll leaders, “peace” and the “pocketbook” issues. In the White House, we pondered this sudden surge of public concern about cleaning up America and providing more open spaces for parks, and a heightened awareness of the necessity to dedicate more land for wildlife habitat. Why, we asked, after it was so long delayed, was the environmentalist awakening so much more advanced in the United States than in other countries? What motivated millions to so much activity so long after publication of Rachel Car-

2 Differing Views on the Environment

son’s Silent Spring in 1962? Many factors seem to have been involved. First, the environmental movement probably bloomed at the time it did mainly because of afﬂuence. Americans have long been relatively much better off than people of other nations, but nothing in all history compares even remotely to the prosperity we have enjoyed since the end of World War II, and which became visibly evident by the mid-ﬁfties. An afﬂuent economy yields things like the 40-hour week, three-day weekends, the two-week paid vacation, plus every kind of labor-saving gadget imaginable to shorten the hours that used to be devoted to household chores. The combination of spare money and spare time created an ambiance for the growth of causes that absorb both money and time. Another product of afﬂuence has been the emergence of an “activist” upper middle class – collegeeducated, afﬂuent, concerned, and youthful for its ﬁnancial circumstances. The nation has never had anything like this “mass elite” before. Sophisticated, resourceful, politically potent, and dedicated to change, to “involvement”, it formed the backbone of the environmentalist movement in the United States. Other factors included the rise of television and the opportunities it provides for advocacy journalism. ...

In July 1970, President Nixon submitted to the Congress the Environmental Protection Agency Plan, and EPA was established on December 2, 1970. A variety of laws regarding clean air, water and solid waste were enacted, ocean dumping was restricted, and standards for offshore oil drilling were tightened (cf. [16] and the discussion of the Clean Air Act in Subsection 9.1.2).

2.2 The Environmental Movement in the US

19

Similarly to the situation in the EU, there were some issues regarding the “willingness to pay” for a cleaner environment. Polls in the early 1970s showed that there was a demand for a clean environment, but with government money. Spending one’s own money was obviously considered to be something completely different. In May 1971, three quarters of the population were reported to pay small price increases for pollution control, but six out of ten opposed large price increases (cf. again [16]). This attitude regarding the willingness to pay is obviously comparable to the situation in the EU, although the aversion against taxes, in particular pollution taxes, seems to be higher in the US. Has this situation changed fundamentally in recent years? EPA certainly built upon the power it was granted by the Clean Air Act (CAA) of 1970. Now EPA plans to, among other things, use the CAA to control the emissions of coal power plants, after the cap and trade system could not be implemented in 2010 (cf. Subsection 11.5.3). If these plans ﬁnd support, the Tennessee Valley Authority, for example, will have to install state of the art pollution controls in most of its coal-burning units resulting in a signiﬁcant reduction of NOx and SO2 emissions. Nevertheless, many business groups oppose this kind of regulations, referring to a likely increase in energy costs. In a Pew Research/National Journal Congressional Connection Poll, conducted June 10-13, 2010, a sizable share of 37% still voted for keeping energy prices low, 56% for protecting the environment (the polling results mentioned in this section are taken from [12]). Most recent polls on environmental issues in the US refer, however, to climate change and global warming, the really controversial issue in the US (cf. again Subsection 11.5.3). The polls reveal that US citizens are in principle ready to face the challenges associated with climate change. According to a Virginia Commonwealth Life Sciences Survey, conducted May 12-18, 2010, a majority of 54% believe that climate change represents a “major problem”, and 51% say that the federal government is currently doing “too little” to reduce global warming. However, as soon as the personal willingness to pay comes in, things are different. In an Ipsos/McClatchy Poll, conducted December 3-6, 2009, 48% oppose a cap and trade program, which lowers greenhouse gas emissions signiﬁcantly but raises the monthly electrical bill by 10 dollars; 55% oppose the program, if monthly electrical bills are raised by 25 dollars. And, in addition, according to a Gallup Poll, conducted March 4-7, 2010, more than two thirds think that global warming will not pose a serious threat to them or to their way of life in their lifetime (cf. [12]). Thus, the “attitude of US citizens towards the environment” is not much different from those of European citizens. The most remarkable exception is, probably, the handling of the issue of greenhouse gas emissions. Due to the fact that the country is – in comparison to Europe – more dependent on oil and cars, any environmental policy addressing a cap on CO2 emissions is going to face severe opposition, not only from industry. And due to the fact that there seems to be a general aversion to new taxes or tax increases, at least in a signiﬁcant part of the population, pollution taxes will not ﬁnd much support in the US either. Nevertheless, the US as a major source of CO2 emissions, has to be integrated into an international agreement to reduce greenhouse gas emissions. Excluding or

20

2 Differing Views on the Environment

omitting the US would render all other attempts to curb climate change ineffective, if not comparatively meaningless (cf. also Chapter 12). The next section investigates the environmental situation in parts of the developing world. The presentation will mostly refer to China and India, which are (China) or will be (India) major and further strongly increasing sources of greenhouse gas emissions.

2.3 The Developing World and the Environment Rapidly growing developing countries pose a particular challenge to international climate negotiations. Without a substantial reduction of future greenhouse gas emissions in countries such as China or, on a somewhat lower level, India, the industrialized world would be more or less left alone, and, in view of the strongly increasing greenhouse gas emissions in these countries, without the chance of a signiﬁcant effect on global warming.5 So the question arises, how to motivate China and other developing (and developed) countries to participate in the global efforts to combat climate change? This issue will, however, be addressed in more depth in Chapter 12, in particular in Section 12.2. This section is more devoted to the “environmental movement” in developing countries. What is then the main focus of these movements, what is the attitude of the citizens towards the environment? How do these movements depend on the integration of a developing country into the network of international trade? How can these movements be affected by the industrialized countries?

2.3.1 China and the Environment The rapid expansion of China’s economy is accompanied by environmental disasters, with an increasing frequency. In summer 2010 more than 1,000 tons of crude oil spilled into the Yellow Sea, thousands of barrels containing hazardous chemicals were spotted in a river in northeast China, and a leak of waste killed probably 2,000 tons of ﬁsh in southeast China ([13]). Of course, one does not have to point to the explosion of the Deepwater Horizon platform to point out that comparable and even larger disasters are happening everywhere. However, the number and the frequency of these catastrophes in China is striking and justiﬁes the question, whether China can or should continue with its rapid pace of economic growth. Nevertheless the fact that this information is available and that more and more Chinese people are aware of the environmental pollution in their neighborhood is a promising signal. The rising income for large parts of the population is helping 5

Besides China and India, the effective participation of the US in the efforts to reduce greenhouse gas emissions is also required to put a ceiling on global warming.

2.3 The Developing World and the Environment

21

gradually to change the attitude towards the environment, and the authorities have to react to the protests of the populations and have to get ready (and are getting ready) to meet the environmental “demands” of the population. Thus, China experiences the classical development regarding environmental awareness. First, at the beginning of the economic growth process, environmental pollution and degradation typically increase. Thereafter, with a higher income, people in urban areas become more and more concerned about the environment and the future of their children. For example, a series of food scandals including the contamination of milk powder in 2008 increased worries among the population about food safety in China. An investigation of Chinese attitudes towards the environment conducted in 2004 revealed serious concerns about the state of the environment (the following numbers are taken from [1]): 91% of those interviewed in 2004 believed that the environment had deteriorated severely during the previous decade in comparison to only 44% interviewed in 1999. Moreover, 83.9% conﬁrmed that the environmental pollution affected their health. The “Grain for Green Project”6 found the support of 78%. Not surprisingly, when asked whether they are willing to donate money for environmental conservation, 72.8% of those interviewed were willing to donate a weighted mean (cf. [1], p. 57, for details) of 32 US dollars per person. 40.9% of the people said that the environment and the economy are equally important, while 35.3% prioritized the environment. The survey also found a strong correlation between environmental attitudes and the key factors net income and education level. The poorest citizens (income 625 US dollars or below per year) and citizens with an income of 1,876 US dollars or above per year expressed in particular their concern about the degradation of the environment. Moreover, better educated citizens are more concerned about the state of the environment than those with a lower education level ([1], Tables 4 and 5). There is a further aspect regarding the environment in China: Chinese industry with its goal of becoming world market producers and even world market leaders for certain environmental technologies. In fact, Chinese companies are exporting solar products to Europe and the US, and are gaining increasing market shares at the expense of US American and European companies. According to a report of “The New York Times” of June 23, 2011, China produced at least half of the world’s solar panels in 2010 with the US accounting for 1.6 billion US dollars of the 29 billion US dollars global market ([14]). Thus, on the one hand, China is facing a multitude of severe and potentially health impairing local environmental problems extending from air pollution in the major cities to water pollution and to pollution from landﬁlling hazardous waste. A substantial share of the GDP is devoted to remediation efforts; and this share will probably increase further. On the other hand, however, China is on the road to becoming the world’s leading producer and exporter of sophisticated environmental technologies such as solar 6 Between 1999 and 2010, the Chinese government converted a substantial area of (marginal) farmland into forest and grassland with farmers receiving living subsidies as compensation for lost income from farming ([1], p. 56).

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2 Differing Views on the Environment

panels and wind turbines. Total renewable power capacity in China, including hydro power, reached 226 GW in 2009. This is more than one quarter of China’s total installed power capacity of 860 GW ([10]). Despite these and many other efforts, Chinese greenhouse gas emissions are expected to continue to rise over the next decades, at least with a “business as usual” policy. But even with all new coal power plants equipped with Carbon Capture and Storage (CCS) Technology, China’s CO2 emissions are likely to increase by 80% by 2030 ([11]). Thus, reduction of greenhouse gas emissions in China will remain a challenge, both for China and the industrialized world (cf. also the considerations in Section 12.2).

2.3.2 India and the Environment The primary causes of environmental degradation in India have to be attributed to the rapid growth of the population in combination with economic development and overuse of natural resources. Serious environmental calamities in India include land degradation, deforestation, soil erosion, habitat destruction and loss of biodiversity. Economic growth and changing consumption patterns have led to, among other things, a rising demand for energy and increasing transport activities. Air, water and noise pollution together with water scarcity dominate the environmental issues in India (cf. [15] for more details). The Indian Agricultural Research Institute expects that “more ﬂoods, frequent droughts and forest ﬁres, decrease in agricultural and aquacultural productivity, displacement of coastal dwellers by sea level rise and intense tropical cyclones, and the degradation of mangroves may be some of the likely consequences of climate change in Asia” ([9]). This indicates substantial problems for a nation with such a large population depending on the productivity of primary resources and whose economic growth relies heavily on industrial growth. For this reason, India – and other countries in the area – should have particular interest in the reduction of global greenhouse gas emissions or, to be more precise, in preventing a strong increase of these emissions in the further course of economic development. This will be a challenge for climate policy in India. In 2008, India’s per capita emissions of greenhouse gases from fuel combustion were with 1.25 tons of CO2 still very low in comparison to, for example, Germany with 9.79 tons or the US with 18.38 tons per year ([7], p. 95ff.). On the other hand, India’s greenhouse gas emissions per capita rose by 80% between 1990 and 2008 ([7], p. 11) and have more than doubled in absolute terms in this period ([7], p. 23). Chances are that they will continue to increase from 2008 levels by more than 2.5 times by 2030 due to the growth of the population and the economy ([7], p. 23). A substantial application of renewable energy sources will, thus, be needed to curb CO2 emissions. In this context, India announced in November 2009, ahead of the international climate summit in Copenhagen, that it would reduce the intensity of greenhouse

2.4 Attitudes Towards the Environment: A Summary

23

gas emissions – the amount of gases released per unit growth in GDP – by 20-25% between 2005 and 2020 (cf. again [7], p. 23). Opponents are afraid that this will “freeze inequity in the world” (cf. the report on India’s position in the Copenhagen negotiations on p. 118). As part of the “National Action Plan on Climate Change” released in 2008 (cf. [8]), the Indian government plans to arrive at a 10% share of renewable energy sources in power generation by 2015. In 2010, this share was estimated at 4%, although the installed capacity of renewable energies is more than 10% of total installed capacity ([2]). In conclusion, India is on the right path although there is still a long way to go to more than compensate the increase in greenhouse gas emissions due to population growth and economic growth through the application of renewable energy sources.

2.4 Attitudes Towards the Environment: A Summary There are, of course, differences and similarities among the three regions EU, US and China regarding attitudes towards the environment. As these aspects will turn out to be relevant for environmental policies, in particular international environmental policies, they shall be brieﬂy summarized in this section. Some of the results will be reconsidered in other sections of the book. Differences: One of the major differences is the degree of environmental degradation in the various regions. The general state of the environment regarding air, water or soil pollution is clearly signiﬁcantly better in the EU and in the US. This observation points to an interesting relationship between the state of the environment and the state of the economy, which is relevant for international climate negotiations, for example (cf. Chapter 12). Moreover, another difference refers to the speciﬁc type of environmental pollution, which is predominant in these areas. Besides the “classical” air, water and soil pollution, the environmental situation in China seems to be characterized by an often careless, if not to say intentional, pollution, which is also motivated by a rigorous pursuit of proﬁt. This attitude leads then to environmental disasters, among them those mentioned in Subsection 2.3.1. Of course, environmental catastrophes resulting from neglect or carelessness also happen in the EU or the US, however, according to experience, to a much lesser extent. It seems as if environmental awareness is more developed in the industrialized world and, thus, also depends on the state of the economy (cf. also Subsection 4.1.1). The attitude towards climate change in its relationship to man-made greenhouse gas emissions is among those issues, which still seem to separate the EU and the US. One of the reasons for this hesitant and observant behavior in the US regarding the reduction of greenhouse gas emissions is probably the dependence of the US on oil and coal, and the attitude that global warming is not expected to

24

2 Differing Views on the Environment

have much of an effect in the near future (cf. Section 2.2). Moreover, US citizens tend to be against all kind of new taxes or increased taxes. Therefore, certain instruments of environmental policy such as pollution taxes are likely to meet with resistance. There is some concern about global warming in the countries of the developing world. However, due to the rapid economic development in China and India and due to the rapid growth of the population in India, it will be difﬁcult not only to limit the increase, but indeed to reduce greenhouse gas emissions in these countries in absolute terms. Moreover, despite the fact that these countries will, with some probability, be severely affected by climate change, they still tend to blame the industrialized countries for the high concentration of CO2 in the atmosphere, resulting from all kinds of economic activities over the last 200 years. Probably substantial support from the industrialized world is required to solve this problem of transnational “pollution”. Similarities: In all countries, people realize that environmental pollution affects their life, their health, and the well-being of their children. They therefore consider “environmental commodities” as “commodities” in the usual sense, which are, in particular, scarce. In addition, all citizens want the government of their country to take care of environmental issues. However, when asked for their personal “willingness to pay” for some environmental project, the enthusiasm for the environment seems to decline. Obviously, it is better to let the others pay for a cleaner environment. This and related attitudes will prove responsible for a number of environmental problems in both the industrialized and the developing countries (cf., for example, Subsection 5.3.3). A further interesting observation refers to the persistence of certain environmental problems. Citizens in the EU, for example, have complained about the “pollution in towns and cities” for years, obviously without much success so far. So, what is the reason for this? Why is it so difﬁcult to eradicate environmental pollution once and for all? In summary, there are similarities among the attitudes towards the environment in different regions of the world; there are, however, also signiﬁcant differences, which can affect environmental policy, in particular international environmental policy. For example, the international negotiations on global greenhouse gas emissions are confronted with these issues. The next chapter illustrates this growing international dimension of environmental policy.

References 1. Cao S, Chen L, Liu Z (2009) An investigation of Chinese attitudes toward the environment: case study using the Grain for Green Project. AMBIO: A Journal of the Human Environment, 38(1):55-64, published by: Royal Swedish Academy of Sciences, DOI: 10.1579/0044-7447-

References

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4. 5.

6. 7. 8. 9.

10.

11.

12. 13. 14.

15. 16.

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38.1.55 http://www.bioone.org/doi/full/10.1579/0044-7447-38.1.55. Cited June 2011 Chadha M (2010) India’s renewable energy generation capacity could reach 48 GW by 2015. CleanTechnica.com http://cleantechnica.com/2010/07/25/indias-renewable-energy-generation-capacity-couldreach-48-gw-by-2015. Cited June 2011 EU: Decision No 1600/2002/EC of the European Parliament and of the Council of 22 July 2002 laying down the Sixth Community Environment Action Programme. http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2002:242:0001:0015:EN:PDF. Cited June 2011 EU: Website for the Public Opinion Analysis sector of the EC http://ec.europa.eu/public_opinion/index_en.htm. Cited July 2011 EU: Special Eurobarometer 75.2 (2011). Attitudes of European citizens towards the environment http://ec.europa.eu/public_opinion/archives/eb_special_379_360_en.htm. Cited June 2011 EU: Special Eurobarometer. Attitudes of European citizens towards the environment http://ec.europa.eu/public_opinion/archives/eb_special_en.htm. Cited June 2011 IEA Statistics (2010) CO2 emissions from fuel combustion – highlights. IEA, Paris http://www.iea.org/publications/free_new_Desc.asp?PUBS_ID=2143. Cited June 2011 India (2008) National Action Plan on Climate Change http://pmindia.nic.in/Pg01-52.pdf. Cited June 2011 India (2010) Global warming: Indian estimates of greenhouse gas emission from agricultural ﬁelds. Indian Agricultural Research Institute (IARI) http://www.iari.res.in/index.php?option=com_content&view=article&id=198&Itemid=545. Cited August 2011 Martinot E, Junfeng L (2010) China’s latest leap: an update on renewables policy. Renewable Energy World 13(4):51-57 http://www.renewableenergyworld.com/rea/news/article/2010/07/renewable-energy-policyupdate-for-china. Cited June 2011 Mrasek V (2009) China’s greenhouse gas emissions threaten to double. Spiegel Online International http://www.spiegel.de/international/world/0,1518,611818,00.html. Cited June 2011 PollingReport.com http://www.pollingreport.com/enviro.htm. Cited June 2011 Ramzy A (2010) China’s industrial accidents quietly on the rise. Time.com, July 29, 2010 http://www.time.com/time/world/article/0,8599,2007319,00.html. Cited June 2011 The New York Times (online: nytimes.com) (2011) http://topics.nytimes.com/top/news/business/energy-environment/solar-energy/index.html. Cited June 2011 Wikipedia: Environmental issues in India http://en.wikipedia.org/wiki/Environmental_issues_in_India. Cited August 2011 Whitaker JC (1988) Earth Day recollections: what it was like when the movement took off. EPA Journal July/August 1988 http://www.epa.gov/aboutepa/history/topics/earthday/10.html. Cited June 2011

Chapter 3

The International Dimension of the Environment

Abstract Transnational environmental problems such as acid rain, global warming or overﬁshing have gained increasing importance in recent years, and are likely to affect and even dominate international negotiations referring to political, economical and ecological issues. This chapter discusses the development of the international environmental negotiations with respect to various cross-border environmental issues including environmental consequences related to globalization. Thereafter, the “United Nations Conference on Environment and Development” (UNCED) in 1992 with the “Rio Declaration” and the “Agenda 21” is taken as a starting point for international environmental concern, in particular regarding climate change. The “United Nations Framework Convention on Climate Change” (UNFCCC) gave rise to the “Kyoto Protocol” and the negotiations for a second commitment period to reduce global greenhouse gas emissions. The focus in this chapter is on a ﬁrst analysis of relevant issues, which will be reconsidered in later chapters.

3.1 International Environmental Issues The increasing relevance of international environmental issues results from various effects which have gained strength and importance in recent years. There is, ﬁrst of all, a growing number of global environmental commodities. Then there are environmental issues associated with the intensifying globalization. And ﬁnally, there are those environmental problems, which attain an international dimension through the increasing volume of international trade.

3.1.1 Global Environmental Commodities Research and advanced scientiﬁc methods allowed (and will continue to allow) the “detection” of further global or transboundary environmental issues. These issues H. Wiesmeth, Environmental Economics: Theory and Policy in Equilibrium, Springer Texts in Business and Economics, DOI 10.1007/978-3-642-24514-5_3, © Springer-Verlag Berlin Heidelberg 2012

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can be addressed as environmental pollution (acid rain, for example), or as an environmental commodity (reduction of acid rain, for example). Both points of view will be used in the following presentation of a few selected global environmental issues, which have been of relevance for the last decades.

Acid Rain Acid rain counts among the ﬁrst transboundary environmental problems that still affects vast areas of the earth, and is damaging to lakes, streams and forests. In larger countries such as the US and Canada, acid rain has qualities of a local public bad, which can be, at least to some extent, contained by reducing local emissions of SO2 and NOx , in particular. This is, for example, the goal of the “Acid Rain Program” of the EPA, a 1990 amendment to the Clean Air Act in the US (cf. the website http://www.epa.gov/airmarkets/resource/acidrain-resource.html). After scientiﬁc studies conducted in Europe in the 1970s conﬁrmed that SO2 emissions and other air pollutants could travel thousands of kilometers before damaging forests and lakes, a meeting on the protection of the environment was held in Geneva in 1979 resulting in the “Geneva Convention on Long-range Transboundary Air Pollution” negotiated by the “United Nations Economic Commission for Europe” (UNECE). The convention was the ﬁrst international legally binding instrument to deal with problems of air pollution on a broad regional basis. It entered into force in 1983 and has thereafter been extended by eight “protocols” (cf. [6], also for more details). Despite these efforts, which undeniably reduced noxious emissions, in particular in Europe and North America, and which show signiﬁcant positive effects, acid rain will continue to remain an environmental issue, not only in the rapidly developing countries.

Ozone Layer The earth’s ozone layer or, to be more precise, the services of the earth’s ozone layer, namely the absorption of hazardous UV radiation, was also among the ﬁrst of these special environmental commodities. As a lower concentration of ozone in the atmosphere has been observed in the southern hemisphere in particular, these services have more qualities of a local public commodity. Nevertheless, the “Vienna Convention for the Protection of the Ozone Layer” in 1985, followed by the “Montreal Protocol on Substances that Deplete the Ozone Layer” as an international treaty to protect the ozone layer, which entered into force in 1989, initiated a series of international activities. These activities still culminate in “Conferences of the Parties”, referring to the Vienna Convention, and “Meetings of the Parties”, referring to the Montreal Protocol: the “9th Conference” and the “23rd Meeting” are planned for November 2011. Interestingly, although the environmental relevance of the earth’s ozone layer is well understood, and although harmful ozone-depleting substances

3.1 International Environmental Issues

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were identiﬁed more than 20 years ago, non-compliance with the Montreal Protocol is an issue, even today (cf. [9], p. xi).

Greenhouse Gas Emissions The “First World Climate Conference” took place in Geneva in 1979. It was one of the ﬁrst international meetings on the issue of climate change and led, among other things, to the creation of the “Intergovernmental Panel on Climate Change” (IPCC) in 1988. Thereafter, the “United Nations Framework Convention on Climate Change” (UNFCCC), an international treaty negotiated at the “United Nations Conference on Environment and Development” (UNCED) in 1992 (cf. [5]), entered into force in 1994 with the goal of stabilizing greenhouse gas concentrations in the atmosphere at an acceptable level (cf. Subsection 3.2.2 for more details on these international conventions). Greenhouse gas emissions, or rather the reduction of these emissions, constitutes a global public good. This results from the ubiquitous nature of these gases, in particular CO2 : wherever they are emitted, the concentration in the atmosphere will soon adjust for a world-wide more or less constant level. The task of the international climate negotiations, which have followed the UNFCCC, is therefore, in economic terms, the allocation of a global public good (cf. also Chapter 7 for theoretical approaches and Chapter 12 for practical attempts to allocating global public goods).

3.1.2 Consequences of Globalization In an increasingly globalized world, all kinds of “commodities”, including waste, are transported across borders. Environmental degradation can result from these activities in a variety of ways, and this degradation often requires the attention of international organizations and committees. An example is the rapidly growing production of electronic devices such as cell phones, laptops or personal computers, which is already leading to enormous amounts of e-waste. The problematic issue is that this e-waste is often “exported”, both legally and illegally, to developing countries, where these discarded commodities are “recycled” with often hazardous effects on health and the environment (cf. Subsection 10.1.1). Another example is provided by “pollution havens”, i.e., by companies which set up business in a country abroad with lax environmental standards or low enforcement of these standards and which pollute the environment excessively. It is, however, difﬁcult to imagine that a renowned company of an industrialized country with high environmental awareness and high environmental standards still considers this option. It certainly risks credibility and the loss of customers at home, once such activities are uncovered.

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3.1.3 The Environment and International Trade International trade is often associated with environmental degradation of various kinds. Increasing transport activities are among the more obvious environmental effects leading, in particular, to air and noise pollution.1 Moreover, overﬁshing is related to increasing global demand for ﬁsh. Due to the endeavors of the World Trade Organization (WTO) to further raise the global volume of trade, this source of environmental pollution will remain a challenge to all countries (cf. Chapter 13 for a discussion of the environmental aspects of international trade agreements). Of relevance are also mining activities in the developing countries for special metals which are then exported to the industrialized countries where they are used in the production of electronic equipment, for example. These mining activities can lead to trade-related environmental degradation in the form of water pollution or soil erosion. Similarly, the export of precious timber from tropical countries can induce environmental problems, again in the form of soil erosion or a general loss of tropical rain forests with further effects on the environment. Other trade-related environmental issues point to the internationalization of production activities by making use of comparative advantages. If, for example, China, the “world export champion”, produces commodities which are consigned for export in an environmentally questionable way, then the resulting environmental degradation is also trade-related. This holds true, in particular, for higher than necessary greenhouse gas emissions associated with the production of these commodities. Therefore, the interesting question arises to what extent China’s greenhouse gas emissions are trade-related in this sense. In general, this is a highly controversial issue. The question is whether the potential for economic growth, which is usually associated with international trade activities, is sufﬁcient to compensate for the environmental pollution through increased trade, and provides the ﬁnancial means to tackle these environmental issues. Experience shows that developing countries are dependent on being integrated into international trade for economic growth. However, they typically have to face, at least at the beginning of the growth process, substantial environmental problems regarding waste, air, water and soil pollution. But once economic development has surpassed a certain level, environmental awareness seems to increase, and part of the GDP is used to clean up the environment and prevent further environmental degradation. A long, often heated, and not yet exhausted discussion characterizes the mostly opposing standpoints of “free-traders” and “environmentalists” regarding this issue. Bhagwati, a prominent trade economist, published several books, in which most of the relevant arguments regarding trade and environment are addressed (cf. [1], for example). So much for this survey on “international environmental issues”. The following section will address more carefully the “United Nations Conference on Environ1

In this context, the growing level of freight trafﬁc is considered one of the greatest challenges facing the alpine countries Austria and Switzerland. This rapidly increasing trafﬁc impacts on the alpine environment and, potentially, the health of the residents.

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ment and Development” (UNCED) and the international environmental activities associated with this “Earth Summit” in 1992.

3.2 International Conferences and Environmental Agreements After the goal of sustainable development was propagated with the Brundtland Report in 1987 (cf. Section 1.1), the UN initiated and hosted a series of international conferences and conventions addressing cross-border environmental issues.

3.2.1 The United Nations Conference on Environment and Development (UNCED) The “Earth Summit”, which was attended by government ofﬁcials from 178 countries took place in Rio de Janeiro in 1992. The participants discussed solutions for global problems such as poverty, the growing gap between industrialized and developing countries, and environmental issues. The concept of sustainable development, taken from the Brundtland Report (cf. Section 1.1), comprised economic and social development together with the prevention of environmental degradation. Climate change was already an important issue in 1992. The results of the UNCED included the Rio Declaration with its 27 “Principles of Environment and Development”, the “Agenda 21”, and a “Statement of Principles for the Sustainable Management of Forests”. The “United Nations Framework Convention on Climate Change” (UNFCCC) and the “United Nations Convention on Biological Diversity” were opened for signatures at the UNCED. The preamble of the Rio Declaration refers to the goal “of establishing a new and equitable global partnership through the creation of new levels of cooperation among states, key sectors of societies and people, working towards international agreements which respect the interests of all and protect the integrity of the global environmental and developmental system, recognizing the integral and interdependent nature of the Earth, our home, . . . ” ([7], preamble). For this reason, the UNCED was much more than just an “environmental conference”. It linked social, economical and ecological aspects of development: poverty and environmental degradation in developing countries and the way of life in industrialized countries are therefore not independent.

The Rio Declaration on Environment and Development (excerpt from [7]) The United Nations Conference on Environment and Development, having met at Rio de Janeiro from 3 to 14 June 1992, reafﬁrming the Declaration

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of the United Nations Conference on the Human Environment, adopted at Stockholm on 16 June 1972, and seeking to build upon it, with the goal of establishing a new and equitable global partnership through the creation of new levels of cooperation among States, key sectors of societies and people, working towards international agreements which respect the interests of all and protect the integrity of the global environmental and developmental system, recognizing the integral and interdependent nature of the Earth, our home, proclaims that: Principle 1: Human beings are at the center of concerns for sustainable development. They are entitled to a healthy and productive life in harmony with nature. Principle 2: States have, in accordance with the Charter of the United Nations and the principles of international law, the sovereign right to exploit their own resources pursuant to their own environmental and developmental policies, and the responsibility to ensure that activities within their jurisdiction or control do not cause damage to the environment of other States or of areas beyond the limits of national jurisdiction. Principle 3: The right to development must be fulﬁlled so as to equitably meet developmental and environmental needs of present and future generations. Principle 4: In order to achieve sustainable development, environmental protection shall constitute an integral part of the development process and cannot be considered in isolation from it. Principle 7: States shall cooperate in a spirit of global partnership to conserve, protect and restore the health and integrity of the Earth’s ecosystem. In view of the different contributions to global environmental degradation, States have common but differentiated responsibilities. The developed countries acknowledge the responsibility that they bear in the international pursuit of sustainable development in view of the pressures their societies place on the global environment and of the technologies and ﬁnancial resources they command. Principle 8: To achieve sustainable development and a higher quality of life for all people, States should reduce and eliminate unsustainable patterns of production and consumption and promote appropriate demographic policies. Principle 9: States should cooperate to strengthen endogenous capacitybuilding for sustainable development by improving scientiﬁc understanding through exchanges of scientiﬁc and technological knowledge, and by enhancing the development, adaptation, diffusion and transfer of technologies, including new and innovative technologies. Principle 10: Environmental issues are best handled with the participation of all concerned citizens, at the relevant level. At the national level, each individual shall have appropriate access to information concerning the environment that is held by public authorities, including information on hazardous materials and activities in their communities, and the oppor-

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tunity to participate in decision-making processes. States shall facilitate and encourage public awareness and participation by making information widely available. Effective access to judicial and administrative proceedings, including redress and remedy, shall be provided. Principle 11: States shall enact effective environmental legislation. Environmental standards, management objectives and priorities should reﬂect the environmental and developmental context to which they apply. Standards applied by some countries may be inappropriate and of unwarranted economic and social cost to other countries, in particular developing countries. Principle 12: States should cooperate to promote a supportive and open international economic system that would lead to economic growth and sustainable development in all countries, to better address the problems of environmental degradation. Trade policy measures for environmental purposes should not constitute a means of arbitrary or unjustiﬁable discrimination or a disguised restriction on international trade. Unilateral actions to deal with environmental challenges outside the jurisdiction of the importing country should be avoided. Environmental measures addressing transboundary or global environmental problems should, as far as possible, be based on an international consensus. Principle 16: National authorities should endeavor to promote the internalization of environmental costs and the use of economic instruments, taking into account the approach that the polluter should, in principle, bear the cost of pollution, with due regard to the public interest and without distorting international trade and investment. Principle 27: States and people shall cooperate in good faith and in a spirit of partnership in the fulﬁllment of the principles embodied in this Declaration and in the further development of international law in the ﬁeld of sustainable development.

The key concept of of the UNCED in general and of the Rio Declaration in particular is sustainable development, pointing to unsustainable patterns of production and consumption, which have to be reduced or even eliminated (cf. Principle 8 of the Rio Declaration). As already mentioned, this concept was introduced in the Brundtland Report, presented to the public in 1987 (cf. [4] and Section 1.1). The Agenda 21 is, however, considered to be the key document. In the preamble, it refers to the necessary “integration of environment and development concerns”. Only in “a global partnership for sustainable development” will it be possible to achieve “the fulﬁllment of basic needs, improved living standards for all, better protected and managed ecosystems and a safer, more prosperous future”. In its 40 chapters, “Agenda 21 addresses the pressing problems of today and also aims at preparing the world for the challenges of the next century. It reﬂects a global consensus and political commitment at the highest level on development and environment cooperation. Its successful implementation is ﬁrst and foremost the re-

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sponsibility of Governments. National strategies, plans, policies and processes are crucial in achieving this. International cooperation should support and supplement such national efforts” ([8], preamble).

Agenda 21: Environmentally Sound Management of Biotechnology (excerpt from [8], Ch. 16) Biotechnology is the integration of the new techniques emerging from modern biotechnology with the well-established approaches of traditional biotechnology. Biotechnology, an emerging knowledge-intensive ﬁeld, is a set of enabling techniques for bringing about speciﬁc man-made changes in deoxyribonucleic acid (DNA), or genetic material, in plants, animals and microbial systems, leading to useful products and technologies. By itself, biotechnology cannot resolve all the fundamental problems of environment and development, so expectations need to be tempered by realism. Nevertheless, it promises to make a signiﬁcant contribution in enabling the development of, for example, better health care, enhanced food security through sustainable agricultural practices, improved supplies of potable water, more efﬁcient industrial development processes for transforming raw materials, support for sustainable methods of afforestation and reforestation, and detoxiﬁcation of hazardous wastes. Biotechnology also offers new opportunities for global partnerships, especially between the countries rich in biological resources (which include genetic resources) but lacking the expertise and investments needed to apply such resources through biotechnology, and the countries that have developed the technological expertise to transform biological resources so that they serve the needs of sustainable development. Biotechnology can assist in the conservation of those resources through, for example, ex situ techniques. The programme areas set out below seek to foster internationally agreed principles to be applied to ensure the environmentally sound management of biotechnology, to engender public trust and conﬁdence, to promote the development of sustainable applications of biotechnology and to establish appropriate enabling mechanisms, especially within developing countries, through the following activities: (a) Increasing the availability of food, feed and renewable raw materials; (b) Improving human health; (c) Enhancing protection of the environment; (d) Enhancing safety and developing international mechanisms for cooperation; (e) Establishing enabling mechanisms for the development and the environmentally sound application of biotechnology. Ch. 28 of the Agenda 21 presents the idea and the concept of a Local Agenda 21 to stress the importance of the participation of local authorities in the implementation

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of environmental policies. A consensus on a Local Agenda 21 should have been achieved by 1996. However, after 15 years, the eagerness to participate in appropriate activities of a Local Agenda 21 seems to have declined, at least in some parts of the world.

Agenda 21: Local Authorities’ Initiatives in Support of Agenda 21 (excerpt from [8], Ch. 28) Because so many of the problems and solutions being addressed by Agenda 21 have their roots in local activities, the participation and cooperation of local authorities will be a determining factor in fulﬁlling its objectives. Local authorities construct, operate and maintain economic, social and environmental infrastructure, oversee planning processes, establish local environmental policies and regulations, and assist in implementing national and subnational environmental policies. As the level of governance closest to the people, they play a vital role in educating, mobilizing and responding to the public to promote sustainable development. The following objectives are proposed for this programme area: (a) By 1996, most local authorities in each country should have undertaken a consultative process with their populations and achieved a consensus on “a local Agenda 21” for the community; (b) By 1993, the international community should have initiated a consultative process aimed at increasing cooperation between local authorities; (c) By 1994, representatives of associations of cities and other local authorities should have increased levels of cooperation and coordination with the goal of enhancing the exchange of information and experience among local authorities; (d) All local authorities in each country should be encouraged to implement and monitor programmes which aim at ensuring that women and youth are represented in decision-making, planning and implementation processes. Although “Local Agenda 21” continues to be an important issue for many communities (cf., for example, [2] for the City of Dresden in Germany), there are communities, which are canceling their participation in the Agenda 21 initiative (cf., for example, [3] for Maryland County in the US). Whereas German communities use the Local Agenda 21 to establish networks between communities, public organizations, business companies and institutions of the private sector of the economy and not-for-proﬁt organizations to further the key issue of sustainability, critical communities in the US are afraid that “sustainability invokes government power to enforce activists’ views of environmentalism”. Some opponents even consider it “an attack on capitalism, and an attack on America’s middle-class lifestyle” (cf. [3]).

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As a consequence, it seems as if – after 15 years – the Local Agenda 21 again needs more attention and more publicity. The truth is that sustainability as a model for the development of economic and social systems depends critically on the support of the vast majority of the population.

3.2.2 The United Nations Framework Convention on Climate Change (UNFCCC) Besides the Rio Declaration and the Agenda 21, which together with the Statement of Forest Principles are the major agreements adopted at the UNCED in 1992, two legally binding conventions, which aimed at preventing global climate change and sustaining the diversity of biological species, were opened for signature at the “Earth Summit”: the “United Nations Framework Convention on Climate Change” (UNFCCC) and the “United Nations Convention on Biological Diversity”. The UNFCCC establishes and coordinates efforts to combat global warming. Its ultimate objective is the “stabilization of greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system. Such a level should be achieved within a time-frame sufﬁcient to allow ecosystems to adapt naturally to climate change, to ensure that food production is not threatened and to enable economic development to proceed in a sustainable manner” ([5], Article 2). The UNFCCC sets out some guiding principles. The precautionary principle says that the lack of full scientiﬁc certainty should not be used as an excuse to postpone action when there is a threat of serious or irreversible damage. The principle of the common but differentiated responsibilities of states assigns the lead in combating climate change to developed countries. Other principles deal with the special needs of developing countries and the importance of promoting sustainable development. The general commitments accepted by both developed and developing countries include the adoption of national programs for mitigating climate change and the development of strategies for adapting to its impacts. They should also promote technology transfer and the sustainable management, conservation, and enhancement of greenhouse gas sinks. In addition, the issues of climate change should be taken into account in all relevant social, economic, and environmental policies. Cooperation in scientiﬁc, technical, and educational matters, and the promotion of education, public awareness, and the exchange of information related to climate change are also part of the general commitments (cf. the websites of the UNFCCC at http://unfccc.int for further information). However, industrialized countries are assumed to undertake several speciﬁc commitments. Most members of the OECD plus the states of Central and Eastern Europe (together known as Annex I Parties) are committed to adopting policies and measures aimed at reducing greenhouse gas emissions.

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The supreme body of the UNFCCC is the “Conference of the Parties” (COP). The COP comprises all the states that have ratiﬁed the Convention (195 Parties in March 2011), which entered into force in 1994. It held its ﬁrst meeting (COP 1) in Berlin, Germany, in 1995; COP 17 is scheduled for Durban, South Africa, in late 2011. Of particular importance is COP 3, which took place in Kyoto, Japan, in 1997. The Kyoto Protocol is the well-known result of this meeting.

3.2.3 The Kyoto Protocol Whereas UNFCCC with its general commitments encouraged industrialized countries to reduce greenhouse gas emissions, the Kyoto Protocol committed them to do so. Under the principle of common but differentiated responsibilities, and given that the developed countries have signiﬁcantly contributed towards the high concentration of greenhouse gases in the atmosphere, a heavier burden was placed on the Annex I Parties (cf. the regulation of the Kyoto Protocol in [11]). The Kyoto Protocol was adopted on December 11, 1997, and entered into force on February 16, 2005, after having been ratiﬁed by at least 55 Parties to the UNFCCC which accounted in total for at least 55% of the CO2 emissions of the Annex I Parties in 1990. The detailed rules for the implementation of the Kyoto Protocol were adopted at COP 7 in Marrakesh in 2001, and are called the “Marrakesh Accords” (cf. [16]). These accords include operational rules for the ﬂexible mechanisms of the Kyoto Protocol. The ﬂexible mechanisms, which are meant to allow cost-effective reductions of greenhouse gas emissions, comprise International Emissions Trading, the Clean Development Mechanism, and Joint Implementation. International Emissions Trading: This mechanism allows countries that have succeeded in reducing their emissions below their Kyoto Protocol target to sell excess allowances to countries that face a shortfall in meeting their targets. The various cap and trade systems, such as the “EU Emissions Trading System” (EU ETS), are integrated into the regulations of the Kyoto Protocol (cf. Section 11.5). Clean Development Mechanism (CDM): This instrument is meant to bring investments in greenhouse gas emission reduction projects to countries without obligations regarding the Kyoto Protocol. The intended projects have to be approved and authorized by all Parties involved. At the beginning of June 2011, more than 6,000 CDM projects were active or given a positive validation (cf. [17]). Companies in Annex I countries can obtain Certiﬁed Emission Reductions (CERs) for reductions achieved by a CDM project, if they are additional to what would otherwise have occurred. These CERs can be used for the target in the Kyoto Protocol or in the EU ETS. Joint Implementation (JI): This mechanism allows a country with an emission reduction or limitation commitment under the Kyoto Protocol to earn Emission Re-

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duction Units (ERUs) from an emission reduction or emission removal project in another Party with an emission reduction or limitation commitment, which can be counted towards meeting the Kyoto target.

CDM Project 3159: Jinxiu Fengmuao Hydro Power Project Description of the small-scale project activity (excerpt from [18]) The Jinxiu Fengmuao Hydro Power Project . . . is a reservoir type small-scale hydro power project in Guangxi Zhuang Autonomous Region of the People’s Republic of China . . . The Project will utilize the hydrological resources of the Mentou River in a reservoir type hydro power facility that will generate low emissions electricity for the China Southern Power Grid. The Project Developer has obtained permission to sell generated electricity to the Guangxi Power Grid which is an integral part of the China Southern Power Grid. The China Southern Power Grid is a coal-dominated power grid. The electricity currently generated by the grid is relatively carbon intensive, . . . The Project is therefore expected to reduce emissions of greenhouse gases by an estimated 20,823t CO2 -eq per year during the ﬁrst crediting period. The Project is contributing to sustainable development of the Host County. Speciﬁcally the Project: • Achieves greenhouse gas (GHO) emission reductions by avoiding CO2 emissions from the business-as-usual scenario electricity generation of those fossil fuel-ﬁred power plants connected to the China Southern Power Grid which is dominated by fossil fuel-ﬁred electricity. • Increases employment opportunities in the area where the Project is located (approximately 25 persons will be permanently employed for the Project operation and the construction of the Project secures jobs in the construction sector) and thereby contributes to poverty alleviation. • Enhances the local investment environment and therefore improves the local economy. • Diversiﬁes the sources of electricity generation, which is important for meeting growing energy demands and the transition away from diesel and coal-supplied electricity generation. • Makes greater use of renewable hydroelectric resources. Moreover the Marrakesh Accords provide incentives to comply with the commitments of the Kyoto Protocol: failure to achieve the reduction goals during the ﬁrst commitment period of the Protocol ending in 2012 leads to a higher reduction load in the second commitment period – which, however, does not yet exist. The Kyoto Protocol will be further investigated under different aspects in later subsections and sections. Subsection 5.3.2, for example, analyzes compliance with

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the Protocol, whereas Section 7.3 interprets the Protocol as a cost sharing mechanism for the provision of a public good. Finally, Chapter 12, in particular Subsection 12.2.1, draws the attention to strategies to inﬂuence the outcome of international climate negotiations, which are then considered as an allocation mechanism for a global public good, namely the reduction of greenhouse gas emissions. These negotiations with the goal of an extension or replacement of the Kyoto Protocol with a second commitment period for the time after 2012, shall now be addressed brieﬂy.

3.2.4 Copenhagen, Cancun, Durban and Rio? With the “ﬁrst quantiﬁed emission limitation and reduction commitment period” of the Kyoto Protocol ending in 2012, current international climate negotiations are increasingly focusing on the period thereafter, on the “second quantiﬁed emission limitation and reduction commitment period”. Additional scientiﬁc insight into the issue of climate change as well as the rapid economic growth of various countries in transition require challenging reduction targets for greenhouse gas emissions and instruments to “enforce” these commitments.

COP 15 – Copenhagen 2009 The Conference of the Parties in Copenhagen in 2009 (COP 15) took note of the Copenhagen Accord with 114 Parties agreeing to the Accord. A key goal of the Accord is “to reduce global emissions so as to hold the increase in global temperature below two degrees Celsius, and take action to meet this objective consistent with science and on the basis of equity” ([12], paragraph 2). Moreover, all Parties to the UNFCCC are urged to implement individually or jointly the quantiﬁed emission targets for 2020, which should have been submitted by the end of January 2010. Annex I Parties are thereby asked to further strengthen their emission reductions initiated by the Kyoto Protocol ([12], paragraphs 4 and 5), as several countries are still far from their targets (cf. Subsection 5.3.2). The quantiﬁed economy-wide emission targets submitted by the Parties are not generally deemed sufﬁcient to support the two-degree goal (cf. [10]). Moreover, various targets submitted are contingent on other developments. Thus, “Australia will reduce its greenhouse gas emissions by 25% on 2000 levels by 2020 if the world agrees to an ambitious global deal capable of stabilizing levels of greenhouse gases in the atmosphere at 450 ppm CO2 -eq or lower. Australia will unconditionally reduce . . . emissions by 5% below 2000 levels by 2020, and by up to 15% by 2020 if there is a global agreement which falls short of securing atmospheric stabilization at 450 ppm CO2 -eq and under which major developing economies commit to substantially restrain emissions and advanced economies take on commitments comparable to Australia’s” ([13]).

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This way of linking one’s own commitment to the potential commitment of others is to some extent typical for this kind of agreement. Section 12.2 will investigate such strategies and the resulting outcomes for climate negotiations. The Copenhagen Accord Emission Targets Submitted by the Government of India ([14]) Dear Mr. Yvo de Boer, I have the honour to communicate to you the information on India’s domestic mitigation actions as follows: India will endeavour to reduce the emissions intensity of its GDP by 20-25% by 2020 in comparison to the 2005 level. Please note that the proposed domestic actions are voluntary in nature and will not have legally binding character. Further, these actions will be implemented in accordance with the provisions of the relevant national legislations and policies as well as the principles and provisions of the UNFCCC, particularly its Article 4, paragraph 7. This Communication is made in accordance with the provisions of Article 12 paragraph 1(b), Article 12 paragraph 4 and Article 10 paragraph 2(a) of the UNFCCC. Sincerely yours, Rajani Ranjan Rashmi Joint Secretary Ministry of Environment & Forests

COP 16 – Cancun 2010 The Conference of the Parties in Cancun in 2010 resulted in the adoption of the Cancun Agreements. These decisions by the international community attempt to address the long-term challenge of climate change collectively and comprehensively over time and to take concrete action to speed up the global response. The following are the main objectives of the Agreements (cf. [15]), which are considered to “represent key steps forward in capturing plans to reduce greenhouse gas emissions and to help developing nations protect themselves from climate impacts and build their own sustainable futures”: • establish clear objectives for reducing human-generated greenhouse gas emissions over time to keep the global average temperature rise below two degrees; • encourage the participation of all countries in reducing these emissions, in accordance with each country’s different responsibilities and capabilities to do so; • ensure the international transparency of the actions which are taken by countries and ensure that global progress towards the long-term goal is reviewed in a timely way;

References

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• mobilize the development and transfer of clean technology to boost efforts to address climate change, getting it to the right place at the right time and for the best effect; • mobilize and provide scaled-up funds in the short and long term to enable developing countries to take greater and effective action; • assist the particularly vulnerable people in the world to adapt to the inevitable impacts of climate change; • protect the world’s forests, which are a major repository of carbon; • build up global capacity, especially in developing countries, to meet the overall challenge; • establish effective institutions and systems which will ensure these objectives are implemented successfully. The signiﬁcance of the key agreements reached at Cancun is seen in the collective effort to reduce greenhouse gas emissions, in the comprehensive package agreed to help developing nations deal with climate change and the timely schedule to review the progress towards the objective of keeping the average global temperature rise below two degrees Celsius (cf. [15]. Again, a further analysis of these issues with practical relevance will reveal the difﬁculties to achieve a binding and enforceable agreement to reduce greenhouse gas emissions (cf. again Section 12.2).

COP 17 – Durban 2011 In summary, the agreements reached in both Copenhagen, 2009, and in Cancun, 2010, point to a lack of political will to deliver on results which are concrete and promise an effective approximation to the two-degree target. In this context, one has to observe that the Cancun meeting revealed the gap between mitigation pledges regarding greenhouse emissions and the targets needed to limit global warming to below two degrees. Thus, the possibility of a “second quantiﬁed emission limitation and reduction commitment period”, determining the future of the Kyoto Protocol, will likely be on the table at COP 17 in Durban in late 2011, or at COP 18 in Rio, celebrating 20 years of climate negotiations. The EU seems to be in favor of this second commitment period offering emission reductions of at least 25% by 2020. How to motivate and stimulate the large “carbon” countries for a second commitment will remain the key question for Durban (and potentially for Rio).

References 1. Bhagwati J (2004) In defense of globalization. Oxford University Press, New Delhi 2. Lokale Agenda 21 für Dresden e.V. http://www.dresdner-agenda21.de. Cited June 2011

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3. McManus J (2011) Maryland County cancels Agenda 21 participation. New American, March 3, 2011 http://www.thenewamerican.com/index.php/tech-mainmenu-30/environment/6542-maryland-county-cancels-agenda-21-participation. Cited June 2011 4. UN (1987) Our common future. Report of the World Commission on Environment and Development http://www.un-documents.net/ocf-02.htm. Cited June 2011 5. UN (1992) United Nations Framework Convention on Climate Change http://unfccc.int/resource/docs/convkp/conveng.pdf. Cited June 2011 6. UNECE (1979) Convention on Long-range Transboundary Air Pollution http://www.unece.org/env/lrtap/full%20text/1979.CLRTAP.e.pdf. Cited June 2011 7. UNEP (1992) Rio Declaration on Environment and Development http://www.unep.org/Documents.Multilingual/Default.asp?documentid=78&articleid=1163. Cited June 2011 8. UNEP (1992) Agenda 21 http://www.unep.org/Documents.Multilingual/Default.asp?DocumentID=52&ArticleID=49 &l=en. Cited June 2011 9. UNEP (2009) Handbook for the Montreal Protocol on Substances that Deplete the Ozone Layer. 8th ed. UNEP, Nairobi http://ozone.unep.org/Publications/MP_Handbook/MP-Handbook-2009.pdf. Cited June 2011 10. UNEP (2010) The emissions gap report: Are the Copenhagen Accord pledges sufﬁcient to limit global warming to 2 degrees or 1.5 degrees Celsius? UNEP, Nairobi http://www.unep.org/publications/ebooks/emissionsgapreport/index.asp. Cited June 2011 11. UNFCCC (1997) The Kyoto Protocol http://unfccc.int/resource/docs/convkp/kpeng.pdf. Cited June 2011 12. UNFCCC (2010) The Copenhagen Accord http://unfccc.int/resource/docs/2009/cop15/eng/11a01.pdf#page=4. Cited June 2011 13. UNFCCC (2010) The Copenhagen Accord: Australia http://unfccc.int/ﬁles/meetings/cop_15/copenhagen_accord/application/pdf/australiacphaccord_app1.pdf. Cited June 2011 14. UNFCCC (2010) The Copenhagen Accord: India http://unfccc.int/ﬁles/meetings/cop_15/copenhagen_accord/application/pdf/indiacphaccord_app2.pdf. Cited June 2011 15. UNFCC (2011) The Cancun Agreements http://cancun.unfccc.int/cancun-agreements/main-objectives-of-the-agreements/#c33. Cited June 2011 16. UNFCCC (2001) The Marrakesh Accords http://unfccc.int/cop7/documents/accords_draft.pdf. Cited June 2011 17. UNFCCC: CDM Projects Pipeline http://cdmpipeline.org/overview.htm. Cited June 2011 18. UNFCCC: CDM Project 3159: Jinxiu Fengmuao Hydro Power Project http://cdm.unfccc.int/Projects/DB/TUEV-SUED1259244341.04/view. Cited June 2011

Part II

Theoretical Environmental Economics

This part of the book provides the theoretical background of environmental economics. The basic concept of an environmental commodity allows, in principle, the application of the tools and instruments well-known from economic theory. However, characteristics of the environmental commodities affect the allocative functions of the market mechanism, usually adversely. For this reason the framework conditions of a market economy have to be adjusted to allow a consideration of environmental issues. A deeper understanding of the allocation problems in the context of environmental commodities is required for an economically and ecologically sound environmental policy. The following chapters contain the relevant theoretical concepts and results and deliver, again from a theoretical point of view, the tools for dealing with external or environmental effects and public commodities. Missing markets characterize external effects in general and environmental effects in particular. The theory of environmental economics is therefore mostly concerned with an appropriate completion of the market system. The careful introduction of property rights for environmental commodities may also prove helpful in this context. However, international environmental issues, such as the global reduction of greenhouse gas emissions, deserve a special attention. The various international negotiations under the roof of UN organizations serve as allocation mechanisms for the affected global environmental commodities. Therefore, the last chapter investigates relevant properties of such a mechanism from a theoretical point of view. The practical applicability of the instruments resulting from theoretical environmental economics will then be investigated and discussed in Part III of the monograph.

Chapter 4

Basics of Environmental Economics

Abstract Not unlike regular commodities, the state of the environment affects the well-being of mankind – locally and globally, in the short run and in the long run. It is therefore quite natural to integrate the “environment” into the economic system, to analyze the “environment” in the context of the economic allocation problems, which are and have been relevant for any economic system in any period of time. The concept of environmental economics refers exactly to this situation and does not imply or intend a subordination of the environment to the economic system. In view of these remarks this chapter then introduces the concept of an environmental commodity and discusses relevant, characteristic properties. Moreover, the integration of the environment into the economic system leads to interesting details regarding economic efﬁciency and environmental pollution.

4.1 Fundamental Concepts The concept of a good or, equivalently, a commodity, comprising both a physical commodity or a service, is basic for any economic system and can be extended to include environmental goods or environmental commodities. Like any other good, environmental commodities inﬂuence the well-being of mankind in general, or of economic agents, consumers and producers, in particular. However, as is the case with regular commodities, only perceived scarcity renders environmental commodities relevant for a rigorous economic analysis.

4.1.1 Environmental Awareness and Perceived Scarcity The concrete experience of scarcity of an environmental commodity depends on a variety of conditions of which actual physical scarcity is only one. For example, research activities in natural sciences contribute to the continuous discovery of more H. Wiesmeth, Environmental Economics: Theory and Policy in Equilibrium, Springer Texts in Business and Economics, DOI 10.1007/978-3-642-24514-5_4, © Springer-Verlag Berlin Heidelberg 2012

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and more “scarce” environmental commodities. In this context, the ecological relevance of the earth’s ozone layer and its limited capacity to store chloroﬂuorocarbons (CFCs) only became known with the advancement of science and the development of sophisticated instruments to measure and document the relevant chemical processes. Most important for the perceived scarcity of environmental commodities is, however, the state of environmental awareness in a particular population. A high level of environmental concern raises the importance of environmental issues in a society, which is a prerequisite for an effective environmental policy. The difﬁcult thing is that environmental awareness itself seems to depend on the level of economic well-being. Grossman/Krueger ”ﬁnd no evidence that environmental quality deteriorates steadily with economic growth. Rather, for most indicators, economic growth brings an initial phase of deterioration followed by a subsequent phase of improvement. The turning points for the different pollutants vary, but in most cases they come before a country reaches a per capita income of $8000” ([3], abstract; the dollars are 1985 dollars). Developing countries are therefore typically characterized by a low level of environmental awareness, accompanied by a variety and in many cases increasing number of environmental problems.1 Simple economic issues such as a sufﬁcient amount of food or a suitable place to live are, at least temporarily, more important. This fact is gaining importance in the context of the increasing number of international or cross-border environmental issues. The EU, the US and China have differing positions on the ecological relevance of global warming.2 These differences with respect to the necessity and the urgency of appropriate measures to reduce greenhouse gas emissions are also the consequence of differences in environmental awareness. However, an international environmental policy to control climate change would not be effective if the US and China were not party to it. Given this situation, how can the EU “motivate” other countries, in particular the rapidly growing emerging economies, to participate in the worldwide efforts to curb emissions of greenhouse gases? With respect to applications and environmental policy this question will be addressed in Section 11.5 and, with a focus on international negotiations, also in Chapter 12. In short, cross-border environmental issues in one country may not be of much concern in another one, may not be “perceived” as an environmental problem in another country, and issues with no environmental relevance at one point of time may gain high ecological importance at another point of time. Moreover, research efforts in the ﬁelds of natural sciences will continue to extend the list of “scarce” 1

Even highly industrialized countries such as Germany experienced this kind of development. In the 1960s it was still considered natural to have a “grey sky” over the Ruhr valley, then a huge industrial area with coal mining, steel production and related industries in the northern part of Germany. At that time this air pollution symbolized economic growth and was only rarely perceived as a threat to one’s health. 2 Although some important steps are being taken towards emissions control and alternative energy, China’s ﬁrst priority seems to maintain its rapid economic development accompanied by an increasing use of fossil energy; in the US, climate change remains a controversial issue (cf. Chapter 2 for more details).

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environmental commodities with the implicit necessity to clean up the environment and control future pollution. An immediate consequence is that environmental issues will always challenge societies and economies in terms of their effects on economic well-being and economic cost.

4.1.2 Environmental Commodities and Allocation Problems At this point a closer inspection of the economic allocation problems is necessary, with a clear reference to environmental commodities. The allocation problems postulate answers to the following fundamental economic issues: • Which commodities shall be produced? What quantities are required? • How shall these commodities be produced? • Who shall have access to these commodities? Under which conditions will access be granted? For a speciﬁc example in the environmental context think about the “services” provided by the earth’s ozone layer. It is well understood today that the ozone layer protects life on earth from the effects of ultraviolet rays from the sun, and should therefore have no “holes”, no signiﬁcant reductions in concentrations. A way to restore this layer is the ban on CFCs, and once restored, nobody can be excluded from the services of the ozone layer. In general, a solution to the allocation problems requires a mechanism or system, which – ideally – leads to an optimal allocation, at least under some reasonable conditions. The market mechanism constitutes such a mechanism or system based on a decentralization of economic decisions by means of a price system. Clearly, in order for the market mechanism to function properly, regular markets are required for each commodity. Moreover, none of the economic agents should have an effect on the price system; otherwise distorted prices would provide false signals to consumers and producers. Applying these considerations to the allocation of environmental commodities, one has to deal with some problems. First of all, for quite a few environmental commodities regular markets will, for more or less obvious reasons, not exist. This is true for the above-mentioned services of the ozone layer, for example: anyone buying these services would also buy them for many others without receiving their ﬁnancial contributions.3 Moreover, the consumption or the production of most environmental commodities involves environmental or external effects, which are not reﬂected in the market system. The emission of noise through transport activities provides an example for this case: typically nobody pays or has to pay for emitting noise while riding a motorcycle. A closer inspection will show (cf. Section 6.1) that these external effects are characterized by missing markets, e.g. missing markets for 3

“Buying” the services of the ozone layer could be interpreted as willingness to pay for reducing the emission of substances which deplete the ozone layer (CFCs) by a certain amount. Similarly, “selling” means that someone is offering to reduce these emissions for a payment.

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emissions of noise. It is difﬁcult to imagine a regular market for these emissions for reasons similar to those mentioned above in the context of the ozone layer. As a consequence, the market mechanism cannot be expected to function optimally, when environmental commodities exerting external effects are present. There is a gap between private and social costs of using or producing these environmental commodities: from a private point of view the earth’s ozone layer can be used as a place to store CFCs without any private costs; however, it is well-known today that the social costs of such behavior can be quite high. Most environmental tools and instruments therefore aim to reduce or close this gap. To be more precise, the services of the earth’s ozone layer provide an example of a public commodity: exclusion of somebody from the consumption of the commodity is not feasible, and total supply is not affected by the number of consumers. Similarly, the available supply of “clean air” is (almost) not affected by the decision of an additional individual consumer to use a private car for commuting instead of public transport: this decision has only negligible effects on trafﬁc congestion and the state of the environment. Again, these features are characteristic for public commodities with ensuing complications for the market mechanism. In summary, environmental commodities are perceived to be scarce due to physical scarcity or due to an increasing environmental awareness. Their integration into the market system requires special attention due to missing markets resulting from properties of public commodities and external effects. A detailed investigation and discussion of the relevant implications is required for appropriate modiﬁcations of the framework conditions of a market system with environmental commodities. These considerations demonstrate the close relationship between economic and environmental issues. On the one hand, the framework conditions of an economic system, which should “guide” individual agents to maximum welfare,4 can in principle – with some modiﬁcations – be applied to prevent future environmental pollution; on the other hand, environmental pollution affects the well-being of the individual agents, not only in the context of a rising environmental awareness, and leads to future costs for cleaning up the environment. The following analysis of the concept of economic efﬁciency emphasizes these points and clariﬁes some controversies, which seem to play an important role in practical economic and environmental policy, and which moreover seem to dominate the political discussions on environmental issues.

4.2 Efﬁciency as a Normative Criterion for Environmental Economics Environmental issues thus constitute an essential part of most economic systems with perceived scarcity of environmental commodities depending on, among other 4

This corresponds to the metaphor of the invisible hand used by Smith in 1776 to illustrate the ideal self-regulation of the market economy (cf. [7]).

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things, environmental awareness and the state of economic development. As a consequence, environmental commodities should be and have to be integrated into the economic allocation problems to allow a thoughtful analysis of environmental issues within the context of the economy. This does not imply a subordination of the environment to the economy. But it means that economic and environmental issues are intertwined and should not be separated. In this sense this section continues the discussion of the last section with further remarks on feasible allocations. Most important, however, is the extension of the normative criterion of Pareto efﬁciency to allocations covering environmental commodities. This raises the question, whether an economic efﬁciency criterion can also serve in an environmental context?

4.2.1 Economic Efﬁciency and the Environment: Theory A feasible allocation is an attainable solution to the allocation problems. For a particular period of time it provides a more or less satisfactory answer to the continuing challenges of an economic system to allocate ﬁrst the available resources to the various production processes of the economy and thereafter the commodities produced to the consumers. The concept of an “economic system”, such as a market economy or a centrally planned economy, then describes the never-ending attempt to choose, again for a period of time, a feasible allocation with certain optimality properties. The result is an optimal or efﬁcient allocation which affects the well-being of the economic agents. The concept of efﬁciency has to be based on a normative criterion, which is, in the case of market economies, the already mentioned Pareto Criterion. A feasible allocation is Pareto-efﬁcient or Pareto-optimal, if there is no other feasible allocation which improves the well-being, the utility, of at least one individual (consumer or household), without diminishing the utility of any other. One of the crucial issues of this criterion in an environmental context is therefore its focus on the well-being of man-kind. Environmentalists may be concerned whether issues of biodiversity etc. can ﬁnd an adequate forum and gain an adequate attention under these framework conditions? It is not the goal of this text to go into the philosophical details of this criterion, which is indeed one of the cornerstones of a market economy and will therefore be retained for this monograph. The reader is referred to the relevant literature for more details.5 It remains to mention: a broad rejection of the Pareto Criterion in an environmental context would immediately raise the question for an alternative normative criterion. Straightforward applications of this criterion in the context of the environment demonstrate, however, that economic and environmental issues are indeed closely related to each other. Assume ﬁrst that environmental pollution is detrimental to the 5

Various textbooks on intermediate microeconomics such as [5], [6] and [9], and on general equilibrium theory such as [4] provide a thorough understanding of this material.

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well-being of the individual agents. A feasible allocation, which leaves room for producing and consuming approximately the same amounts of the “regular” commodities at a lower level of environmental pollution, can then obviously not be efﬁcient (for an example cf. Subsection 4.2.2). Moreover, at the “production frontier”, environmental commodities and regular commodities play the same role regarding efﬁciency. There is then a trade-off regarding more environmental protection or more consumption commodities, similar to the trade-off between more cars or more houses in an economy with all factors fully employed. Thus, there is no intrinsic, no natural controversy between the economy and the environment, given the Pareto Criterion, and environmental issues should be integrated into the economic system as outlined above.

4.2.2 Economic Efﬁciency and the Environment: Applications Some practical examples of the relationship between efﬁciency and the environment refer to the situation in the former German Democratic Republic (GDR). In 1987, three years before German reuniﬁcation, per capita production and consumption levels in the Federal Republic of Germany (FRG) were signiﬁcantly higher in comparison to the GDR. Nevertheless, energy consumption in the GDR was 20% higher per capita. Moreover at 319 kg per capita, emissions of sulfur dioxide (SO2 ) were more than ten times higher in the GDR than in the FRG, which emitted 30 kg per capita ([8]; cf. also [1], p. 26). Since 1990 emissions of SO2 in Germany have been reduced by more than 90% ([2]). It was thus possible to “decouple” economic growth and emissions of noxious substances in Germany.6 These and similar examples from all over the world demonstrate that environmental resources such as clean air or clean soil are often exploited in production processes in an inefﬁcient, non-economical way. Many current environmental problems are in fact the consequence of such inefﬁcient economic processes. Quite often, feasible allocations with an inefﬁcient factor employment will also prove problematic from an environmental point of view. For example, if a production process uses water in an inefﬁcient way, then the resulting pollution is higher than need be. Practical problems tend to arise between the economy and the environment when in a situation with incomplete information on ecological or economic issues one side gains quasi-monopolistic power. An integration of both views will then become increasingly difﬁcult. In such situations, representatives of business will point to an increasing burden due to rising environmental standards with consequences for international competitiveness; environmentalists will downplay possible consequences for the business sector of the economy and will rather develop ecological doomsday scenarios. It is also this atmosphere which leads to the common, fundamental controversy between the economy and the environment, although both sides should strive for a simultaneous development of the economy and the environment. 6

Of course, a substantial proportion of these emissions reductions resulted from the breakdown of a large part of the industry of the former GDR after reuniﬁcation.

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The consequence is a separation of practical policy into economic and environmental issues, which today is mirrored in separate ministries for the economy and the environment – among a variety of additional institutions. These separate entities tend to defend their area of inﬂuence, thereby forgetting the intrinsic relationship between the economy and the environment. Part III will reconsider this topic in a more general context (cf. Subsection 9.1.1). In view of the above examples, there is then the problem of how to “motivate” companies to reduce their noxious emissions, to develop and install environmentally friendly production technologies. There is, moreover, the problem of how to “induce” consumers to reduce pollution resulting from all kinds of household activities, to demand and buy environmentally friendly consumption commodities. The question is, whether it is possible to adjust the framework conditions of a market economy towards an “ecological market economy”, which supports all kinds of activities for a cleaner environment. The issue of a fair distribution of income also plays a role in this context, in particular in the form of sharing the burden of an environmental measure, both on a national and an international level.7 So-called “ecotaxes” place an additional ﬁnancial burden on producers and consumers, which is not always considered to be fair, given the possibilities of passing on the tax.8 Perhaps more important in this context is the fact that different individuals, for example households in different countries, have different “propensities” towards the protection of the environment, typically accompanied by differing degrees of willingness to pay for environmental initiatives (cf. also Chapter 2). The problem of choosing a feasible allocation, which respects these differing valuations of environmental issues, constitutes a challenge for practical environmental policy, in particular on an international level.9 Arrow’s impossibility theorem10 demonstrates that there is no mechanism (voting procedures such as majority voting, . . . ), which provides a satisfactory solution to this problem in a general context. This theorem states that it is not possible to aggregate individual preferences to a social preference ordering, given some plausible, reasonable and acceptable assumptions (cf. [5], Section 5.5 or [9], Ch. 33). As a consequence, general equilibrium theory typically focuses more on efﬁciency and less on distributional issues. This is also true for theoretical environmental economics. In the context of a market economy “environmental economics” therefore aims at an efﬁcient solution of the allocation problems including scarce environmental com7

Of course, the distribution problem also arises in the context of regular commodities. There it is governed by the distribution of the initial endowments and the functioning of the market mechanism accompanied by various redistribution measures of the government. The additional difﬁculty with environmental commodities also results from the limited possibility of employing the market mechanism in this context to obtain an acceptable or “fair” allocation. 8 For example, there are plans to modify the German ecotax from 2011: the many exemptions from paying the full tax or from paying the tax at all shall be reduced; the consequences for consumer prices and the ﬁnal tax burden are, however, not completely known. 9 These differences are, for example, mirrored in the international negotiations on sharing the burden for global reductions of greenhouse gas emissions (cf. Section 3.2). 10 Some authors, for example [5], prefer to call it “Arrow’s possibility theorem”.

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modities. Because of the special characteristics of the environmental commodities this requires a thorough theoretical analysis to appropriately adjust the framework conditions of the market mechanism.

References 1. Beilke S, Uhse K, Jäschke M (2003) Jahresbericht 2002 aus dem Messnetz des Umweltbundesamtes. German Federal Environmental Agency (UBA) http://www.umweltdaten.de/publikationen/fpdf-l/2559.pdf. Cited July 2011 2. Gniffke P (2010) National trend tables for the German atmospheric emission reporting 1990 – 2008. German Federal Environmental Agency (UBA) http://www.umweltbundesamt.de/emissionen/archiv/EM_Entwicklung_in_D_Trendtabelle_LUFT_v1.3.0_out.xls.zip. Cited July 2011 3. Grossman GM, Krueger AB (1995) Economic growth and the environment. Quart J Eco 110:353–377 4. Hildenbrand W, Kirman AP (1976) Introduction to equilibrium analysis. North-Holland, Amsterdam 5. Kreps, DM (1990) A course in microeconomic theory. Harvester Wheatsheaf, New York 6. Perloff JM (2001) Microeconomics. Addison-Wesley, Boston 7. Smith A (1776) The wealth of nations. W. Strahan and T. Cadell, London 8. Strogies M (1998) Emissionen nach Emittentengruppen in der ehemaligen DDR/den neuen Ländern 1970 bis 1995. German Federal Environmental Agency (UBA) 9. Varian HR (2006) Intermediate microeconomics, 7th edn. Norton, New York

Chapter 5

Allocation Problems in a Market Economy

Abstract The following sections contain a formal description of the solution of the allocation problems in a simple model of a market economy. The analysis is ﬁrst restricted to the case of an economy with private commodities on regular markets, which serves as a “benchmark”. Thereafter the investigations are extended to an economy which includes environmental or external effects. The formal model, which is adjusted to allow for special externalities, reveals the impact of environmental effects on the basic structure of the economy and the effects on the functioning of the market mechanism. The ﬁnal section refers to public commodities and the public good characteristics of many environmental commodities.

5.1 Efﬁcient Equilibrium Allocations This section investigates efﬁciency properties of the market mechanism for an economy with private commodities exchanged and traded on regular markets. The underlying model of a market economy is rich enough to yield results, which are of relevance in more general settings, but it is still simple enough to keep the formal analysis manageable. It is then possible to elaborate the core aspects of problems in environmental economics, a prerequisite for investigating and designing appropriate solutions. The ﬁrst subsection contains the basic assumptions and structural properties of the model economy, which will thereafter be extended to include environmental or external effects.

5.1.1 The Model Economy The production sectors of the model economy provide two consumption commodities: F (“ﬁsh”) and G (“paper”). These two commodities can be produced by emH. Wiesmeth, Environmental Economics: Theory and Policy in Equilibrium, Springer Texts in Business and Economics, DOI 10.1007/978-3-642-24514-5_5, © Springer-Verlag Berlin Heidelberg 2012

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ploying the unique factor L (“labor”) in the production functions f : IR+ → IR+ and g : IR+ → IR+ . f and g are assumed to be twice continuously differentiable, strictly monotone and concave. The marginal products will therefore only decrease with an increasing input of the factor L. Moreover, the factor L is assumed to be essential in the production of the two commodities: f (0) = g(0) = 0. f and g will usually be considered as aggregated production functions; sometimes, however, they are assumed to represent the production possibilities of a “small” company in the corresponding sector; the given context will allow a correct interpretation. If L¯ denotes the maximum amount of the factor L available in a period of time, then the aggregate supply set A of this economy is given by: ¯ A = {(F, G) ∈ IR2+ : F = f (LF ), G = g(LG ), LF + LG ≤ L}. A is the set of all consumption bundles, which can, in principle, be produced in this economy and thus also be consumed in the given period of time. Because of the concave production functions, the aggregate supply set A is a convex set (cf., for example, [4]). The boundary of A is the transformation curve G = G(F) = g(L¯ − f −1 (F)) with the marginal rate of transformation −(dG/dF) = g (LG )/ f (LF ) or −(dF/dG) = f (LF )/g (LG ) at (F, G) = ( f (LF ), g(LG )). Therefore, the marginal rate of transformation corresponds to the ratio of the marginal products. 500 400 300 F 200 100 0

....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... 0 0 ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... 1 1 ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ...

Transformation Curve F = F (G)

u (F , G )

u (F , G )

Aggregate Supply Set A

0

5

10

15

20

25

G Fig. 5.1 Aggregate supply set (case without external effects)

Note 5.1. For the calculations above observe d( f −1 (F))/dF = 1/ f (LF ) with F = f (LF ). This is an immediate consequence of the comparison of the derivatives of the identical functions F → f ◦ f −1 (F) and F → F. Moreover, for the case of strictly concave production functions, the second derivative d 2 F/dG2 is not positive, implying the concavity of the transformation curve and a convex aggregate supply set.

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Example 5.1. For f (LF ) = 50 · LF and g(LG ) = 2.5 · LG one obtains with L¯ = 10 the following formal expressions for the transformation curve: G(F) = 25 − (F/20) and F(G) = 500 − 20G respectively (cf. Figure 5.1). The transition from a commodity bundle (F0 , G0 ) to a bundle (F1 , G1 ), both located on the decreasing transformation curve, always implies a reduced amount of one of the two commodities. Therefore, given a bundle on the transformation curve, it is not possible to simultaneously increase production of both commodities. The preferences of the only consumer of this economy with respect to the consumption commodities F and G are described by the utility function u : IR2+ → IR. u ¯ > u(F, G), if the bundle (F, ¯ contains, ¯ G) ¯ G) is strictly monotone on IR2++ , thus u(F, in comparison to (F, G), not less of both commodities and more of at least one. Moreover, u is assumed to be quasi-concave and twice continuously differentiable. The indifference curves of u are therefore “smooth” and convex to the origin (cf. Figure 5.2). Alternatively, it could be assumed that there are many consumers, all characterized by the same homothetic preference ordering. A homothetic preference ordering can be represented by a linearly homogeneous utility function. The associated Engel curves are then linear and pass through the origin, and the distribution of income does not affect aggregate demand.1 By means of these simplifying assumptions (only one consumer or identical consumers with homothetic preferences) it is possible to avoid difﬁcult issues associated with the distribution of initial endowments regarding the production factor and the shares regarding the production companies.2 Moreover, the assumption of identical and homothetic preferences guarantees uniqueness of the market equilibrium and the Pareto-efﬁcient allocation (cf. [1], Ch. 9 for a thorough discussion of uniqueness of equilibrium). It should, however, be mentioned that, in principle, the following considerations also remain valid for the case of an economy with many and different consumers (cf. again [1] for more details regarding this issue). The following deﬁnition formalizes the concept of a feasible allocation as a solution to the allocation problems: Deﬁnition 5.1 (Feasible Allocations). Assume that the model of the economy is given as above with the commodities F and G, the factor L, production functions f and g and the consumer with utility u(F, G). The vector (LF , LG , F, G) ∈ IR4+ is a feasible allocation of this economy, if: ¯ F ≤ f (LF ) and G ≤ g(LG ). LF + LG ≤ L, Clearly, a feasible allocation is a solution to the allocation problems: LF and LG determine the quantities of the consumption commodities to be produced, F and G assign these quantities (or part of it) to the consumer, who derives utility u(F, G) from this solution of the allocation problems. 1

For example, Cobb-Douglas utility functions represent homothetic preferences (cf. [12], Ch. 4). In a pure market economy there is private property with respect to the means of production (typically factors and production companies). 2

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The market mechanism, considered in the next subsection, is a special allocation mechanism based on private property and decentralized decisions of the consumers and the producers coordinated through a price system. The resulting market equilibrium yields an equilibrium allocation, which is characterized by efﬁciency properties.

5.1.2 Market Equilibrium Pareto efﬁciency assumes consumption as the ultimate goal of production – with immediate consequences for production, of course. With monotone preferences, an efﬁcient employment of the factor will necessarily lead to an aggregate supply bundle located on the transformation curve.3 Any other production plan with aggregate supply below the transformation curve is inefﬁcient in the sense that it is possible to provide more of both commodities by rearranging production. A distribution of this “surplus” to the consumers will then raise their utility levels, implying a Pareto improvement. Therefore, Pareto efﬁciency entails an efﬁcient employment of the factor (cf. [6], [8] or [12] for more detailed discussions of these fundamental relationships). Moreover, an aggregate supply bundle located on the transformation curve of the model economy will only then be part of a Pareto-efﬁcient allocation, if an indifference curve of the consumer’s utility function is tangent to the transformation curve at this supply bundle, otherwise a Pareto improvement will again be possible. This tangency implies equality of the marginal rate of substitution (MRS) with the marginal rate of transformation (MRT) at the given aggregate supply bundle. Convexity of the aggregate supply set with a concave transformation curve then guarantees Pareto efﬁciency or Pareto optimality for this commodity bundle (cf. Figure 5.2 and again [8] or [12] for these fundamental results). The question is now, whether the market mechanism is capable of establishing efﬁciency in the production and consumption sectors, leading to a Pareto-efﬁcient allocation in the economy. For this, a competitive structure akin to a market economy is assumed: there are many “small” ﬁrms with production possibilities in the two sectors characterized by the aggregated production functions f and g respectively.4 These small ﬁrms have only a negligible effect on the price mechanism. Similarly, the many “small” (and in this case) identical consumers have to take and accept the prices they observe in the markets. Private property refers to the “means of production” in general, comprising factor endowment and shares of the production companies. In the model economy, the only consumer therefore “owns” all production companies and the total factor supply. This consumer offers the factor labor at the given wage rate to the companies in 3

In the simple case considered here, utility of the consumers depends in fact only on consumption. In more general frameworks, individual “labor supply” could affect utility as well. 4 With the linear aggregated production functions introduced in Example 5.1 it could be assumed that there are many small identical F and G companies with these production functions.

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the F and the G sectors. The companies strive for proﬁt maximization as the shareholder is interested in high dividend payments which increase the income. This is an implicit justiﬁcation of the goal of proﬁt maximization in this context.5 The solution of the allocation problems is then achieved by means of the price mechanism or the market mechanism. , F , G ) is a Deﬁnition 5.2 (Market Equilibrium). An allocation z = (LF , LG market equilibrium, if a price system p = (pL , pF , pG ) exists with the following properties: in the G sector maximize proﬁt • The factor employment LF in the F sector and LG at prices given by p . • The commodity bundle (F , G ) maximizes utility u(F, G) in the budget set of the household at prices given by p . ¯ F = f (LF ) and G = g(LG • All markets are cleared: LF + LG = L, ). This implies that z is a feasible allocation.

The allocation z is then an equilibrium allocation and the price system p is an equilibrium price system. Note 5.2. Proﬁt in the F sector (and analogously in the G sector) at prices p and factor employment LF is given by: πF (p, LF ) = pF f (LF ) − pL LF . In this context the budget set B(p) of the consumer at prices p is given by: B(p) = {(F, G) ∈ IR2+ : pF F + pG G ≤ pL L¯ + πF (p) + πG (p)} with maximum proﬁts πF (p) in the F sector and maximum proﬁts πG (p) in the G sector at prices p, i.e., LF and LG are chosen to yield maximum proﬁts at prices p. Therefore, if p = (pL , pF , pG ) is an equilibrium price system, then the equilibrium respectively, and the equilibrium quantities F and factor quantities LF and LG G respectively of the consumption commodities satisfy the following ﬁrst-order conditions: ) and pF · f (LF ) = pL = pG · g (LG ) uF (F , G ) g (LG pF dG = = =− |F . pG uG (F , G ) f (LF ) dF

As all markets are cleared in equilibrium due to monotone preferences, one ob = L, ¯ and aggregate supply (F , G ) is in equilibrium located on the tains LF + LG 5

This economic agent acts as a consumer on the markets for the consumption commodities with income derived from the shares of the production companies and from selling labor; this agent acts as a producer in the form of a “managing director” of the production companies maximizing proﬁts for the shareholder.

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transformation curve. Moreover, in equilibrium the marginal rate of transformation corresponds to the ratio of equilibrium commodity prices and to the marginal rate of substitution of the household. This follows from the ﬁrst-order conditions above. , F , G ) is therefore feasible and ParetoThe equilibrium allocation z = (LF , LG 6 efﬁcient. This result corresponds to the First Theorem of Welfare Economics, which is valid under more general assumptions (cf. [12], Ch. 33, for further details regarding “welfare economics”). In a simple way, these formal considerations allow an insight into much deeper relationships. A comparison of results to be obtained later with results obtainable in this reference system will prove helpful and will reveal one of the crucial advantages of working with formal models. Example 5.2. Assume that the consumer introduced in Example 5.1 is characterized by the Cobb-Douglas utility function u(F, G) = F · G. The allocation z = , F , G ) = (5, 5, 250, 12.5) is then an equilibrium allocation with prices (LF , LG p = (pL , pF , pG ) = (50, 1, 20) (cf. Figure 5.2). 500

....... ....... ....... ....... ....... ....... ... ....... ... ....... ... ....... ....... ... ....... ... ....... .... ....... .... ....... ..... ....... G F ... ....... ....... ......... ....... ..... .. . ....... ..... . ....... ..... .. . . ............ .. ............. ... ............ ... ....... ........ .... ........ .. ........ ......... ........ .......... ................. ................. ....... ........... ....... ............... .. ....... ....... .................................. ................ ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ...

Indierence Curve

400

F

300 F 200 100 0

(p , p )

u Equilibrium

Aggregate Supply Set

0

5

10

G

15

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25

G Fig. 5.2 Market equilibrium (case without external effects)

Note 5.3. There are various ways of arriving at the equilibrium allocation of the economy of Example 5.2. One could, for example, determine the commodity bundle (F , G ) on the transformation curve, where the marginal rate of substitution corresponds to the marginal rate of transformation. Then one obtains the unique Pareto-efﬁcient allocation, which also represents the unique equilibrium allocation (cf. [1], Ch. 9, and the remarks on p. 55):

6

Efﬁciency follows from the ﬁrst-order conditions above, which imply tangency between the indifference curve through (F , G ) and the transformation curve (cf. also Figure 5.2.

5.2 Environmental Effects in a Market Economy

−

59

dG 1 G uF (F , G ) G = . |F = = = dF 20 uG (F , G ) F 500 − 20G

= 5. With constant The solution results in G = 12.5, F = 250 with LF = LG returns to scale in both sectors, equilibrium proﬁts have to be zero (“zero proﬁt condition”), as any planned positive proﬁt could be doubled by doubling the . In the context factor employment. Thus: pF F = pL LF and pG G = pL LG of the formal models considered here, only relative prices matter (cf., for example, [12], Ch. 16). Therefore, one can always ﬁx one of the prices at an arbitrary (positive) level. One obtains pF = 1 and pG = 20 with pL := 50.

This reference system demonstrates the ideal self-regulation of the market mechanism in the sense that the equilibrium allocation is Pareto-efﬁcient.7 What happens if one introduces environmental or external effects into this model?

5.2 Environmental Effects in a Market Economy Environmental effects originate in production or consumption processes8 which are accompanied by further activities or emissions of substances which pollute the environment.9 Environmental effects are external effects in the sense that they are “external” to the regular production and consumption activities, and are, therefore, typically not integrated into the market process. As an immediate consequence, it cannot be expected that the market mechanism will continue to function efﬁciently in the presence of such environmental or external effects. This section investigates and analyzes the impacts of environmental effects on an economic system. The model economy of Section 5.1 will serve as a reference system and will provide the benchmark case.

5.2.1 The Concept of an External Effect A common and widely accepted deﬁnition of external effects is provided by Baumol/ Oates ([3], p. 17): 7

For the issue of how the “market forces” operate to achieve an equilibrium refer to [1], Ch. 11, or to [6], Ch. 15, for an introduction to “bilateral bargaining”. 8 The analysis is thus restricted to “man-made” polluting activities. This is suitable for environmental economics with the goal of “regulating” the economy in order to prevent or reduce future man-made environmental pollution. 9 The term environment comprises commodities affecting the well-being of mankind. Environmental pollution restricts the ability of some of these commodities to fulﬁll their role, so that it is rather their absence which should be considered a “good”.

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Deﬁnition 5.3 (External Effect). An externality is present whenever some individual’s (say A’s) utility or production functions include real (that is, non-monetary) variables, whose values are chosen by others (persons, corporations, governments) without particular attention to A’s welfare. Of particular importance in this deﬁnition is the aspect of a “real” variable, which affects production or consumption activities. Pure pecuniary effects are therefore excluded and not considered as “externalities”.10 Of further interest is the motivation for an external effect: the “polluter” typically has no intention to inﬂict “damage” on others.11 A distinction between “proper” external effects and “pecuniary” effects is not always easy to make. Take the gasoline tax, which constitutes a substantial part of the price of gasoline in many countries. Should the environmental effects of private transport therefore be considered as pure pecuniary effects, because they might already be “internalized” through the gasoline tax? This discussion plays some role in Germany (cf. [2] for a more detailed examination of this German “case”). A closer inspection shows that external effects originating from production activities drive a “wedge” between marginal private cost and marginal social cost of the relevant production process (cf. the statement of A.C. Pigou below). A company exerting an externality does not necessarily take into account the potentially negative consequences, or “costs”, of its production plans on other companies. Similarly, external effects can inﬂuence economic decisions of households, for example, when they install noise-proof windows to protect themselves from the externalities of an airport. A.C. Pigou: “The Economics of Welfare” (excerpt from [9], Ch. IX) “I now turn to the second class of divergence between social and private net product . . . . Here the essence of the matter is that one person A, in the course of rendering some service, for which payment is made, to a second person B, incidentally also renders services or disservices to other persons C, D and E, of such sort that technical considerations prevent payment being extracted from the beneﬁted parties or compensation being enforced on behalf of the injured parties. . . . Among these examples we may set out ﬁrst a number of instances in which marginal private net product falls short of marginal social net product, because incidental services are performed to third parties from whom it is technically difﬁcult to extract payment. . . . . It is true of resources devoted to the prevention of smoke from factory chimneys: for this smoke in large towns inﬂicts a heavy uncharged loss on the community, in injury to buildings and 10

Pure pecuniary effects are obviously integrated into the market system and need no further consideration. 11 Consider a car driving through a quiet neighborhood; noise and exhaust fumes disturb the households living in the street, but neither is this the car driver’s intention, nor can the households do much against this “pollution”.

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61

vegetables, expenses for washing clothes and cleaning rooms, expenses for the provision of extra artiﬁcial light, and in many other ways. . . . It follows immediately from the concept of an external effect that many, if not most “man-made” environmental problems are in one way or the other the consequence of an externality. This is the case regarding problems with the earth’s ozone layer, the pollution of rivers and natural habitats, the issue of overﬁshing, climate change and many others. A thorough understanding of the intrinsic nature of external effects will be provided by the following subsection. The formal analysis in the context of the suitably extended model economy will focus on an external effect in the production sector. An additional example of an externality in the consumption sector will be investigated in Subsection 9.3.2.

5.2.2 Analysis of an Externality In order to introduce an externality into the model economy of Subsection 5.1.1, assume that the paper producers discharge waste water into a river which is used by the ﬁsheries to cultivate and raise ﬁsh. The resulting pollution of the water affects the growth of the ﬁsh adversely with consequences for the “actual” production function of the ﬁsheries. Thus, the activities of the paper companies imply a (negative) external effect on the ﬁsheries. Formally: G = g(LG ) and F = f (LF , A) = f (LF , G) with ∂ f (LF , G)/∂ G =: f2 (LF , G) < 0. “A” denotes “waste water”; by assumption, one unit of waste water is discharged with each unit of paper produced. Moreover, for simplicity, emissions of waste water correspond to immissions, and there is no “build-up” of waste water over time. This implies that the water pollution affects the ﬁsheries directly and immediately, thereafter the polluting substances are assumed to disappear through attenuation. The rather complicated analysis of time-dependent processes can thus be avoided in this context. −1 (G), G) ¯ The functional form of the transformation curve is F = F(G) = f (L−g with the marginal rate of transformation given by the absolute value of the derivative of F(G): MRT = −

f (LF , G) dF(G) dF |G = − = 1 − f 2 (LF , G) dG dG g (LG )

with (F, G) = ( f (LF , G), g(LG )) (cf. Note 5.1). The second derivative of F(G), which determines the curvature of F(G), is also affected by the derivative of − f 2 (L¯ − g−1 (G), G) with respect to the second variable, in contrast to the situation without externalities. The sign of the second derivative, and therefore the curvature of F(G), is thus not a priori determined – and it need no longer be concave.

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The following modiﬁcations (A) and (B) of the original example (cf. Examples 5.1 and 5.2 together with Figures 5.3 and 5.4 illustrate ﬁrst the possibility of an aggregate supply set which is no longer convex. 120

90

F

60

30

0

... ... ... ... ... ... ... ...u ... Pareto-ecient State ... ... ... ... Indierence Curves .... .... .... ..... ...... ...... ....... Market Equilibrium ....... ........ .......... ............u ................ ? ................ .................... Transformation Curve .................................. ....................................... ........ 0 5 10 15 20 25 ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... .. ... .. ... ... ... ... ... .. .. ... .. ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... ... .... ... .... ... .... ... ..... ... ..... .... ..... .... ..... .... ..... .... ..... ..... ..... ..... ...... ..... ...... ..... ...... ..... ....... ...... ....... ...... ........ ...... ......... ....... .......... ........ ........... ......... ............ .......... .............. ........... ................ ........................ ................... .................. ...................... ......................... ............................ ........................ ............................................................... ............................ .................. ..................................... .................................................

G

Fig. 5.3 Market equilibrium (Example A with external effects)

Example 5.3 (A). With concrete production functions f A (LF , G) = 50 · LF /(G + 1) and g(LG ) = 2.5 · LG the formula for the transformation curve is F(G) = (500 − 20 · G)/(G + 1). The aggregate supply set A with boundary F(G) is, however, no longer a convex set: the commodity bundles (500, 0) and (0, 25) are contained in A for L¯ = 10, but not (250, 12.5), which is located right in the middle of the straight line connecting these two commodity bundles (cf. Figure 5.3).

F

... ... 500 ............. ... ... ... ... ........ ... ... . ........ ........ .................. Indierence Curves ........ ..... ..... ........ ...... ..... 400 ........ ..... ........ ..................... ...................... .. ... .... ..... ...... ... Pareto-ecient State ... ... .. ..... ... ... 300 ....... ... .......... .... .......... ..... ..... u ... .......... .. . .. ....... ....... .................. ....... Market Equilibrium .......... ....... ....... ........ ..... .. ..... ........ ........ ..... ..... 200 u ... .. .. ............................. ............................................................... ........ ................................................................ - ................ ....................................................................................................................................................... Transformation Curve ...................................... ......... ..... 100 .......... ........... ............ Aggregate Supply Set ................. ..................... 0 0 5 10 15 20 25

G Fig. 5.4 Market equilibrium (Example B with external effects)

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63

Example 5.3 (B). With production functions f B (LF , G) = 0.08 · LF · (625 − G2 ) and g(LG ) = 2.5 · LG , the formula for the transformation curve is F(G) = (500 − 20 · G − 0.8 · G2 + 20 · G3 /625). Again, the aggregate supply set A with boundary F(G) is no longer a convex set (cf. Figure 5.4).

Note 5.4. If one compares Figures 5.3 and 5.4 with Figure 5.2 then the relevance of a convex aggregate supply set becomes obvious. The Pareto-efﬁcient allocation, which is unique due to the identical, homothetic preferences of the consumers (cf. the remarks on p. 55), is located at the point of tangency between the transformation curve and an indifference curve. The tangent deﬁned this way represents the budget line of the (single) consumer and, at the same time, an iso-proﬁt line with respect to total proﬁt of the companies in both sectors and total cost corresponding to total factor costs. Due to the convexity of the aggregate supply set in the case without externality, this aggregate commodity bundle maximizes utility of the consumer and total proﬁt of the companies. This need no longer be true, if the aggregate supply set is not convex as in Examples 5.3 (A) and 5.3 (B) (cf. also the corresponding Figures 5.3 and 5.4). Moreover, the individually rational decisions (maximizing utility or maximizing proﬁt) may no longer be optimal (or efﬁcient) from a social point of view. These issues will be addressed in the following subsection.

5.2.3 Market Equilibrium with External Effects The following deﬁnition of an equilibrium with external effects refers to the above examples with their special structural properties. Of course, the deﬁnition has to be adjusted to accommodate external effects with different characteristics. The results, which are obtained for these examples and which demonstrate the inefﬁciency of a market equilibrium with external effects, remain in principle true in other market constellations with externalities. Deﬁnition 5.4 (Market Equilibrium with External Effects). An allocation z = , F , G ) is a market equilibrium with external effects, if a price system p = (LF , LG (pL , pF , pG ) exists with the following properties: • Factor employment LF in the F sector is proﬁt maximizing at prices p and at the given quantity G of the G sector. in the G sector is proﬁt maximizing at prices p . • Factor employment LG • The commodity bundle (F , G ) maximizes utility u(F, G) at prices p in the consumer’s budget set B(p ). = L, ). ¯ F = f (LF , G ) and G = g(LG • All markets are cleared: LF + LG

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The allocation z is an equilibrium allocation with external effects, and the price system p is an equilibrium price system. The above deﬁnition incorporates the structural characteristics of an external effect: the ﬁsheries are affected by the water pollution due to paper production. Under the given framework conditions there is no possibility of regulating the G production and reducing the discharge of waste water into the river. Formally, the activities of the G companies reduce production possibilities and proﬁts in the F sector, the quantity G – and with it the level of pollution – is, however, taken as given for the F companies. They can only optimally adjust or “react” to this level of pollution. On the other hand, the paper producers need not respect the level of pollution and its consequences in their production decisions under the given framework conditions. The additional costs, resulting from the paper production and inﬂicted on the ﬁsheries, are then considered to constitute additional social costs, which are not covered by the paper companies. In general, one should therefore expect a level of paper production which is “too high”.

Note 5.5. For a given production level G in the G sector and for a given factor employment LF , proﬁt in the F sector is maximal at prices p , if pF f (LF , G ) − pL LF ≥ pF f (LF , G ) − pL LF for all LF ≥ 0. The companies of the F sector cannot affect or modify the production level G of the G sector, in accordance with the deﬁnition of an external effect (cf. Deﬁnition 5.3). These considerations demonstrate again the advantage of a formal analysis: the fundamental structural effects of externalities can be revealed and illustrated in a simple manner. Among other things one realizes that problems for the price or market mechanism may result from a not necessarily convex aggregate supply set. Inefﬁcient corner solutions may follow from proﬁt maximization. The second-order conditions need not be fulﬁlled, and the ﬁrst-order conditions are no longer sufﬁcient for an efﬁcient outcome – in contrast to the situation with concave production functions, quasi-concave utility functions, and private commodities without externalities. The later discussion of the assignment of property rights will make further use of these formal results. Moreover, the formal analysis shows that the indifference curve passing through the equilibrium allocation may intersect the transformation curve (cf. Figures 5.3 and 5.4). This is a well-known additional source of inefﬁciency of the market mechanism, which will be investigated further in the following examples. Individually rational behavior, in this case of the consumer, will not necessarily yield a Paretoefﬁcient allocation, a social optimum. Example 5.4 (A). For the above Example 5.3 (A), the uniquely determined Paretoˆ ≈ (8.36, 1.64, 81.98, 4.1) with ˆ G) efﬁcient allocation is given by zˆ = (Lˆ F , Lˆ G , F, √ ˆ ˆ utility level uˆ ≈ 336. More precisely, F = 20 · G with Gˆ = 26 − 1. The unique , F , G ) with market equilibrium with external effects is given by z = (LF , LG

5.2 Environmental Effects in a Market Economy

65

z ≈ (5, 5, 18.52, 12.5) at equilibrium prices p = (pL , pF , pG ) = (50, 13.5, 20) and utility level u ≈ 231.5 (cf. Figure 5.3). Example 5.4 (B). For the above Example 5.3 (B), the uniquely determined Paretoˆ ≈ (6.1, 3.9, 258.34, 9.76) with ˆ G) efﬁcient allocation is given by zˆ = (Lˆ F , Lˆ G , F, utility level uˆ ≈ 2521.4. The unique market equilibrium with external effects is , F , G ) with z = (5, 5, 187.5, 12.5) at equilibrium prices given by z = (LF , LG p = (pL , pF , pG ) = (50, 4/3, 20) and with utility level u ≈ 2343.75 (cf. Figure 5.4). Note 5.6. For Example (A), the uniquely determined Pareto-efﬁcient allocation is located at the point of tangency of an indifference curve with the transformation curve (equality of MRT and MRS): MRT = −

ˆ ˆ ˆ G) F(G) uG (F, dF 520 500 − 20Gˆ = MRS. = = |Gˆ = = 2 ˆ ˆ Gˆ + 1) ˆ G) dG (Gˆ + 1) uF (F, G( Gˆ

These conditions yield then immediately the efﬁcient allocation. Regarding the market equilibrium, one should again observe the “zero proﬁt condition” (cf. Note 5.3), leading to equilibrium prices pF = G + 1 and pG = 20, if one deﬁnes pL := 50. The ﬁrst-order condition for utility maximization then yields: G (G + 1) uF (F , G ) pF G + 1 G = = . = = pG 20 500 − 20G F(G ) uG (F , G ) Solving this equation then immediately leads to G and the further details of the equilibrium allocation. Example (B) is treated completely analogously. These examples illustrate the consequences of an external effect in the production sector of the economy. The production level of the paper companies, which pollute the environment, is “too high” in equilibrium; the resulting equilibrium allocation is no longer Pareto-efﬁcient. The reason for this inefﬁciency is the fact that – as already mentioned – the paper producers do not “see”, do not take into account the negative externality of their activities on the ﬁsheries in their production decisions. Under the framework conditions given, the ﬁsheries cannot “motivate” the paper producers to modify their production plans. This illustrates the role of the framework conditions governing an economic system, inﬂuencing the decisions of consumers and producers. In the sense of a wellstructured economic policy they have to be chosen to accommodate external effects and to restore the efﬁciency of a market economy. If, in the more general setting of the model economy (cf. Subsection 5.2.2), p = (pL , pF , pG ) denotes equilibrium prices associated with the equilibrium al , F , G ) with (in this case negative) external effects in the location z = (LF , LG

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production sector, then the ﬁrst-order conditions for individual proﬁt maximization in both sectors yield: pG f (L , G ) f (L , G ) = 1 F < 1 F − f2 (LF , G ), pF g (LG ) g (LG ) as f 2 (LF , G ) is negative under the structural assumptions of the model economy. The term on the right-hand side corresponds, however, exactly to the marginal rate of transformation at the commodity bundle (F , G ). Therefore, the aggregate budget line with a slope of pG /pF (absolute value) intersects the transformation curve. The characteristics of the externality given here allow for technical efﬁciency in the production sector in the sense that the aggregate production bundle is located on the transformation curve. However, the equilibrium allocation is, in general, no longer Pareto-efﬁcient (cf. Figures 5.3 and 5.4). The question arises how to cope with “market failure” in the sense of inefﬁciency of the equilibrium allocation originating from external effects.12 Market-oriented instruments aim to close the gap between marginal private cost and marginal social cost of production, if the externality affects the production sector. This internalization of the external effect allows a correct and complete allocation of total (private and social) cost resulting from production activities and “motivates” the polluters to modify their production plans towards an efﬁcient allocation. In order to allow for such an internalization of external effects, the framework conditions of the economic system have to be adjusted. The formal analysis will again prove useful, also with respect to the relations between the various approaches with more or less practical relevance. As many environmental commodities have properties of public commodities, which are, in principle, characterized by “bundles” of external effects, the following section is devoted to the allocation of public commodities in the environmental context. Thereafter, the internalization of environmental effects will be investigated in the next chapter.

5.3 Public Commodities in Environmental Economics Pure public commodities are, in general, characterized by the “non-exclosure principle” and “non-rivalry” of consumption. This implies that nobody can or should be excluded from consuming this commodity, at least in a certain local area,13 and that the consumption of this commodity by a group of consumers does not sustainably reduce available supply. Or, put another way, a certain amount of a public commod12

Some economists refrain from associating this result with a “market failure”, as it is not a malfunction of the markets, but rather “missing markets” which are to blame. This will be discussed in Chapter 6. 13 Consider the publications of M. Wooders (cf. [14] and the literature cited there) for a detailed presentation of the concept of a local public good.

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67

ity, which is provided by an individual, can also be consumed by others. For the case of so-called merit goods, such as schooling, exclosure (or paying a high admission, participation or tuition fee) is often ruled out for political, economic or social reasons. Public goods or public commodities therefore show particularly intense external effects: if one individual provides a unit of a (pure) public good, it affects the wellbeing of all others, it thus exerts an external effect on all others. This property will be important for appropriate mechanisms to allocate public goods efﬁciently. With respect to the environmental context, one has to admit that environmental commodities are, in general, not pure public commodities. Nevertheless most of them affect the well-being of many individuals (in a positive or negative way), as in the case of the polluted water in the examples discussed above. Moreover, other environmental commodities such as the services of the ozone layer are independent of the number of people protected. Two well-known mechanisms with serious consequences for a variety of social, political and economic problems are also relevant for environmental issues: the “Prisoners’ Dilemma” and the “Tragedy of the Commons”. As they are closely related to the issue of allocating public goods, they will be presented and analyzed in the following subsections.

5.3.1 The Prisoners’ Dilemma in an Environmental Context As in the context of the examples introduced earlier, A denotes the amount of waste water discharged into the river by the G producers with proﬁt-maximizing production, but without any cleaning activities. CV (A | A ) represents the avoidance costs, which accrue to the G companies if they reduce the emission of waste water at given prices from the amount A to the lower amount A.14 If the F companies are interested in a reduction of the emissions to the level A < A , then they would have to pay the amount CV (A | A ) to “motivate” the G companies to engage in appropriate activities.15 Example 5.5. Assume that the companies of the G sector (paper companies) produce √ according to the aggregated production function G = g(LG ) = 10 · LG . With each unit of G one unit of waste water A is discharged into √ the river. A company of the F sector (ﬁsheries) can produce F = f (LF , A) = 8 · LF /(A + 1) units of F by employing LF units of the factor. As usual with external effects, the amount A of waste water, emitted by the G companies, is a “given” for the ﬁsheries. At given prices p = (pL , pF , pG ) = (1, 1, 1) one obtains the proﬁt-maximizing amount of G = A = 50 units for the G sector. If one assumes that a reduction 14

These avoidance costs could be expenses for clearing the waste water, but also, as in the example considered below, reduced proﬁts from a reduced production level. 15 It is assumed here that the G companies own the property rights, i.e. they are “allowed” to produce paper and discharge waste water into the river. The issue of an allocation of property rights will be addressed in Section 6.6 in the context of the Coase Theorem.

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of the amount of paper produced is the only possibility to limit the discharge of waste water,16 then the avoidance costs correspond to the proﬁt loss due to lower sales. The formal function for these avoidance costs is thus given by CV (A | A ) = 25 − A + A2 /100. In particular, CV (0 | A ) = 25. Assume that there are two F companies, which each gain an additional proﬁt of πF (A) − πF (A ) through a partial or complete clearing of the water. πF (A) thereby denotes the proﬁt of each of the two companies in the F sector, if the amount A, A ≤ A , of waste water is discharged into the river by the G companies. The following inequalities, which are essential for the Prisoners’ Dilemma, are then assumed to hold in this special situation: 1 πF (0) − πF (A ) < CV (0 | A ) and πF (0) − πF (A ) > CV (0 | A ). 2 Thus, the two F companies can together, at a proﬁt for themselves, compensate the G sector to stop pollution completely. However, one F company alone will realize a loss if it tries to pay for the avoidance costs by itself. If both the proﬁt function πF (A) and the function for the avoidance costs CV (A | A ) are continuous in A, then the above inequalities hold for all values of A with 0 ≤ A < A0 for a special value A0 with 0 < A0 ≤ A . Moreover, none of the F companies can be excluded from the advantages of clear water, even if it does not participate in sharing the compensation costs for the G companies. As a consequence, each of the F companies will prefer to wait and see what the other company is going to do. If one of the F companies compensates the G sector for clearing the water, the other will proﬁt twofold: from the clear water and from not having to pay for it. However, as each company will incur a loss by paying for a complete clearing of the water alone, this complete clearing will also not happen. Perhaps a clearing at a level A > A0 will be achieved, which might allow a gain for the F companies, even if they do act alone.17 In summary, it will be difﬁcult to arrive at A = 0 in this situation. Such a constellation is called a “Prisoners’ Dilemma”: although a preferred outcome – sharing the costs for a complete clearing of the water – is available, this outcome will probably not be implemented, because other “strategies”, which, however, are only available for one of the two companies, promise an even better outcome. The reader is referred to [6], Section 14.1, or [12], Section 28.4 for further details, also with respect to the original version of the Prisoners’ Dilemma. Alternatively, it could be assumed that there is a cost sharing agreement among the affected ﬁrms. But even this will not principally solve the underlying issue, if there is no superior organization which has the power to monitor the agreement. This is particularly relevant for the Kyoto Protocol, which will be addressed below (cf. also Subsection 7.2.2 on cost-share equilibria). 16

In most practical situations, ﬁrms can switch to alternative, less polluting technologies, or they can ﬁlter and clear the waste water. 17 This happens if the inequality sign changes for the ﬁrst inequality for A > A0 (cf. also Example 5.6).

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69

Example 5.6. With the above assumptions one obtains πF (A) = 16/(A + 1)2 from proﬁt maximization. The ﬁrst of the inequalities holds then for 0 ≤ A < 50. This implies that neither of the two F companies alone can proﬁtably compensate the G sector, no matter what the reduced level of A will be. The second inequality holds only in a small neighborhood of A = 0, for 0 ≤ A ≤ 0.13, approximately. This is due to the fact that the ﬁrst small units of A signiﬁcantly reduce proﬁts in the F sector. A further discharge of waste water into the already polluted water has no signiﬁcant additional effect on proﬁts in the F sector. It only makes sense to stop pollution completely, if at all. For this situation, the Prisoners’ Dilemma can be displayed formally (in a gametheoretic setting) by means of the following matrix, which shows the strategies of the two F companies and the monetary consequences of the strategies chosen, the payoffs. The analysis considers the case A = 0, i.e., a full compensation of the G sector for completely stopping the discharge of waste water. One then obtains πF (0) = 16 and CV (0 | A ) = 25, and the two inequalities hold. Each of the two F companies can join an agreement to compensate the G companies or refrain from such an agreement, with the following results for the changes in the proﬁts (some of the numbers are again given approximately): F2 : Join F2 : Refrain F1 : Join (3.5,3.5) (-9,16) F1 : Refrain (16,-9) (0,0) Table 5.1 Example of a Prisoners’ Dilemma situation

The left-hand numbers refer to F company 1, F1 ; if both companies join the agreement, then they share the total compensation of 25 units of money for the G companies and are therefore left with approximately 3.5 = 16.0 − 12.5 units. If F1 refrains from joining the agreement, then its payoffs are 16 or 0 units of money respectively, depending on F2 ’s decision. It is important to note that these payoffs are better than 3.5 or -9 units of money respectively, the payoffs F1 will get if it joins the agreement. Thus, whatever F2 does, it is always better for F1 to refrain from signing the agreement. As this “game” is obviously symmetric, the same holds true for company F2 . As a result, neither company will join the agreement, but rather will stay with its current proﬁts associated with A = 50. Observe that this inefﬁcient outcome18 is the outcome of rational decisions by the two F companies. However, individual rationality no longer leads to a socially desired allocation. 18

Both sectors could increase their proﬁts and distribute higher dividend payments to their shareholders, the consumers. If prices do not change, which could be assumed for a large economy, all shareholders would be better off, and the utility of the other consumers would not decrease. In this sense, a Pareto improvement is possible.

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Remark 5.1. The “demand” for the environmental commodity can thus not be “revealed” through the price mechanism, at least not in a sufﬁcient way. It is important to note that individual rationality, and not necessarily insufﬁcient environmental awareness , prevents the economic agents from achieving a socially optimal result. In this sense, this outcome is more a consequence of the intrinsic nature of the environmental commodity, or the intrinsic nature of the external effect, and not so much a consequence of a poor attitude towards the environment. The provision of an environmental commodity with characteristics of a public good by one company (or institution, or country, . . . ) yields a “double dividend” for other companies (or institutions, or countries, . . . ): ﬁrstly, the other companies (or institutions, or countries, . . . ) need not put their competitive edge at risk through higher costs of higher environmental standards; secondly, they can directly enjoy the beneﬁts of the environmental commodity provided by the other company (or institution, or country, . . . ). Similar “mechanisms” are also relevant for the problem of overﬁshing, or for other international environmental issues, which will be analyzed in Part IV. One should therefore also expect such constellations, governed and controlled by the Prisoners’ Dilemma, in industrialized countries with presumably a high environmental awareness, and not only in developing countries or transition economies. And, indeed, an interesting example can be found in the global “acceptance” of the Kyoto Protocol.

5.3.2 The Prisoners’ Dilemma and the Kyoto Protocol In the Kyoto Protocol, the parties to the “United Nations Framework Convention on Climate Change” (UNFCCC) agreed to to reduce the emissions of greenhouse gases by 5.2% in the period 2008 - 2012 compared to the emission levels in 1990 (cf. also Subsection 3.2.1). The industrialized countries had to share the burden of reducing the emissions, the developing countries were exempted. The Kyoto Protocol was enacted in February 2005, after it was ratiﬁed by at least 55 Annex I countries representing at least 55% of greenhouse gas emissions.19 Table 5.2 shows the reduction results for some countries up to 2007. Obviously it is difﬁcult to get reliable data on CO2 emission reductions. The numbers given by the International Energy Agency (IEA) are less promising for all the countries considered than the UNFCCC numbers. The UNFCCC numbers are based on greenhouse gas inventories reported by the countries to the UNFCCC secretariat (cf. [11], Section II, for an overview regarding the “status of reporting” these inventories). The IEA estimates of CO2 emissions from fuel combustion are calculated using energy balances, among other things. Its estimates may differ from a country’s ofﬁcial 19

According to an annex to the Kyoto Protocol, the“Annex I” countries include the industrialized countries. Except for Belarus and Turkey, which have not (yet) agreed to a target under the Protocol, and the United States, which has not (yet) ratiﬁed the Protocol, these are the members of the Kyoto Protocol with obligations to reduce greenhouse gas emissions.

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submission of inventory data for a variety of reasons (cf. [5], p. 28, for this and a discussion of the methods applied by the IEA to estimate greenhouse gas emissions). Country Germany UK Greece Australia Japan Spain Annex I

Target -21.0 -12.5 25.0 8.0 -6.0 15.0 -5.2

IEA-Report UNFCCC-Report -15.4 -22.2 -7.0 -18.5 33.2 23.1 52.9 31.4 8.2 1.0 54.3 42.3 0.0 -6.1

Table 5.2 Target reductions and 2008 reductions of CO2 emissions according to the IEA and UNFCCC reports for some Annex I countries (Sources: [5] and [11])

More important, however, is the fact that, according to the IEA estimates, none of the countries has achieved its goal.20 The Prisoners’ Dilemma can be held responsible for this result in the following way: A particular Annex I country might expect a disadvantage with respect to the competitive edge of its industry if it moves too quickly to reach its target level for the reduction (or increase) of the CO2 emissions. If it slows down the process it will gain twofold: its industry will gain a competitive advantage internationally, and it will also proﬁt from the emission reductions of the other countries. Thus, decelerating the process of compliance with the obligations of the Kyoto Protocol seems to be a dominant strategy and leads to the outcome predicted by the Prisoners’ Dilemma.21 Of course, there are other reasons for compliance or non-compliance with the obligations of the Kyoto Protocol. One is the doubt that rising concentrations of greenhouse gases in the atmosphere will in fact lead to a substantial climate change. In a Gallup poll taken in the US in March 2010, 48% (up from 35% just two years previously) of the respondents said they believe the threat of global warming to be “generally exaggerated” (The New Yorker, April 12, 2010, p. 21). The Prisoners’ Dilemma plays some role in the current climate debates too, although other issues such as “positioning” a country for a second commitment period, seem to have dominated the negotiations since the Copenhagen Accord (cf. also Chapter 12 for an analysis of this issue). Whereas earlier climate summits concentrated, among other things, on the fulﬁllment of the obligations of the Annex I countries, which is indeed affected by the Prisoners’ Dilemma, the focus now shifted to a second commitment period of the Kyoto Protocol beyond 2012, the time horizon for the current commitment period. For such a new treaty it is indeed important to attain an acceptable “bargaining position”. 20

This is aggravated by the fact that some countries proﬁted from extraordinary circumstances. For example, the collapse of industry in the former GDR supported German efforts to reduce greenhouse gas emissions. 21 Observe that this reasoning does not take into account a potential “First-Mover Advantage” regarding the development of innovative environmental technologies.

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However, the Copenhagen Accord of December 2010 ended with a non-binding political accord which includes an “aspirational” target to limit global warming to two degrees Celsius. The “Accord” does not aim at a global reduction of emissions, nor does it divide the burden between industrialized and developing countries. The negotiations were continued in Cancun in 2010 and will be continued in the next climate summits in Durban and Rio de Janeiro, respectively (cf. Subsection 3.2.4 for some results on the meetings in Copenhagen and Cancun). The following excerpt from a publication of the Center for Statistics & International Studies (CSIS) ([7]) provides valuable hints regarding the obstacles hindering a new climate agreement. Sarah O. Ladislaw:22 “A Post-Copenhagen Pathway” (excerpt from [7]) To even more than the casual observer, the events that transpired at the global climate change negotiations in Copenhagen are somewhat mystifying. For veterans of international processes and meetings, it is hard to believe that so many countries could come together for such a large and anticipated event with no pre-planned resolution. Granted, international climate negotiations have not previously garnered participation from so many heads of state and previous sessions typically ran late by a day or more in order to reach conclusion. This time, however, the agreement in question was widely anticipated for nearly two years. . . . The accord itself included an aspirational goal of limiting global warming to 2 degrees Celsius, but agreed to review the science and progress toward this goal in 2015 to assess whether a more ambitious target is possible. The review was added to address the concerns of certain developing countries who want to limit global temperature rise to no more than 1.5 degrees in order to avoid climate impacts that would negatively impact the most vulnerable countries and because current pledges are not expected to limit temperature rise to 2 degrees (most estimates say current pledges will yield a 3.2 degree increase). The accord did not include a global target for emissions reductions nor did it divide the share of emissions reduction between developed and developing countries. Countries are to submit their pledges (developed country targets and developing country actions) by January 31, 2010 and these actions will be compiled and stored in a registry. Perhaps one of the most contentious areas of negotiations was on monitoring and veriﬁcation of actions. The developed country block, led by the United States, insisted that all countries must be accountable for the actions they pledge to take, especially when international ﬁnancing is used to fund those actions. Major developing economies, led by China, sought to protect their sovereignty and 22

Sarah O. Ladislaw, Center for Statistics & International Studies (CSIS), Washington DC, kindly granted permission to reuse this article.

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pushed back on the idea that they should be held accountable for their actions because of their developing country status which exempts them from responsibility to take action. In the end, the accord states that developed country (Annex I) action will be measured, reported, and veriﬁed (MRV) in accordance with existing or any future guidelines adopted by the Conference of Parties, developing country action will be subject to domestic MRV with results reported in biennial national communications subject to “international consultation and analysis”, and developing country action receiving international ﬁnancing will be subject to MRV guidelines yet to be adopted. This is an important step forward, but much depends on the details of these MRV guidelines and domestic programs. . . .

The numbers provided in the tables that – according to the Copenhagen Accord – had to be ﬁlled in by February 1, 2010 with national pledges of emissions reductions for 2020, are not overly ambitious. The European Union offered a range of cuts between 20 and 30%, the United States provided a target of 17% below 2005 levels, which is equivalent to 3% below the levels of 1990. China’s target to lower its emissions per unit of GDP by 40 to 45% compared to 2005 levels is not much more than a business as usual development. 76 countries, together accounting for about 80% of global industrial emissions, had ﬁlled in their pledges by April 13, 2010 (cf. [10] for these numbers). As of August 12, 2010 the total number of Parties that have expressed their intention to be listed as agreeing to the Copenhagen Accord is 138 (cf. http://unfccc.int/home/items/5262.php). Scientists consider these pledges insufﬁcient to meet the goal of limiting global warming to two degrees Celsius (cf. again [10] for an opinion of scientists from the Potsdam Institute for Climate Impact Research and other institutions). The efforts to monitor and verify the actions, which were accorded some importance in Copenhagen, are probably related to the Prisoners’ Dilemma. Once a treaty is signed and ratiﬁed, chances are that strategies well known from the Prisoners’ Dilemma will signiﬁcantly reduce the efforts to protect the climate and extend the time horizon for effective actions. In order to prevent these all-too-familiar developments, most of the industrialized countries obviously want to hold the accord countries accountable for their actions. For good reason such efforts are rejected by other countries, among them many important developing countries and transition economies. Another issue relates to the increasing number of climate meetings.23 From game theory it is well known that an indeﬁnite number of repetitions of the Prisoners’ Dilemma can yield cooperation, can lead to an efﬁcient outcome (cf. [6], Ch. 14). It is thus possible that the growing number of climate meetings constitutes an attempt to arrive eventually at cooperation. However, changing participants from the various 23

Since the UNFCCC entered into force in 1994, the parties have been meeting annually in “Conferences of the Parties” (COP). The meeting in Copenhagen in December 2009 was therefore “COP 15”. Additional climate talks and debates supplement these ofﬁcial conferences (cf. again Subsection 3.2.4).

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countries may complicate this goal. In addition, there is typically a multitude of Nash equilibria for these games repeated an indeﬁnite number of times (cf. again [6], Section 14.2). As indicated above, there is still the problem of how the participating countries arrive at a treaty such as the Kyoto Protocol with its differing obligations to reduce greenhouse gas emissions, even when the Prisoners’ Dilemma prevents a more or less complete implementation thereafter. In general, the countries will have different goals: the industrialized countries might want to fully integrate the large transition economies, whereas the latter might try to reduce their obligations with a reference to historical developments. This question of “positioning” oneself in such negotiations is thus of great practical importance. Chapter 12 addresses this issue of allocating an international environmental commodity in the context of a principal-agent approach.

5.3.3 The Tragedy of the Commons This subsection considers a related issue which is – in contrast to the Prisoners’ Dilemma – relevant for the case of a large number of consumers or producers who jointly enjoy an environmental commodity. Assume that the F sector consists of such a large number of “small” companies which proﬁt from unpolluted water. If any of these companies contributes an amount bi towards clearing the water, for example by compensating the G companies for reducing the emissions of waste water, then gross proﬁt of of each company would increase (by assumption) by z = h(∑ j b j ) with h (b) < 1. The function h thereby indicates administrative and overhead costs, for example. Net proﬁt of company i will therefore change by Δ πi (bi ) = z − bi = h(∑ j b j ) − bi ; with the derivative Δ πi (bi ) < 0 the optimal choice will be given by the boundary solution bi = 0 (cf. [13], Section 1.4.2, for this example). For each company it is therefore completely rational to rely upon the environmental activities of the others. One’s own activities (or, in view of the above example, non-activities) will only marginally contribute towards a further pollution of the environment and are therefore negligible. An environmental issue arises through the similarly careless behavior of many individuals (cf. also [12], Section 31.6, for a more detailed elaboration of the Tragedy of the Commons). The Tragedy of the Commons is “responsible” for various types of environmental pollution. Consider the issue of the modal split, the distribution of commuters to the various means of transportation such as public transport or private cars. Despite a higher level of pollution (also in the form of greenhouse gases), and despite daily trafﬁc congestion, especially during rush hours, many commuters continue to use their own car to get to and from work, also in spite of a presumably high level of environmental awareness in most cases. An explanation is provided by the Tragedy of the Commons: the additional (or marginal) pollution of a commuter in a private car is negligible, as is the marginal effect on the overall trafﬁc situation in the city. So, why switch to the less comfortable public transport? If the other commuters take

References

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the public buses or trains, then the streets will be less crowded. . . . The consequence is clear: nobody has much of an incentive to change his or her behavior. Of course, there are reasons to use public transport for commuting: cost saving, no need to search for a parking space, . . . . But these reasons are “competing” with the other ones mentioned above. As is the case in the Prisoners’ Dilemma, it is difﬁcult to regulate individual behavior governed by the Tragedy of the Commons. Again, individually rational behavior leads to environmental pollution through the combined effect of a large number of “small”, almost “negligible” polluters. It is again the task of “environmental economics” to design appropriate instruments to close or narrow this gap between individual and collective rationality. The following chapter analyzes the formal methods and tools required to do so from a theoretical point of view.

References 1. Arrow KJ, Hahn FH (1980) General competitive analysis. North-Holland, Amsterdam 2. Baum H, Behnke N (1997) Der volkswirtschaftliche Nutzen des Strassenverkehrs. Schriftenreihe des Verbandes der Automobilindustrie e.V., Bd. 82, Frankfurt 3. Baumol W, Oates W (1988) The theory of environmental policy. Cambridge University Press, Cambridge 4. Hildenbrand W, Kirman AP (1976) Introduction to equilibrium analysis. North-Holland, Amsterdam 5. IEA Statistics (2010) CO2 emissions from fuel combustion – highlights. IEA, Paris http://www.iea.org/co2highlights/co2highlights.pdf. Cited July 2011 6. Kreps DM (1990) A course in microeconomic theory. Harvester Wheatsheaf, New York 7. Ladislaw SO (2010) A post-Copenhagen pathway. Center for Strategic & International Studies, Washington DC http://csis.org/ﬁles/publication/100111_Ladislaw_Post_copenhagen.pdf. Cited August 2010 8. Perloff JM (2001) Microeconomics. Addison-Wesley, Boston 9. Pigou A (1929) The economics of welfare. Macmillan, London 10. Rogelj J, Meinshausen M et al (2010) Copenhagen Accord pledges are paltry. Nature 464:1126–1128 11. UNFCCC (2010) National greenhouse gas inventory data for the period 1990-2008. Secretariat of the UNFCCC, Bonn http://unfccc.int/resource/docs/2010/sbi/eng/18.pdf. Cited July 2011 12. Varian HR (2006) Intermediate microeconomics, 7th edn. Norton, New York 13. Weimann J (1990) Umweltökonomik, 1st edn. Springer, Heidelberg 14. Wooders MH (1978) Equilibria, the core, and jurisdiction structures in economies with a local public good. J Eco Theory 18:328–348

Chapter 6

The Internalization of External Effects

Abstract Environmental or external effects are not sufﬁciently integrated into the market system, leading therefore to “market failure” in the sense of an inefﬁcient market equilibrium. The “internalization” of external effects intends to restore efﬁciency and reestablish optimality of the equilibrium allocation. As external effects signal missing markets, the main idea to be investigated in this chapter is the assigning of “property rights” for the environmental commodities in question or the immediate establishing of “artiﬁcial” markets, thereby “completing” the market system. The various tools to achieve this task are formally related.

6.1 External Effects and Missing Markets Environmental commodities affect the well-being of economic agents and are “commodities” in the usual sense. Perceived scarcity makes them eligible for consideration in the context of the allocation problems. However, the “classical” market mechanism fails in the sense of necessarily leading to a Pareto-efﬁcient outcome. External effects or, more generally, properties of public commodities, are responsible for this outcome. As a consequence, the framework conditions characterizing a market economy in general have to be adjusted to allow for externalities, to internalize the external effects, which are not sufﬁciently integrated into the market system, and thus not appropriately mirrored in the equilibrium prices. The goal of an internalization of external effects is therefore to restore efﬁciency of the market mechanism (cf. Section 4.2 for a discussion of the role of efﬁciency in environmental economics). The analysis will show that a discrepancy is likely between the theoretical results and their application in practical considerations; this will be investigated in Part III. However, even this problematic insight will contribute towards a deeper understanding of the prerequisites of an economically sound environmental policy. As many environmental commodities show properties of public commodities, allocation mechanisms for these commodities need to be investigated. Public comH. Wiesmeth, Environmental Economics: Theory and Policy in Equilibrium, Springer Texts in Business and Economics, DOI 10.1007/978-3-642-24514-5_6, © Springer-Verlag Berlin Heidelberg 2012

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modities are characterized by a multitude of externalities: each individual (or each institution, or each country) providing an environmental commodity (reducing pollution, for example) with qualities of a public commodity exerts externalities on other individuals, institutions or countries.1 An effective allocation mechanism for public commodities in general, and for environmental commodities with public good properties in particular, has to respect this multitude of external effects. These issues will be addressed in the next chapter, again accompanied by complications when applied to practical issues. The externalities, which are not appropriately respected by the price mechanism, imply “missing opportunities” to exchange certain commodities, or even “missing markets” for some commodities. As a consequence, the market system has to be “augmented” or even “completed” to allow for externalities. This can be accomplished in various ways. The direct establishment of the required markets by order of the government is possible, although rather unlikely. More realistic is the proposal to supplement the market system with “artiﬁcial” markets, such as markets for tradeable emission certiﬁcates or pollution rights. Pigou Taxes, which can be interpreted as market prices on the missing markets, will also prove sufﬁcient to internalize an environmental effect. In these cases, the property rights regarding the environmental commodities remain with the government or a governmental institution. Sometimes, negotiations and simple contracts between the relevant parties can prove helpful to internalize an externality, especially if transaction costs for negotiating the contract are low. This approach is related to the Coase Theorem (cf. Section 6.6) and requires the explicit assignment of property rights to individuals or groups of individuals. In this context, establishing artiﬁcial markets is always associated with the assignment of property rights, most often to the government in general. To consider the extreme cases investigated in the model economy introduced in Chapter 5 however, the paper industry might – for example for historical reasons – refer to the “right” to pollute the water; or, alternatively, the ﬁsheries might claim the right to an unpolluted lake or river. These aspects point to a “two-sided” nature of external effects: on the one hand, the paper producers affect the ﬁsheries by polluting the water; but, on the other hand, the ﬁsheries “disturb” the paper producers by their sheer presence. Without the ﬁsheries no externality, without the paper producers no externality!2 However, it has to be admitted that this latter interpretation is non-standard and requires some open-mindedness to be taken seriously.3 This reciprocal nature of external effects (cf. also [3]) results from missing property rights and, consequently, missing markets, with the further consequence of 1 In this sense, an individual (or a country, . . . ) reducing the “pollution” of the ozone layer by limiting emissions of CFCs exerts a positive external effect on all other individuals. 2 For simplicity, it is assumed that the waste water discharged by the paper producers does not lead to any further environmental degradation (cf. also the remarks in Subsection 5.2.2). 3 The issue of deﬁning the “polluter” in a concrete case is related to this ambiguous aspect: are the paper producers the polluters because they discharge the waste water into the river, or are rather the consumers, who demand and consume the paper, the polluters?

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“market failure” (cf. footnote 12 on p. 66 for some comments on the term “market failure”). In the case of the model economy, the ﬁsheries will blame the paper producers for the resulting pollution, and the paper industry will point to the inappropriate location of the ﬁsh producers. What is therefore missing is an appropriate assignment of property rights with respect to the environmental commodity “clear water”, maybe a market for this commodity, to handle this reciprocal nature of the externality appropriately. Thus, if the paper producers are assigned the right to use (and pollute) the water, the ﬁsheries have to approach the paper companies regarding a reduction of the pollution. They might start negotiations to buy pollution rights from the paper producers.4 However, if the ﬁsheries are assigned the right to unpolluted water, then the paper producers have to ask permission to discharge waste water. The ﬁsheries might grant permission by selling them pollution rights. Alternatively, an environmental bank, established by the government, might issue pollution rights or any other directives to regulate and limit pollution. This “bank” could also operate as a “market”, as a place for issuing and trading emission certiﬁcates. The following sections examine these ideas for supplementing or completing the market system. The formal, theoretical analysis of this and the following chapters will then be applied to practical environmental issues in the next part of the book. Again, the investigations will mostly refer to the model economy introduced in Chapter 5. The companies of the G sector, the paper producers, exert a negative external effect on the ﬁsheries, the companies of the F sector. Each F company is confronted with the pollution resulting from the waste water of the G production. Of course, different environmental effects could be modeled and analyzed in appropriately adjusted model economies (cf. Subsection 9.3.2 for the model of an environmental effect in the consumption sector of the economy).

6.1.1 Supplementing the Market System The environmental pollution in the model economy results from the “commodity” A (“waste water”), a by-product of the paper industry. Due to missing property rights (who wants to “own” or “acquire” waste water?), no regular market for this commodity emerges. Thus, in the context of establishing a market, the G companies will be obliged to “offer” waste water at a negative price. Thus, the G sector will have to pay for selling this commodity to some public environmental institution such as an environmental bank, for example. Property rights regarding “waste water” or “clear water” are then assigned to this institution.5 Can establishing a “market” for commodity A restore the efﬁciency properties of the market mechanism? For simplicity it is assumed that the production of one unit 4 “Buying” pollution rights from the paper producers implies a reduction of the amount of waste water to be discharged into the river in a certain period of time. 5 Both interpretations work in the sense that the environmental bank has the means and the power to regulate the extent of the pollution.

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of G entails the production of one unit of A. It is moreover assumed that there is no alternative, environmentally friendlier technology with a lower level of emissions of pollutants:6 F = f (LF , A), G = g(LG ) and A = g(LG ). The market price for commodity A will be negative, as already explained. Alternatively, it is possible to treat A (or rather “clear” water, cf. Section 6.3) as a factor, of which one unit is necessary for the production of one unit of G, without the possibility (in the context considered here) of substituting this factor for any other. In this case, the G companies would have to pay a (positive) price for using this “environmental factor”, implying again additional expenses.7 The environmental institution or bank buying commodity A will redistribute the revenue (remember, the price of A is negative) to the consumers in the form of a lump sum payment. Therefore, the model economy will remain “closed” in the sense that all monetary ﬂows originate and terminate within the economy. Observe that due to the assumption of identical and homothetic preferences, the concrete distribution of the revenue to the consumers will not affect the equilibrium; in fact, as dicussed in Subsection 5.1.1, it can be assumed that there is just one consumer with these preferences and a budget corresponding to aggregate income. This simpliﬁes the investigation substantially and helps to focus the analysis on the efﬁciency issues. Let pA denote the absolute value of the price of commodity A. Then the conditions for proﬁt maximization in both sectors are given by: max [pF · f (LF , G) − pL · LF ] and max [(pG − pA ) · g(LG ) − pL · LG ]. LF

LG

The ﬁrst-order conditions for proﬁt maximization and for utility maximization yield the following conditions, which are necessary for an (interior) equilibrium: f (LF , G) f (LF , G) pA uG (F, G) pG pG − pA = 1 = 1 . and = + pF g (LG ) uF (F, G) pF g (LG ) pF If pA := −pF · f 2 (LF , G), then the above ﬁrst-order conditions yield an allocation for which the indifference curve is tangent to the transformation curve: the marginal rate of substitution coincides with the marginal rate of transformation. As a consequence, the resulting equilibrium again represents the Pareto-efﬁcient allocation, which is unique in this case.8 Examples 5.3 (A) and 5.3 (B) demonstrate that, in the presence of external effects, the transformation curve need no longer be concave. Second-order conditions therefore become relevant and have to be checked explicitly. They are, however, 6

The replacement of a polluting technology with an innovative and less polluting technology will be investigated in Section 9.3. 7 Of course, an artiﬁcial “market” for the factor A would also have to be established in this case. 8 As there are no externalities in the consumption sector of the economy, this condition is indeed necessary for efﬁciency of an interior solution. Sufﬁciency depends on the relative curvature of the transformation curve and the indifference curve (cf. also Examples 5.3 (A) and 5.3 (B)).

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fulﬁlled in the case of these examples as an investigation of the curvature of the transformation curve and the indifference curve shows (cf. Figures 5.3 and 5.4). Example 6.1 (A). If in Example 5.3 (A) the price pˆA (to be paid by the G companies) ˆ (= F), ˆ then the Pareto-efﬁcient for commodity A is deﬁned by pˆ A := − pˆF f2 (Lˆ F , G) ˆ ˆ ˆ ˆ ˆ allocation zˆ = (LF , LG , F, G, A) ≈ (8.36, 1.64, 81.98, 4.1, 4.1) is an equilibrium with prices pˆ = ( pˆL , pˆF , pˆG , pˆA ) ≈ (50, 5.1, 101.98, 81.98) for the factor, the regular commodities and “commodity” A. Moreover, pˆG − pˆA = 20, and the ﬁrst-order conditions derived above are fulﬁlled. The “revenue” pˆA · Aˆ from selling A increases the factor income pˆ · Lˆ of the consumer in this closed economy. Total income is then just ˆ at prices pˆF and pˆG . The price ˆ G) sufﬁcient to pay for the commodity bundle (F, system ( pˆL , pˆF , pˆG , pˆA ) is an efﬁciency price system, as it “supports” the Paretoefﬁcient allocation in equilibrium.

Note 6.1. Taking into account constant return to scale in both sectors and, therefore, the zero proﬁt condition, one obtains, with pˆL normalized to 50, the following details for the equilibrium prices from the ﬁrst-order conditions: pˆF = Gˆ + 1 and pˆG − pˆA = 20. Therefore: ˆ = (Gˆ + 1) · pˆA := − pˆF f2 (Lˆ F , G)

50Lˆ F ˆ = F. (Gˆ + 1)2

Inserting this into the above ﬁrst-order conditions for an equilibrium yields: 20 Fˆ Fˆ = + . Gˆ Gˆ + 1 Gˆ + 1 ˆ ˆ ˆ ˆ Together √ with F = F(G) = (500 − 20G)/(G + 1) one obtains the result ˆ G = 26 − 1 (cf. also Example 5.4 (A)) and the remaining data for the ˆ ˆ now efﬁcient equilibrium allocation (Lˆ G = G/2.5, Lˆ F = 10 − Lˆ G , Fˆ = 20G, pˆG = 20 pˆF with pˆL := 50). With this data it is then straightforward to verify ˆ at prices pˆ corˆ G) that the budget required to buy the equilibrium bundle (F, responds exactly to the sum of the consumer’s factor income and the revenue from the market for commodity A. Thus, the economic system considered here is closed indeed.

Example 6.1 (B). In the context of Example 5.3 (B) deﬁne the price pˆA (again ˆ = to be paid by the G companies) for commodity A by pˆA = − pˆF f2 (Lˆ F , G) 2 ˆ ˆ ˆ ˆ ≈ ˆ ˆ ˆ ˆ 0.16 · LF · G · 625/(625 − G ) ≈ 11.24. Then the allocation zˆ = (LF , LG , F, G, A) (6.1, 3.9, 258.34, 9.76, 9.76) is efﬁcient and represents an equilibrium at prices pˆ = ( pˆL , pˆF , pˆG , pˆA ) ≈ (50, 1.18, 31.24, 11.24) with pˆL normalized to 50. Moreover, pˆG − pˆA = 20, and the ﬁrst-order conditions derived above are fulﬁlled. Again, the proceeds pˆA · Aˆ from selling commodity A increases the factor income pˆ · Lˆ of the

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(single) consumer in this closed economy, and ( pˆL , pˆF , pˆG , pˆA ) is an “efﬁciency price system”, as it “supports” the Pareto-efﬁcient allocation in equilibrium. Observe that the price pˆA for commodity A has to be ﬁxed by the public agency which is in charge of regulating this artiﬁcial market. Obviously, this requires a lot of information, which is not readily available. The question whether there are approaches to this problem, which are more amenable to competitive forces, will be investigated later. In the context considered here the agency then collects the revenue and redistributes it to the consumer as indicated above. The amount of commodity A, of waste water, bought from the G sector, is simply discharged into the river. The resulting pollution is, in view of the above results, lower than before the internalization of the external effect.9 This result demonstrates ﬁrst of all that environmental pollution need not necessarily stop completely in order to internalize the external effect, in order to arrive at an efﬁcient outcome.10 The challenge is to determine the “optimal” amount of polluting activities, which is not always an easy thing to do, as individuals might have and indeed do have dissenting views and opinions. Moreover, it is sometimes difﬁcult to communicate such a result to active groups of environmentalists. Secondly, this results outlines a “shortcut” to the internalization of an external effect. There is, of course, no need whatsoever on the side of the public agency to ﬁrst buy and collect the waste water at (negative) price − pˆA and thereafter to dump it into the river.11 It is obviously sufﬁcient, to impose the price pˆA on each unit of waste water discharged into the river by the G industry. pˆA could then be interpreted as a tax on waste water, or equivalently, as a tax on the production (or the consumption) of commodity G. In the latter cases, the artiﬁcial market for commodity A would almost disappear and be “replaced” by this production or consumption tax on the ﬁnal product G. This environmental tax, the Pigou Tax, will be investigated in the next section. Moreover, instead of taking care of this issue itself, a governmental institution could award or sell the property rights regarding a clean environment or clear water either to the G companies or the F companies. Then, a market for pollution rights could emerge. It remains to be seen under which conditions such a market will again lead to a Pareto-efﬁcient outcome, under which conditions such an arrangement will help to internalize the external effect. The Coase Theorem will provide a fundamental answer in this context (cf. Section 6.6). These approaches and various other ones will be studied in the following subsections. However, it is important to note that they are all variations on the same theme: the internalization of an external effect requires the establishment of appropriate 9 This way of motivating the internalization of an external effect, although it may appear strange at ﬁrst, allows a simple introduction to and foundation of other instruments of environmental economics, such as the Pigou Tax or tradeable emission certiﬁcates. 10 This can be seen in the context of public and private transport, for example. Probably nobody would argue in favor of a complete ban on private transport activities, although transport activities constitute a major source of air pollution. 11 Observe that p is deﬁned as the absolute value of the negative price of commodity A. A

6.2 The Pigou Tax

83

markets for speciﬁc commodities, and there is a variety of ways to accomplish this, at least in theory. For practical applications, for environmental policy, there might be differences, however. An environmental tax on the production of a commodity (commodity G, for example) might provide different incentives for reducing pollution in comparison to a price (or tax) on the polluting substance (commodity A, for example). Moreover, there are differences regarding the role of the government. In the case of an environmental tax the dominant inﬂuence of the government is indicated by the usual context in which a “tax” is embedded; in particular, the tax rate has to be determined by the government and the issue of using the revenue becomes apparent. On the other hand, in the case of a market for tradeable emission certiﬁcates, for example, the role of the government is “restricted” to establishing the framework conditions; “market forces” will then lead to the desired outcome, if the framework conditions provide the right incentives. Thus, there is a crucial difference between a more discretionary and a more market-oriented approach to an environmental policy, in complete analogy to regular economic policy. These issues and their consequences for environmental policy will be revisited in Part III of the book.

6.2 The Pigou Tax Given the remarks given in the last subsection, a formal analysis of the Pigou Tax turns out to be simple and straightforward: instead of paying the price pA per unit of commodity A, a tax of tG units of money per unit of G will now be imposed on the production of G. The revenue from the tax will be redistributed to the consumers in a lump sum way. As the conditions for proﬁt and utility maximization will not change, a tax rate of tˆG := pˆA will lead to the Pareto-efﬁcient equilibrium allocation denoted by zˆ in the above examples.12 Again, although completely equivalent from a formal point of view, there might be differences between the application of pˆA and of tˆG in the context of environmental policy.

A.C. Pigou: “The Economics of Welfare” (excerpt from [5], Ch. IX) “It is plain that divergences between private and social net product of the kinds we have so far been considering cannot, like divergences due to tenancy laws, be mitigated by a modiﬁcation of the contractual relation between any two contracting parties, because the divergence arises out of a service or disservice rendered to persons other than the contracting parties. It is, however, possible for the State, if it so chooses, to remove the divergence in any ﬁeld by “extraordinary encouragements” or “extraordinary restraints” Beyond the fact that one unit of G leads to one unit of A, the amount Aˆ of the polluting substance no longer plays an explicit role in this context.

12

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6 The Internalization of External Effects

upon investments in that ﬁeld. The most obvious forms which these encouragements and restraints may assume are, of course, those of bounties and taxes. . . . The private net product of any unit of investment is unduly large relatively to the social net product in the businesses of producing and distributing alcoholic drinks. Consequently, in nearly all countries, special taxes are placed upon these businesses. . . . ”

Some further thoughts on this tax, named after A.C. Pigou, who back in 1929 proposed (cf. the excerpt above) “removing” any “divergence between private and net social product” through taxes or subsidies. Observe that a market equilibrium in an economy characterizes a situation where the plans of consumers and producers become compatible, demand equals supply on all markets. The supply curve of a ﬁrm corresponds to the curve of its marginal costs (cf. [7], Ch. 22). In a competitive framework, a proﬁt-maximizing ﬁrm produces where price equals marginal costs. This result extends to industry supply as the “horizontal sum” of individual supply curves (cf. [7], Ch. 23). Again, the market price corresponds to marginal costs of all individual ﬁrms. If there are no externalities which affect production decisions, these “marginal private costs” coincide with the “marginal social costs” of production. These relationships will now be studied by means of the basic examples introduced in the last chapter (cf. ﬁrst the basic examples without externalities: Example 5.1 and Example 5.2). Example 6.2. With production functions f (LF ) = 50 · LF resp. g(LG ) = 2.5 · LG , and the consumer characterized by utility u(F, G) = F · G and the initial endowment L¯ = , F , G ) = (5, 5, 250, 12.5) is an equilibrium 10 of labor, the allocation z = (LF , LG with price system p = (pL , pF , pG ) = (50, 1, 20) (cf. Example 5.2). The additional costs of producing one more unit of G, the marginal (private) costs, correspond to the costs of the marginal factor requirements. Thus, the marginal private costs of G production are given by pL /g (g−1 (G )) = 50/2.5 = 20 units of money. From a social point of view, the production of additional units of G implies a lower production level of F: the decrease in the amount of F produced corresponds to the marginal rate of transformation and turns out to be −dF/dG = ) = 20. With equilibrium price p = 1 an additional unit of G implies f (LF )/g (LG F a lower production of 20 units of F, equivalent to 20 units of money. Marginal social and marginal private costs of the G production are therefore identical. With environmental or external effects, however, a discrepancy, a gap between marginal private and social costs of production may arise, culminating in market failure. The focus only on private costs of production in equilibrium decisions drives this result, whereas efﬁciency requires the appropriate integration of social costs. Pigou’s proposal is then to close this gap with a tax. As is well known, such a production tax will shift the aggregate supply curve by the amount of the tax rate, and an efﬁcient outcome will be attained by the market mechanism. This will be inves-

6.2 The Pigou Tax

85

tigated by means of the two basic examples with externalities: Example 5.3 (A) and Example 5.3 (B) respectively. Example 6.3 (A). In order to analyze marginal social costs of G production, the decrease in the production level in the F industry resulting from an increase in the production of G will be evaluated at price pF (G) = G + 1 with G denoting the current level of production in the G sector. With pL := 50 and given production level G, this is the price which leads to “zero proﬁt” in the F sector. At constant returns to scale this is a prerequisite for an equilibrium price system. This leads then to the following result for the marginal social costs of the G production: SF (G) := pF (G)· | F (G) | = pF (G) ·

520 520 = . (G + 1)2 G+1

Marginal private costs are given by pL /g (g−1 (G)) = 20; thus, SF (G) − 20 corresponds to the additional marginal social costs of the G production. 200

150

$

100

50 20 0

... ... ... ... ... ... SF (G) ... ... ... ... ... Additional marginal ... social costs of G pro... ........ . duction at G = 12.5 .... .... ... ... ..... ... ...... @ .... ... ....... ... ........ @ ... Marginal private ......... @ ... ............ .... ....@ ... ................ costs of G production ... ....... ... @ R..... .......................................................... @ .... ... ....................................................................................................................................................................................................................... ................................................................................................................................................................... ... .... ... ... ... ... ... ... . . 0

ˆ G

10

G

15

20

25

Fig. 6.1 Marginal social cost of G production (Example (A))

Observe that marginal private costs remain constant at 20 units of money in this example. Marginal social costs SF (G), however, decrease with an increasing amount of G: marginal damage for the F industry is highest at low levels of G. Put differently, the ﬁrst unit of G leads to signiﬁcant damage or loss of proﬁt in the F industry. A further extension of the G production adds to this damage, but less signiﬁcantly (cf. Figure 6.1). The price pF (G) increases with G, but this increase is not sufﬁcient to compensate for the loss due to the rapidly decreasing marginal “physical” product | F (G) | in the F sector. This results in a falling SF (G) curve. As SF (G) > 20 for 0 ≤ G < 25, marginal private and social costs of the G production differ at the equilibrium level G = 12.5. This indicates once again the inefﬁciency of the equilibrium allocation z in Example 5.4 (A).

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6 The Internalization of External Effects

Note 6.2. With √ the formula derived above, marginal social costs of the √ G proˆ = 520/(Gˆ + 1) = 20 26. The duction at Gˆ = 26 − 1 are calculated√to SF (G) additional marginal social costs 20( 26 − 1) = 20Gˆ = Fˆ correspond then – as required – to the “equilibrium price” pˆA of commodity A or the Pigou Tax tˆG respectively (cf. Example 6.1 (A)). The situation in Example 6.3 (B) with the modiﬁed production function fB (LF , G) = 0.08 · LF · (625 − G2 ) for the F sector is somewhat different: Example 6.3 (B). The analogous calculation of the marginal social costs of G production at equilibrium prices pF (G) = 625/(625 − G2 ) for commodity F with pL := 50 (cf. the remarks in Example 6.3 (A)) yields: SF (G) := pF (G)· | F (G) | = pF (G) · (20 + 1.6 · G − (60/625) · G2 ). Again, marginal private costs are pL /g (g−1 (G)) = 20 units of money; and as SF (G) > 20 for G > 0, marginal social costs of the G production at the equilib rium level G = 12.5 exceed marginal private costs (cf. Example 5.4 (B)). .......... ........................ ..................... . . . . . . . . . . . . . . . . . .......... SF (G) ................. ............... . . . . . . . . . . . . ...... @ 6 Additional marginal R.............................. @ 30 ... .. . . . . . . . . . . . . . . . . . . . . . . . social costs of G pro. ........ .... ... ......... . . . . . . duction at G = 12.5 . . . . . ....... .... . . . . . . . . ? .. ..... 20 ............................................................................................................................................................................................................................................................................................................................................ 6 ..... 40

$

... ... .. ... ... ... ... ... ... ... ... ... ... ... ... ... .

10

0 0

5

ˆ G

Marginal private costs of G production

? G

15

20

25

Fig. 6.2 Marginal social cost of G production (Example (B))

In this case marginal social costs SF (G) are rising. Marginal damage to the F companies increases with an increasing G production (cf. Figure 6.2). A more detailed analysis would reveal that the marginal “physical” damages of the G production given by | F (G) | increase for G ≤ 25/3 and decrease thereafter. This effect is, however, compensated by the faster increasing price pF (G).

6.3 Firm-Speciﬁc Prices for an Environmental Commodity

87

According to the above considerations, the tax rate tˆG per unit of G has to be chosen such that the gap between marginal private and social costs will be closed. This has the following implications in the context of the examples: √ Example 6.4. Under the given assumptions tˆG = [520/(Gˆ + 1)] − 20 = 20 · ( 26 − 1) ≈ 81.98 in Example 6.3 (A) and tˆG = [625/(625 − Gˆ 2 )] · [20 + 1.6 · Gˆ − (60/625) · Gˆ 2 ] − 20 ≈ 11.24 in Example 6.3 (B). These deﬁnitions lead to the (efﬁcient) equilibrium in the examples. The “zero proﬁt condition”, a prerequisite for proﬁt maximization, is fulﬁlled with price pˆG − tˆG = 20 after taxes in the G sector, and with prices pˆF (G) in the F sector depending on G. The budget of the consumer is given ˆ resulting in equilibrium demand by factor income pˆ · Lˆ = 500 and tax revenue tˆG · G, ˆ ˆ (F, G) for the two commodities. “Market failure” due to externalities can thus be corrected by means of a tax, the Pigou Tax. Formally, this tax can be designed as a pollution tax, an output tax, or an input tax.13 However, for practical applications, one has to be aware of further reactions of the economic agents to speciﬁc taxes, such as avoidance effects.14 Moreover, in order to ﬁnd the “right” value of the tax rate, the government again requires a great deal of detailed information. These issues and others, which pose serious difﬁculties for an environmental policy based on results and recommendations from a theoretical analysis, will be addressed in Part III. Up to now it was assumed that the government or a governmental agency owns the property rights with respect to a clean environment. Producers of commodity G can obtain the right to pollute the water by buying a certain amount of “titles” or by paying a certain “fee”. The producers of commodity F are free to use the water for their purposes.15 In the sense of a “polluter pays principle” this approach seems to be justiﬁed. However, both sectors are using an obviously scarce commodity – clear water – for their production processes. Why not put a price on “clear water” in the ﬁrst place and sell it to the companies of both sectors? The reciprocal nature of the external effect accommodates this modiﬁed framework, which will be investigated further in the following section.

6.3 Firm-Speciﬁc Prices for an Environmental Commodity The environmental commodity “clear water” is required by the ﬁrms of both sectors, although F companies and G companies need it in different quantities and for 13

In the case of the examples, all three versions of the tax lead to an internalization of the external effect with tˆA := tˆG and tˆL := 2.5 · tˆG , with the input tax referring, of course, only to the factor input in the G sector. 14 The term “avoidance effects” illustrates the functioning of the Pigou Tax: agents on whom the tax is imposed try to avoid it by looking for suitable alternatives. In the context of the examples considered here, the only possibility to avoid the tax is to reduce the production of G. 15 Of course, instead of taxing the G producers, it is also possible to subsidize the F producers; the required amount of money must then be taken from the consumers in a lump sum way.

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6 The Internalization of External Effects

completely different purposes. The reciprocal nature of the external effect implies that both sectors are in some sense responsible for the existence of the externality, although to a different extent. As a consequence, one should not expect that a uniform tax rate will be sufﬁcient to internalize the externality, one should attempt a more general approach with different tax rates for the F and the G sector. Let tF , resp. tG denote a Pigou Tax on the production of commodity F, resp. commodity G. It is thereby assumed that the production of one unit of F or G requires one unit of clear water. The conditions for proﬁt maximization read: max[(pF − tF ) · f (LF , G) − pL · LF ] and max[(pG − tG ) · g(LG ) − pL · LG ]. LF

LG

Taking into account utility maximization and the requirement of equality of the marginal rate of substitution and the marginal rate of transformation for the efﬁciency of an allocation, one obtains the ﬁrst-order conditions: f (LF , G) f (LF , G) pG − tG uG (F, G) pG = 1 = 1 and = − f 2 (LF , G). pF − tF g (LG ) uF (F, G) pF g (LG ) Consider the production functions f and g and the further assumptions of Example 5.4 (A). Then the conditions pˆF − tˆF = Gˆ + 1 and pˆG − tˆG = 20 on equilibrium prices and the values of the Pigou Taxes are necessary for achieving the efﬁcient ˆ One then arrives at the following relationˆ G). equilibrium allocation zˆ = (Lˆ F , Lˆ G , F, ship between the Pigou Taxes for the two sectors: 20 · Gˆ + 20 · tˆF = tˆG . Therefore, a variety of combinations between taxes on the one hand and subsidies on the other are possible. Only subsidizing the G production (tG < 0) in combination with taxing the F production (tF > 0) is ruled out. Moreover, the burden on the G producers will always exceed the burden on the F producers, obviously a consequence of the production and consumption possibilities, the units chosen, and the nature of the externality. Note 6.3. With pˆF = tˆF + Gˆ + 1 and pˆG = 20 + tˆG the ﬁrst-order conditions for proﬁt maximization together with Fˆ = 20Gˆ (cf. Example 6.1 (A)) yield: pˆG 20 + tˆG = = 20 = pˆF ˆtF + Gˆ + 1

ˆ ˆ G) uG (F, Fˆ = . ˆ ˆ G) Gˆ uF (F,

From this the formal relationship between tˆF and tˆG follows immediately.

This alternative to the “regular” internalization of the environmental effect through a Pigou Tax establishes a “market” for the environmental commodity “clear water”. However, it turns out that the prices for the access to clear water have to be ﬁrm-

6.4 Tradeable Emission Certiﬁcates

89

speciﬁc in order to allow for an efﬁcient outcome, in order to restore efﬁciency of the market mechanism. This is a feature which is in particular native to the concept of a Lindahl equilibrium for the allocation of a public commodity. As will be demonstrated in Chapter 7, the reciprocal nature of the external effects characterizing the provision of a public commodity lead to personal prices (or ﬁrm-speciﬁc prices) for an efﬁcient equilibrium allocation. The instruments to internalize external effects considered so far are based on prices: a public institution selects and sets prices (or taxes) to regulate the problem of “missing markets” associated with externalities. In contrast to this, the following approach orientates on quantities of an artiﬁcial commodity to be chosen by the government: tradeable emission certiﬁcates.

6.4 Tradeable Emission Certiﬁcates Assume now that an artiﬁcial commodity “emission certiﬁcate” is created and directly linked to a polluting activity in the sense that the purchase of one certiﬁcate entitles the owner to the emission of one unit of the polluting substance. This artiﬁcial commodity derives its utility through this link, and demand for this commodity is derived from demand for the consumption commodity produced with these emissions.16 If these emission certiﬁcates, which are issued through a government agency, such as an environmental bank, are tradeable, a “market” emerges which supplements (or completes) the market system in the sense of Subsection 6.1.1, and thus contributes to internalizing the external effect and restoring efﬁciency of the market equilibrium. More precisely, a total amount of the certiﬁcates which corresponds to the efﬁcient level of the consumption commodity in question, should again lead to an efﬁcient allocation. For the case of Example 6.1 (A) or Example 6.1 (B) with “many” small companies of the F and the G industry, characterized by the aggregated production functions f and g respectively, assume that the environmental bank offers Z certiﬁcates at price pZ to the G industry, which entitles it to the production of G = Z units of G. It is possible to offer “input certiﬁcates” to the companies of both industries for the right to use “clear water” in their production process. However, by symmetry to the case considered in Section 6.3 above, it would then be necessary to allow for different prices for the certiﬁcates offered to F and G companies.17 At prices p = (pL , pZ , pF , pG ) proﬁt of the G industry, if the amount G of the commodity is produced and sold, is given by πG (G) = (pG − pZ ) · G − pL · g−1 (G). 16

Demand for emission certiﬁcates can therefore be classiﬁed as derived demand. It is again assumed here that one unit of “clear water” is required for one unit of commodity F and also for one unit of commodity G. 17

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6 The Internalization of External Effects

This expression corresponds to the one obtained in the context of supplementing the market system (cf. Subsection 6.1.1) or in the context of the Pigou Tax (cf. Section 6.2), if one replaces pA (or tG ) with pZ and uses G instead of LG as the strategic variable. Thus, if the quantity Zˆ of the certiﬁcates issued by the government agency corresponds to the efﬁcient level Gˆ of commodity G, then an equilibrium will result with equilibrium price pˆZ = pˆA (= tˆG ). Besides the structural difference between regulating the price and regulating the quantity, the two basic approaches to internalizing the external effect lead to the same result. There are, however, crucial differences between the two approaches in environmental policy (cf. Part III). Due to the normalization Z = G, the above expression could also be considered as proﬁt πG (Z) depending on the number of certiﬁcates acquired in the market. Then, at least for the case of a strictly concave production function, it is possible to derive the inverse demand function for certiﬁcates from πG (Z). In fact, from the ﬁrstorder condition (pG − pZ ) · g (g−1 (Z)) = pL (cf. Note 5.1) one obtains a functional relationship Z(pZ ) between Z and pZ at given prices pG and pL .18 A closer look at the total differential (pG − pZ ) ·

g (g−1 (Z)) · dZ − g (g−1 (Z)) · d pZ = 0 g (g−1 (Z))

of the above ﬁrst-order condition shows that Z(pZ ) decreases with an increasing price pZ : dZ/d pZ (= dG/d pZ ) < 0, again for given prices pG and pL . The equilibrium price pˆZ results then from the intersection of demand Z(pZ ) (at prices pˆG and ˆ pˆL ) with (price-inelastic) supply Z.

Note 6.4. In the case of supplementing the market system (cf. Subsection 6.1.1), a government agency chooses the price (or the Pigou Tax) and the quantity of the emissions results from the equilibrium mechanism. In the case of tradeable emission certiﬁcates, a government agency chooses the quantity, and the price of the certiﬁcates emerges as equilibrium price. From a theoretical point of view, there is thus no difference between these two approaches. For environmental policy, however, the situation is different. It is probably easier for a governmental agency to regulate emissions with a market for certiﬁcates, which is based on a ﬁxed supply of certiﬁcates. On the other hand, there is a “political” issue, which must not be forgotten: issuing “rights” for polluting the environment is politically different from putting a “tax” on polluting activities. Indeed, from the point of view of environmentalists, the term “pollution rights” may not be politically correct.

Example 6.5. For the basic examples of this text the Pareto-efﬁcient allocation ˆ shall now be attained as an equilibrium allocation by issuing ˆ G) zˆ = (Lˆ F , Lˆ G , F, For the case of the linear production function g(LG ) = 2.5 · LG one obtains the condition pG − pZ = 20 for (equilibrium) prices.

18

6.5 Pollution Rights

91

an appropriate amount Zˆ of tradeable emission certiﬁcates. If one certiﬁcate is required for discharging one unit of waste water, then Zˆ = Gˆ ≈ 4.1 has to be chosen in Example (A), and Zˆ = Gˆ ≈ 9.76 in Example (B). For each example the efﬁcient ˆ is then an equilibrium at prices pˆ = ( pˆL , pˆZ , pˆF , pˆG ), ˆ F, ˆ G) allocation zˆ = (Lˆ F , Lˆ G , Z, ˆ = pˆL with pˆZ = tˆG from Example 6.4. and one obtains ( pˆG − pˆZ ) · g (g−1 (G)) Up to now property rights with respect to the environmental commodities were assigned to a government agency, such as an environmental bank. This institution imposed the Pigou Tax or issued the tradeable emission certiﬁcates. Pollution rights can, however, also be associated with property rights assigned to a group of economic agents, the F companies or the G companies, for example. Then the question arises, whether it is possible to assign these property rights without losing the “ﬂavor” of the results obtained so far, i.e., without losing the possibility to internalize the external effect. This question leads directly the Coase Theorem considered in Section 6.6.

6.5 Pollution Rights Assume that the F companies “own” the right or are assigned the right to use clear water for their ﬁsheries. This could be due to historical reasons, this could result from ownership of the lake in question, or this could be a consequence of an explicit assignment of the property rights to the F companies through a government agency. In each case, G producers have to approach the F companies to negotiate the details for setting up their businesses on the lake. As their production activities impose a negative external effect on the ﬁsheries, G companies will likely have to compensate F companies for the resulting loss in revenue. One possibility to arrive at a situation acceptable to both sides is to establish a market for pollution rights with many “small” F and G companies which offer and demand pollution rights at price pV . Ideally, the market mechanism will again lead to the Pareto-efﬁcient allocation zˆ in this competitive framework. Observe that the F companies now have to choose the values for two strategic variables: factor input LF and the amount V of pollution rights to be sold to the G companies at a price pV per unit. As usual, assume that one unit of the “pollution rights” entitles the G companies to discharge one unit of waste water and to produce, therefore, one unit of commodity G; thus V = G, and f (LF , G) = f (LF ,V ) for simplicity (cf. also Subsection 6.1.1). Maximization of proﬁt H(LF ,V ) of the F sector then implies : max H(LF ,V ) with H(LF ,V ) := [ pˆF · f (LF ,V ) + pˆV ·V − pˆL · LF ]. LF ,V

The ﬁrst-order conditions for an interior maximum are then given by pF f1 (LF ,V ) − pL = 0 and pF f2 (LF ,V ) + pV = 0. Observe that the efﬁcient allocation zˆ (deˆ together with the equilibrium prices pˆ = ( pˆL , pˆV , pˆF , pˆG ) (deﬁne ﬁne Vˆ := G)

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6 The Internalization of External Effects

pˆV := pˆA (= tˆG )) fulﬁlls these ﬁrst-order conditions both for the situation of Example (A) (cf. Example 5.4 (A)) and the situation of Example (B) (cf. Example 5.4 (B)). However, in this case one should have a closer look at the second-order conditions. For an interior maximum the second-order conditions postulate negative deﬁniteness of the quadratic form resulting from the second-order partial derivatives of H(LF ,V ) at the potential equilibrium values (cf. [2], Section 11.4). It is then straightforward to check that these conditions are not fulﬁlled for the case of the two example economies (A) and (B). The quadratic form mentioned above is neither negative deﬁnite nor positive deﬁnite (cf. also Note 6.5). Note 6.5. The function H(LF , G) has an interior maximum at (Lˆ F , Vˆ ), if the ﬁrst-order conditions are satisﬁed and if the following conditions for the second partial derivatives hold at (Lˆ F , Vˆ ): 2 2 ∂ 2H ∂ H ∂ 2H ∂ 2H < 0 and · − > 0. (∂ LF )2 (∂ LF )2 (∂V )2 ∂ LF ∂V For the example economy (A) one obtains ∂ 2 H/(∂ LF )2 = 0. Thus, these two conditions are violated for H(LF ,V ). A similar results holds for the example economy (B). As a consequence, it is not possible to obtain a conclusive result regarding a maximum of H(LF ,V ) at (Lˆ F , Vˆ ) and the associated equilibrium prices p. ˆ The above second-order conditions are only sufﬁcient, but not necessary for an interior maximum (cf. again [2], Section 11.4). Thus, it is still open, whether the efﬁcient allocation zˆ together with prices pˆ constitutes a maximum of H(LF ,V ), whether the allocation zˆ can be obtained as an equilibrium allocation under these framework conditions with pollution rights. This situation will be brieﬂy investigated for the example economies (A) and (B). Indeed, the following results will demonstrate that the efﬁcient allocation cannot be obtained as a market equilibrium under these special framework conditions with property rights assigned to the F sector of the economy. Example 6.6 (A). For Example (A) consider the equilibrium price system pˆ = ( pˆL , pˆF , pˆG , pˆV ) ≈ (50, 5.1, 101.98, 81.98). Proﬁt for the F industry with values LF and V for the strategic variables is given by: H(LF ,V ) = pˆF · 50 · LF /(V + 1) + pˆV ·V − 50 · LF . ˆ proﬁt is calculated to H(Lˆ F , Vˆ ) ≈ At the efﬁcient levels LF = Lˆ F and V = Vˆ (= G), 336.04. However, at V = 0 proﬁt for the F industry increases to H(Lˆ F , 0) ≈ 1713.8, and V = Vˆ is not proﬁt maximizing. The boundary solution with V = 0 is obviously better for the F companies, and they will therefore not sell any pollution rights to

6.5 Pollution Rights

93

the G companies, a market for the pollution rights leading to the efﬁcient allocation under the given framework conditions will not emerge.19 As a consequence, the levels (Lˆ F , Vˆ ) of the strategic variables are not proﬁt maximizing for the F industry and will therefore not be chosen at prices ( pˆL , pˆV , pˆF ) and individual rationality will not guide consumers and producers to an efﬁcient outcome.

Note 6.6. A closer look at the ﬁrst partial derivative ∂ H(Lˆ F ,V )/∂V = −50 pˆF Lˆ F /(V + 1)2 + pˆV of the proﬁt function provides an explanation for ˆ one obtains: this result. For V < Vˆ (= G) ∂ H(Lˆ F ,V ) −50 pˆF Lˆ F −50 pˆF Lˆ F = + pˆV < + pˆV = −Fˆ + 20Vˆ = 0. 2 ∂V (V + 1) (Vˆ + 1)2 As an immediate consequence, a smaller amount of V , starting from Vˆ , yields a higher proﬁt for the F industry.

200

150

$

100

50 20

... ... ... ... ... ... SF (G) ... ... pˆG ≈ 101.98 ... ... ... ... ... ? .... ..... .. ... .. ... .. ..... ..... ..... ..... ..... ..... ..... ..... ..... .. ... .. ... .. ..... ..... ... .................................................................................................................................................................................................................................................................................. .... ..... . .... .... ........ ..... .... ... . .... .... .. ............ .... ........ .... .... . ......... ..... . .... ........... .... .. .... .............. ˆ ...... pˆV .... pˆV · G .................. .... .. ......................... .... .... ............. .... ............................................................................................................................................................................................................................................................................................................................................................................................................................................ . .... .... .

0 0

ˆ G

10

G

15

20

25

Fig. 6.3 Property rights for the F sector (Example (A))

The reason for this somewhat strange constellation is to be found in the structural properties of the marginal damage curve SF (G) = pF (G)· | F (G) | of the F industry at prices pF (G) = G + 1 which yield zero proﬁt (cf. also Example 6.3 (A)). This situation is illustrated in Figure 6.3 with high marginal damages for small quantities of G. 19

For the allocation zˆ the F companies realize that at prices p, ˆ which they cannot affect as “small” producers in a competitive framework, V = 0 yields a higher proﬁt. Therefore, Vˆ will not be chosen, even though (LF = Lˆ F ,V = G = 0) cannot be part of an equilibrium allocation.

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Let pˆV := pˆA ≈ 81.98; then pˆG = 20 + pˆV corresponds to the marginal cost or marginal damage20 of the G production at the efﬁcient level Gˆ with marginal private costs again equal to 20 units of money. The additional social costs, or the additional costs for the F industry, resulting from an extension of the G production up to the ˆ ˆ are given by the area below SF (G) and above 20 between 0 and G. efﬁcient level G, ˆ ˆ This area obviously exceeds the compensation pˆV · V = pˆV · G the F industry would obtain under these framework conditions. Figure 6.3 illustrates this situation already outlined in Figure 6.1 in more detail. Proﬁt in the F sector thus rises with a reduction of the amount of pollution rights to be sold to the G companies. With the assignment of property rights to the F industry, the attempt to establish a regular market for pollution rights with an efﬁcient equilibrium allocation fails. Of course, it is still possible that F and G companies agree on some different kind of compensation, for example a lump sum payment, which is not dependent on the existence of a market for pollution rights. However, for the case considered in this example, not even a lump sum payment will work. Such a payment from the G industry to the F industry will not affect the choice of variables for proﬁt maximization for the G companies. But then pG = 20, and the revenue from production and sale of G is equal to factor costs. Thus, a lump sum compensation for the F industry will result in a loss, and the G companies will stop producing altogether. Again, the efﬁcient allocation zˆ is not attainable as an equilibrium allocation. This result seems to play a role in a much more general context. If, for example, a sufﬁciently strong group of the population of a country “perceives” extremely high marginal damages (to the environment in general) associated with the ﬁrst units of some economic (production or consumption) activity with decreasing marginal damages thereafter21 , and if this group “owns” the property rights regarding this issue22 , then it might be difﬁcult to agree on some positive level for this activity. This can happen, even if an efﬁcient allocation would require a positive amount of this activity. As a consequence, an inefﬁcient allocation might result for political reasons. What is happening here is that strong interests of a particular group of the society are “paired” with sufﬁcient power to enforce these interests successfully. Whether this is still environmental awareness or whether this is already some kind of selﬁshness is irrelevant with respect to the consequences. Both motivations are legitimate although they can lead to an inefﬁcient allocation regarding the commodities in question. This is again a situation with individually rational behavior leading not necessarily to a socially optimal outcome. In some sense this example mirrors the discussion on nuclear power plants in Germany. There is, indeed, a sufﬁciently large group of the German populace with 20

“Damage” has to be interpreted with some care: ﬁrst of all, an additional unit of G causes “damage” to the economy by using up a certain amount of the scarce factor; moreover there is an additional “damage” to F producers resulting in reduced proﬁts. 21 This can mean that even the ﬁrst small units of this activity are deemed dangerous to health. 22 It is sufﬁcient that this group has a sustainable inﬂuence on the public opinion with or without support from political parties.

6.5 Pollution Rights

95

a strong aversion against nuclear power plants. This attitude corresponds to a “perceived” curve of decreasing marginal damage with high marginal damage associated with the ﬁrst nuclear power plant. Moreover, this group has been dominating the public opinion since the 1970s with a growing tendency of politicians to accept this pressure. As a consequence, Germany was one of the few industrialized countries in the world, which decided to shut down all nuclear power plants. This decision was strengthened after the Fukushima Nuclear Catastrophe in March 2011: the last nuclear power plant in Germany will now be closed in 2022. In summary, it seems to be advisable to assign property rights in such critical cases with decreasing (perceived or real) marginal damages to a government agency. As interest groups may then have less power, chances for an efﬁcient outcome will increase. However, as the situation in Germany shows, these cases have usually not only an economical, but also a strong political dimension.

Note 6.7. For the case of increasing marginal damages these problems will, in general, not arise. This corresponds to the “normal” case, which is usually presented in textbooks (cf., for example, [6], Fig. 5-2 or Fig. 6-1). The allocation regarding production activities will then be independent from the assignment of the property rights with respect to the environmental commodities, at least under the framework conditions considered here. There are, however, situations with increasing marginal damages, but with decreasing physical marginal damages, which should be handled with care. Such a situation arises in Example 6.3 (B) and will be further investigated below.

Example 6.6 (B). At prices pˆ = ( pˆL , pˆF , pˆG , pˆV ) ≈ (50, 1.18, 31.24, 11.24) supportˆ A) ˆ ≈ (6.1, 3.9, 258.34, 9.76, 9.76) ˆ G, ing the equilibrium allocation zˆ = (Lˆ F , Lˆ G , F, in Example (B), proﬁt in the F industry at (LF ,V ) is given by: ˆ LF ,V ) ≈ 1.18 · 0.08 · LF · (625 −V 2 ) + 11.24 ·V − 50 · LF . πF ( p, ˆ one obtains πF ( p, For LF = Lˆ F and V = Vˆ (= G) ˆ Lˆ F ) ≈ 109.61; however, for LF = 10 ˆ 10, 5.95) ≈ 123.46. and V = 5.95 proﬁt increases to πF ( p, Again, the levels (Lˆ F , Vˆ ) of the strategic variables are not proﬁt maximizing for the F industry and will therefore not be chosen in a competitive framework at prices ( pˆL , pˆV , pˆF ). This result follows from the partial derivative ∂ H(LF ,V )/∂ LF = 0.08 pˆF (625 − V 2 ) − 50. This derivative is positive for V < Vˆ and LF should be chosen as large as possible. Thus, for LF = 10 the partial derivative ∂ H(10,V )/∂V = −1.6 pˆF V + pˆV is positive for small values of V . One arrives at the “optimal” value V ≈ 5.95 at LF = 10. Altogether this calculation shows that this boundary solution is again better with respect to the proﬁt in the F sector than the efﬁcient allocation zˆ. Similarly,

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6 The Internalization of External Effects

the boundary solution LF = 0 and V = V = 12.5 yields a higher proﬁt than the efﬁcient allocation. ....................... ..................... . . . . . . . . . . . . . . . . . . .......... pˆG ≈ 31.24 ................. ................ . . . . . . . . . . . . . . .. ........................................................................................................................................................................................................................................................... ..........................................................................................................................................................................? ............ .....6 30 ..... . . . . . . . . . . ... Additional marginal ...... .... ... .......... 6 .......... .... . social costs of G pro. . . . . . . . . SF (G) .... .... ............. ˆ ≈ 9.76 duction at G ... .. .......... . .................................................................................................................................................................................................... 20 ..................................................................................................................................................................................................................? 6 40

$

10

Marginal private costs of G production = 20

0 0

5

? ˆ G

15

20

25

Fig. 6.4 Property rights for the F sector (Example (B))

Of course, the combination LF = 10 and V = 5.95 is not feasible because of the maximum amount of the factor L¯ = 10 which is available in a given period of time. But this is not the issue. Of relevance is only the fact that the production plan (Lˆ F , Vˆ ) is not proﬁt maximizing at prices pˆ and pˆV , which cannot be affected by the “small” companies. At these prices, F companies can ﬁnd production plans with higher proﬁts, and the equilibrium allocation will not emerge.23 Note 6.8. In the case of Example (B) marginal damages SF (G) increase with G (cf. Example 6.3 (B) and Figure 6.4). However, even this “regular” case, which does not coincide with the structure of the curve of the marginal physical damages, does not necessarily imply that the efﬁcient allocation zˆ can be attained as equilibrium allocation with respect to the property rights assigned to a speciﬁc group of economic agents. This, at least, is the conclusion obtained from the above considerations . Figure 6.4 shows that for market price pˆV = pˆG − 20 ≈ 11.24 for the pollution rights the additional social costs of the G production (area under SF (G) between 0 and Gˆ and above 20 in Figure 6.4) can be more than covered with revenue pˆV · Gˆ (cf. the framed rectangle in Figure 6.4) from selling the pollution rights. Nevertheless, from the point of view of each single F company, this will not happen, because the above strategy promises a higher proﬁt than selling 23

Of course, F and G companies could jointly agree on proﬁtable production plans “outside” the market mechanism, if transaction costs allow such negotiations (cf. also Section 6.6).

6.5 Pollution Rights

97

altogether Vˆ ≈ 9.76 units of the pollution rights. Again, a government agency with control over the property rights could help to avoid this situation. Possible is also a coordination procedure outside a regular market for the pollution rights (cf. Section 6.6). The above conclusions refer to the assignment of the property rights to the F sector. It is, of course, also possible to award the property rights to the companies of the G sector. In this case, F companies have to offer a compensation to the G companies, if they want them to reduce the pollution. Again, in a market environment with price pV for the pollution rights, the proﬁt function for the F companies is structurally identical to the one obtained above, as is the issue with the second-order conditions. Thus, the efﬁcient allocation zˆ cannot be represented as a market equilibrium under these modiﬁed framework conditions. If one takes the equilibrium quantity G as reference value24 , then the proﬁt of the G industry, if they sell the quantity G −V = G − g(LG ) of pollution rights, is given by πG (LG ) = pG · g(LG ) + pV · (G − g(LG )) − pL · LG . From the ﬁrst-order conditions of this proﬁt function the supply of pollution rights can be obtained as a function of the market price pV , at least for the case of a strictly concave production function g. If the F companies buy G −V pollution rights from the G companies25 , then the proﬁt of the F industry is: πF (LF ,V ) = pF · f (LF ,V ) − pV · (G −V ) − pL · LF . The efﬁcient allocation zˆ from Examples (A) and (B) satisﬁes the ﬁrst-order conditions at prices p. ˆ Similarly it can be shown that zˆ is not proﬁt maximizing at these prices. In the case of Example (A) one obtains: πF (Lˆ F , 0) > πF (Lˆ F , Vˆ ); and for Example (B): πF (10, 5.95) > πF (Lˆ F , Vˆ ). Thus, also this assignment of the property rights does not lead to the efﬁcient allocation, at least not for the market environment assumed here. In conclusion, variations of the market for pollution rights do not necessarily lead to the efﬁcient allocation zˆ. Individual rationality in terms of proﬁt maximization in combination with the property rights may steer the market mechanism away from the efﬁcient allocation. The effect of the property rights can be strong enough to direct the system towards a boundary solution. This remains true even for the case of strictly concave production functions f and g. As the ﬁrst-order conditions are satisﬁed, the efﬁcient allocation zˆ represents some extremal point for the proﬁt of

24

Observe that this amount would be produced in the G sector and consumed in the equilibrium with external effects. 25 This means that the G sector ends up with the amount V of the pollution rights and produces the quantity G = V of the commodity.

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6 The Internalization of External Effects

the F sector. However, as demonstrated above, proﬁt may increase at the boundaries of the intervals for the strategic variables. All these remarks are related to the Coase Theorem which states that, in the absence of transaction costs, any assignment of property rights with respect to the environmental commodity will, in principle, result in the same efﬁcient allocation.26 Coase explored and analyzed the reciprocal nature of the external effects and published his results in a well-known article (cf. [3]) with political conclusions, which will be brieﬂy studied in the following section, followed by a further discussion of the above examples regarding pollution rights.

6.6 The Coase Theorem The analysis of the reciprocal nature of an externality in the last sections led to the assignment of property rights with respect to the environmental commodity in question, and to additional markets supplementing the given system. In most cases efﬁciency of the market mechanism could then be restored, although the assignment of pollution rights to special groups of the population turned out to be less promising, at least in a market environment: in the context of the above examples with a market for tradeable pollution rights the efﬁcient allocation could not be represented as an equilibrium. Individual rationality prevented the market mechanism to achieve the (in these examples uniquely determined) efﬁcient allocation. So far the conclusions from these last sections. The question, whether an arbitrary assignment of property rights will induce negotiations which will lead to an efﬁcient outcome is therefore still open. It constitutes the statement of the Coase Theorem. The following formulation of this theorem is taken from H. Siebert ([6], Ch. 6):27 Theorem 6.1 (Coase Theorem). Let exclusive property titles to the environment be deﬁned, and let them be transferable. Let there be no transaction costs. Let individuals maximize their utilities, and let them be non-altruistic. Then a bargaining solution among different users of the environment will result in a Pareto-optimal allocation of the environment. The resulting allocation is independent of the initial distribution of property titles. Thus, the Coase Theorem states that an internalization of externalities is possible through direct negotiations between the parties, once property rights are assigned and can be transferred without any transaction costs. A discretionary policy of the government to internalize the externality, such as imposing a Pigou Tax, is not always necessary. Coase, therefore, with his pathbreaking contribution (cf. 26 Differences may, however, result from different income distributions associated with different assignments of property rights. 27 Observe that this formulation assumes that the distribution of income does not signiﬁcantly affect the allocation (cf. [6], p. 100).

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99

[3]) opened the discussion in favor of a more “market-oriented” or “negotiationoriented” environmental policy. This is clearly expressed in his 1991 Alfred Nobel Memorial Prize Lecture:

R.H. Coase: “The Institutional Structure of Production”: The 1991 Alfred Nobel Memorial Prize Lecture in Economic Sciences (excerpt from [4], Ch. 1) “I now turn to that other article cited by the Swedish Academy, “The Problem of Social Cost”, published some thirty years ago. . . . . I thought that I was exposing the weaknesses of A.C. Pigou’s analysis of the divergence between private and social products, an analysis accepted by economists, and that was all. . . . Pigou’s conclusion and that of most economists using standard theory was (and perhaps still is) that some kind of government action (usually the imposition of taxes) was required to restrain those whose actions had harmful effects on others (often termed externalities). What I showed in that article, as I thought, was that in a regime of zero transaction costs – an assumption of standard economic theory – negotiations between the parties would lead to those arrangements being made which would maximize wealth, and this irrespective of the initial assignments of rights. . . . . The signiﬁcance to me of the Coase Theorem is that it undermines the Pigovian system. Since standard economic theory assumes transaction costs to be zero, the Coase Theorem demonstrates that the Pigovian solutions are unnecessary in these circumstances.”

The examples analyzed in the last section show mixed results. As long as a government agency owns the “property rights” regarding an environmental commodity, the market mechanism proves sufﬁcient to restore efﬁciency (cf. the discussion of supplementing the market system in Subsection 6.1.1, the discussion of the Pigou Tax in Section 6.2, the introduction of a market for an environmental commodity with ﬁrm-speciﬁc prices in Section 6.3, and the establishment of a market for tradeable emission certiﬁcates in Section 6.4). However, the allocation of the property rights to the F sector in Section 6.5 (or, alternatively, to the G sector) demonstrates clearly that a pure market based approach will not necessarily lead to the efﬁcient allocation. Among the reasons – in the case of these example economies – is decreasing marginal damage, which blocks any incentives to bargain with the companies from the other sector. Strong “perceived” interests combined with the “power” of the property rights assigned to the F companies prove to be responsible in the ﬁrst case of Example (A); in the second case of Example (A) with property rights assigned to G companies the potential to gain substantially from buying the property rights

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6 The Internalization of External Effects

produces the result. In both cases, proﬁt maximization cannot be achieved with the parameters of the efﬁcient allocation. Other means to compensate the G companies for transferring property rights to the F sector, such as a lump sum payment, will not work either in the framework of Example (A), if ﬁrms continue to act individually. In this case, G companies cannot achieve a non-negative proﬁt and will therefore not participate. Thus, a different approach to establishing an efﬁcient outcome has to be developed, for example the following one: assume that the companies of the G sector act cooperatively and compensate the F companies with an amount sufﬁcient to cover the damages resultˆ Such an amount C ing in the F sector from G production up to the efﬁcient level G. is, for example, given by the area under the curve of the marginal damages SF (G) between 0 and Gˆ (cf. Example 6.3 (A)): Gˆ

C := 0

SF (G)dG =

Gˆ 0

√ 520 dG = 520 · ln 26. G+1

F companies then agree to charge consumers the former equilibrium price pˆF = ˆ and distribute the amount Gˆ + 1 (with pˆ L := 50) for each unit of the total quantity F, C to the consumers, their shareholders, in the form of a lump sum payment. On the other hand, G companies agree to produce the quantity Gˆ and offer this quantity also at the equilibrium price pˆ G per unit. The loss incurred through the compensation C to the F sector is covered by the shareholders, again in the form of a lump sum payment to the G sector. Then the efﬁcient allocation zˆ will result.28 It has to be noted, however, that this bargaining “solution” requires some coordination among the F companies and the G companies and their shareholders. If the transaction costs associated with this procedure are too high, then this solution may not be feasible. But this is no contradiction to the Coase Theorem, as transaction costs are explicitly ruled out (cf. Theorem 6.1). In fact, Baumol/Oates provide an example of a monopolistic producer, who pollutes the environment and thereby affects the well-being of a large number of citizens. However, due to transaction costs, these citizens have difﬁculties to organize and express their concern in a credible way (cf. [1], p. 11, footnote 7). Especially this last example illustrates the informational requirements associated with such a “cooperative” solution. For an acceptable solution of the bargaining situation, information on the proﬁts as well as on the utilities is needed. As the individuals involved in this process will typically have an incentive to understate or overstate their personal situation, this kind of “transaction costs” will, in general, prevent an agreement or at least render it difﬁcult to achieve. Nevertheless, “bargaining solutions” play some role in the international context. If, for example, the European Union wants to support countries in Central and Eastern Europe (CEE) to reduce emissions of greenhouse gases, then the EU has to approach these countries to negotiate an agreement. Clearly, this agreement is based 28

This “solution” assumes, of course, that the shareholders of the F and the G companies are able and willing to support this compensation scheme. With the assumption of one consumer and, therefore, one shareholder, this is not a problem in the context considered here.

References

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on rather incomplete information on the concrete situation; moreover, problems of moral hazard may affect the initiatives and measures agreed upon, as the EU has only limited control on the actual activities of these countries, once the ﬁnancial means are granted.29 Observe that this kind of problems characterizes also the international environmental policy with attempts to affect the environmentally relevant behavior of the “emerging markets” (China, India, . . . ) with their rapidly increasing economies and similarly rapidly accumulating environmental problems. This practically relevant issue will be revisited in Chapter 12 and also in Part IV. The allocation of public commodities or environmental commodities with strong characteristics of public goods is also associated with this problem of incomplete information, at least for practical applications. The following chapter investigates the allocation of public goods in the context of environmental economics from a theoretical point of view.

References 1. Baumol W, Oates W (1988) The theory of environmental policy. Cambridge University Press, Cambridge 2. Chiang AC (1987) Fundamental methods of mathematical economics, 3rd edn. McGraw-Hill, New York 3. Coase RH (1960) The problem of social cost. J Law and Economics 3:1–44 4. Coase RH (1992) The institutional structure of production: The 1991 Alfred Nobel Memorial Prize Lecture in Economic Sciences. American Economic Review 82:713–719 5. Pigou A (1929) The economics of welfare. Macmillan, London 6. Siebert H (2008) Economics of the environment, 7th edn. Springer, Berlin 7. Varian HR (2006) Intermediate microeconomics, 7th edn. Norton, New York

29 The EU supported countries in CEE with ﬁnancial means through the program TACIS, for example, which also included environmental goals (cf. http://www.eea.europa.eu/TACIS, the TACIS Project page).

Chapter 7

Public Goods in Environmental Economics

Abstract Environmental commodities are often characterized by properties of public goods: individuals cannot (or should not) be excluded from consuming a particular commodity (for example, the protective services of the earth’s ozone layer); moreover, available supply is more or less independent of the number of consumers. These properties “drive” the conclusions from the “Prisoners’ Dilemma” and the “Tragedy of the Commons” and imply additional difﬁculties for the allocation of public goods. The resulting “overuse” of environmental commodities is a consequence of individually rational behavior, and can be observed even in industrialized countries, despite a presumably high environmental awareness. Thus, private provision of these public commodities can be inefﬁciently low, necessitating an appropriate modiﬁcation of the relevant economic framework and the allocation procedures. In this context, this chapter then investigates properties of the Lindahl equilibrium, analyzes cost-share equilibria and the property of core equivalence with an application to the allocation of global public or environmental commodities.

7.1 The Lindahl Mechanism This section offers a survey on the Lindahl mechanism. It includes the deﬁnition and efﬁciency properties of the Lindahl equilibrium as well as a discussion of the inherent incentive incompatibility associated with this approach. Moreover, the Lindahl equilibrium will be interpreted as an equilibrium with internalized external effects.

7.1.1 The Concept of a Lindahl Equilibrium The Lindahl equilibrium plays a prominent role in the context of economies with public goods, and is central to the theory of efﬁciently allocating a public good (cf. [8], or [9], Ch. 5). In fact, the Lindahl mechanism integrates or internalizes the H. Wiesmeth, Environmental Economics: Theory and Policy in Equilibrium, Springer Texts in Business and Economics, DOI 10.1007/978-3-642-24514-5_7, © Springer-Verlag Berlin Heidelberg 2012

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7 Public Goods in Environmental Economics

external effects, which all agents, who provide a public good or help to preserve a public (environmental) commodity, exert on all other individuals. Unfortunately, the issue of incentive compatibility or rather incompatibility favors “free-riding” or “cheap-riding” and limits the practical applicability of the Lindahl mechanism considerably. The reason is that a Lindahl equilibrium requires “personal” prices, which depend on mostly “hidden” characteristics of the individual consumers or producers. Such “individual” prices played already some role in Section 6.3. Indeed, “ﬁrm-speciﬁc” prices were then necessary to allocate the environmental commodity “clear water” efﬁciently among the competing input requirements for the ﬁsheries and the paper companies. A Lindahl equilibrium internalizes this multitude of external effects, and is therefore part of the theory of internalizing external effects (cf. Chapter 6 and Note 7.2). The following assumptions describe the framework for the investigation of a Lindahl equilibrium: there is an economy with 2 commodities, a private commodity x, and a public commodity y; 1 unit of y can be produced with constant returns to scale from 1 unit of x. The two consumers i = 1, 2 are characterized by their utility function ui (x, y) and by their initial endowment ωi of the private commodity. An allocation of this economy is then given by z = (x1 , x2 , y), where xi , i = 1, 2, denotes individual consumption of the private commodity, and y the (joint) consumption level regarding the public commodity. The allocation z = (x1 , x2 , y) is feasible, if x 1 + x2 + y = ω 1 + ω 2 . Deﬁnition 7.1 (Lindahl Equilibrium). The feasible allocation zL = (x1L , x2L , yL ) of this economy is a Lindahl equilibrium, if a price system pL = (px , p1y , p2y ) exists with price px for the private commodity and personal prices piy , i = 1, 2, for the public commodity such that: • (xiL , yL ) maximizes utility in the budget set {(xi , y) ∈ IR2+ : px xi + piy y ≤ px ωi } of consumer i, i = 1, 2, • ﬁrms maximize proﬁts (under constant returns to scale), thus: px = p1y + p2y (cf. also Note 5.3 for the “zero proﬁt condition”). A Lindahl equilibrium exists under the usual assumptions of continuity, monotonicity, and convexity regarding the preferences of the consumers (cf., for example, [8]). The ﬁrst-order conditions for the Pareto efﬁciency of a feasible allocation z = (x1 , x2 , y) of this economy with a public good result from the following constrained maximization problem: max u1 (x1 , y), such that u2 (x2 , y) ≥ u02 and x1 + x2 + y = ω1 + ω2 .

x1 ,x2 ,y

The “Lagrange method” leads to the well-known Samuelson Condition: the sum of the marginal rates of substitution is equal to the marginal rate of transformation (cf., for example, [10], Ch. 36), which is equal to 1 in the context considered here: ∂ u2 (x2 , y)/∂ y ∂ u1 (x1 , y)/∂ y + = 1. ∂ u1 (x1 , y)/∂ x1 ∂ u2 (x2 , y)/∂ x2

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105

The Samuelson Condition will be reconsidered and adapted to accommodate global environmental commodities with differing production possibilities in Chapter 12.

Note 7.1. The Lagrange function for the above constrained maximization problem with Lagrange multipliers λ and μ is given by: L(x1 , x2 , y, λ , μ) = u1 (x1 , y) − λ [u2 (x2 , y) − u02 ] − μ[x1 + x2 + y − ω1 − ω2 ]. The ﬁrst-order conditions with respect to the variables x1 , x2 and y for an interior solution follow then from the partial derivatives of the Lagrange function: ∂ L(x1 , x2 , y) ∂ u1 (x1 , y) = − μ = 0, ∂ x1 ∂ x1 ∂ L(x1 , x2 , y) ∂ u2 (x2 , y) = −λ − μ = 0, ∂ x2 ∂ x2 ∂ u2 (x2 , y) ∂ L(x1 , x2 , y) ∂ u1 (x1 , y) = −λ − μ = 0. ∂y ∂y ∂y Solving for λ and μ in the ﬁrst two equations and inserting the results into the third equation leads to the desired result, the Samuelson Condition. Observe that in the case of an interior solution, λ and μ are not equal to 0 (cf. also the condition of “complementary slackness” in [2], p. 726). If zL = (x1L , x2L , yL ) is a Lindahl equilibrium with price system p = (px , p1y , p2y ), then utility maximization of the consumers with respect to their budget sets with personal prices yields: p1y p2y ∂ u2 (x2L , yL )/∂ y ∂ u1 (x1L , yL )/∂ y = and = . px px ∂ u1 (x1L , yL )/∂ x1 ∂ u2 (x2L , yL )/∂ x2 Because of p1y + p2y = px , zL satisﬁes the Samuelson Condition. With the assumed monotonicity and convexity properties of the consumers’ preferences, the secondorder conditions are satisﬁed too, and the equilibrium allocation zL is Paretoefﬁcient. The provision of the public commodity through the two consumers – they contribute both to the production of the public commodity – leads to a (positive) external effect of each consumer on the other. It should thus be possible to internalize the externalities through Pigou Taxes or, alternatively, through Pigou Subsidies. The following note contains the details with Pigou Taxes ty1 and ty2 levied on the consumption of the amounts y2 and y1 of the public commodity provided by consumer 2 and 1 respectively. With this formulation consumer i is taxed for the amount y j of the public commodity provided by consumer j with i, j = 1, 2, i = j. It is, moreover, assumed that the “tax revenues” ty1 y2 and ty2 y1 from consumer 1 and consumer 2 are given to consumer 2 and consumer 1 respectively as lump

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sum transfers. Of course, it is possible to apply different compensation schemes. If, for example, total tax revenue ty1 y2 + ty2 y1 is distributed equally, then the budget constraints would have to be adjusted accordingly.

Note 7.2. With Pigou Taxes ty1 and ty2 consider the budget constraints of the two consumers with the compensation scheme as described above: (py − tyj ) · yi + tyi · y j + px · xi = px · ωi , i = j. In equilibrium, py has to be equal to px (:= 1), an immediate consequence of proﬁt maximization. Utility maximization then yields the following result for the marginal rates of substitution (MRS) of the two consumers: MRS1 = 1 − ty2 and MRS2 = 1 − ty1 . The goal with internalizing external effects is to restore efﬁciency. In view of the Samuelson Condition this requires: ty1 + ty2 = 1. Rewriting the budget constraints with this condition leads to tyi · (y1 + y2 ) + xi = ωi , i = 1, 2. The maximization problem max ui (xi , y1 + y2 ) such that tyi (y1 + y2 ) + xi = ωi , i = 1, 2, xi ,yi

is formally equivalent to the modiﬁed problem: max ui (xi , y) such that tyi y + xi = ωi , i = 1, 2, xi ,y

with y = y1 + y2 . This follows immediately from the ﬁrst-order conditions for the Lagrange functions. The concept of a Lindahl equilibrium corresponds then to the solution of these constrained maximization problems, including feasibility. It internalizes the external effects with personalized prices tyi , i = 1, 2, which are equal to the Pigou Taxes and related to the marginal beneﬁts.

7.1.2 Lindahl Equilibrium and Incentive Compatibility Under the framework conditions of the Lindahl equilibrium the “market mechanism”, leads to an efﬁcient allocation in an economy with a public good.1 There 1

For generalizations regarding these existence and efﬁciency results for a Lindahl equilibrium cf. again [8].

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is, however, the issue of incentive compatibility, or rather incentive incompatibility, which creates serious difﬁculties for practical applications of the Lindahl concept. In short, consumers are tempted to beneﬁt from the provision of a public environmental commodity without paying for it, or for understating their preferences for the environmental commodity and therefore contributing too little. The (government) institution taking care of the provision of the public good according to the consumers’ preferences needs detailed information on these preferences, which it will hardly get. “Free-riding” or “cheap-riding” is therefore, not surprisingly, a common feature in the provision of public (environmental) commodities.2 The personal prices, which are part of a Lindahl equilibrium depend on structural properties of the production and utility functions. As they are not known in general, there are many possibilities to misrepresent one’s preferences, for example. The resulting opportunities to at least “cheap-riding” are demonstrated by means of the following example. Example 7.1. In the above economy one unit of the public good can be produced with one unit of the private good. Assume that the utility function of consumer 1 is given by u1 (x, y) = x · y, and that of consumer 2 by u2 (x, y) = x · yα , with x denoting the units of the private, and y the units of the public commodity. The parameter α ∈ [0, 1] characterizes the utility of consumer 2. It determines, to be more precise, the marginal rate of substitution between the private and the public commodity, a higher value of α indicating a higher marginal rate of substitution cet. par. Each consumer is endowed with one unit of the private commodity. One then obtains the Lindahl equilibrium with the (efﬁcient) equilibrium allocation zL : 1 1 1 α L L L L z = (x1 , x2 , y ) = , , + 2 1+α 2 1+α and the Lindahl prices y y pL = (px , p1 , p2 ) = 1,

α/(1 + α) 0.5 , . 0.5 + (α/(1 + α)) 0.5 + (α/(1 + α))

Assume that α = 0.5 represents the “true” value of the parameter. Then consumer 2 attains utility level uL2 = (2/3) · 5/6 ≈ 0.608, if consumer 2 “announces” α = 0.5 to the government institution taking care of the public good. However, if consumer 2 misrepresents the preferences and announces a lower √ level of α, α = 0, for example, then consumer 2 will derive the higher utility u02 = 0.5 ≈ 0.707. In this sense it “pays off” for the consumer to understate the preferences for the public commodity. Thus, if the situation of a Prisoners’ Dilemma is given (cf. Subsection 5.3.1), then each consumer may behave like this, and “underprovision” of the public commodity can result. 2

Observe that this observation applies also to the up to now more or less failed “attempts” to substantially curb global greenhouse gas emissions. The fact that there is not yet a “world government” with sufﬁcient power to impose and enforce reduction targets on relevant countries aggravates the “Lindahl problem” considerably. Cf. also Chapter 12 for this issue.

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Note 7.3. In order to arrive at the Lindahl equilibrium in the above example, consider the ﬁrst-order conditions for utility maximization on the budget set with px := 1: ∂ u1 (x1L , yL )/∂ y x1L ∂ u2 (x2L , yL )/∂ y αx2L y = = p and = = py2 . 1 yL yL ∂ u1 (x1L , yL )/∂ x1 ∂ u2 (x2L , yL )/∂ x2 Inserting these expressions for the Lindahl prices into the budget constraints x1l + py1 yL = 1, resp. x2L + py2 y = 1, yields 2x1L = 1, resp. x2 (1 + α) = 1. From this one obtains the equilibrium values of x1L and x2L . The equilibrium values for yL and for the Lindahl prices follow then immediately from the above equations and the feasibility constraint x1 + x2 + y = 2.

The problem of incentive incompatiblity associated with the Lindahl equilibrium has always stimulated efforts to look for alternative solution concepts in the context of public goods. A particular method, the cost-share equilibrium, has thereby played a dominating role, especially in some practical applications. These equilibria are characterized by the property of core equivalence, which is important in this context and which will be investigated in the following section.

7.2 Core Equivalence in a Public Goods Economy With the core and the cost-share equilibrium this section considers alternative allocation mechanisms for public good economies. Due to characterizing stability properties, these concepts are more appropriate than the Lindahl equilibrium with its incentive compatibility problem. The core property and the issue of core equivalence will be explored in this context after introducing the basic deﬁnitions.

7.2.1 The Core of an Economy with a Public Good In need of a convincing stability property for allocations in an economy with a public good, consider the following procedure: a government institution “proposes” a certain feasible allocation. This allocation could be considered “stable”, if no group of individual agents can come up with a “counterproposal”, which improves utility of the members of this group and which is, in terms of the available initial endowments, solely based on the means of this group. This so-called core property characterizes market equilibria in private goods economies, but also Lindahl equilibria in public goods economies. However, the core of an economy with public goods

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is typically larger than the set of (Lindahl) equilibria. Of course, it would be ideal, if the core property “describes” or “characterizes” a certain equilibrium concept in the sense that only these equilibrium allocations possess this property. Consider the following economy for an investigation of these issues: There is again the private good x and the public good y in the model economy. Constant returns to scale allow the production of a certain quantity of the public good with the same quantity of the private good. The two consumers i = 1, 2 are characterized by the utility functions ui (x, y), which are strictly monotone and continuously differentiable on IR2++ with strictly convex indifference curves completely contained in IR2++ . The initial endowment ωi with respect to the private commodity is used for consumption purposes or for production of the public commodity. ti with 0 ≤ ti ≤ ωi denotes the contribution of consumer i = 1, 2 to the production of the public commodity. Instead of deﬁning an allocation (x1 , x2 , y) in the usual way (cf. Subsection 7.1.1), one can also use (t1 ,t2 ,t) with individual contributions ti := ωi −xi for producing the quantity t := y of the public good. The allocation (t1 ,t2 ,t) is then feasible, if 0 ≤ ti ≤ ωi , i = 1, 2, and if the individual contributions (t1 ,t2 ) are sufﬁcient to produce the quantity t of the public commodity, thus t ≤ t1 +t2 . The utility level of the consumers derived from allocation (t1 ,t2 ,t) is given by ui (ωi − ti ,t) for i = 1, 2. A coalition S of this simple economy consists of either one of the consumers i, i = 1, 2, alone or the two consumers together. Deﬁnition 7.2 (Core). A feasible allocation (t1 ,t2 ,t) is in the core of the economy, if there is no coalition S with contributions (τi )i∈S such that 0 ≤ τi ≤ ωi and ui (ωi − τi , ∑ τ j ) > ui (ωi − ti ,t) for all i ∈ S. j∈S

Similarly, a feasible allocation (x1 , x2 , y) of this economy is in the core, if there is no coalition S with quantities (x¯i )i∈S of the private commodity such that 0 ≤ x¯i ≤ ωi and ui (x¯i , ∑ (ω j − x¯ j ) > ui (xi , y) for all i ∈ S. j∈S

Thus, if the allocation (t1 ,t2 ,t) (or (x1 , x2 , y)) belongs to the core, no coalition S can improve utility for its members by using only the endowments of the members of the coalition. In a Lindahl equilibrium zL = (x1L , x2L , yL ) the consumers maximize their utility on the budget set with personal prices for the public commodity. Thus none of the consumers will be better off acting alone – without the amount of the public good provided by the other agent. Moreover, as zL is Pareto-efﬁcient, also the two consumers together cannot improve their utility simultaneously. As a consequence, the Lindahl allocation belongs to the core, the Lindahl mechanism is characterized by the core property.3 3

Of course, this core property holds also in more general contexts and in economies with more than just two consumers (cf. again [8]).

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However, Lindahl equilibria do not constitute the only core allocations in this economy. Typically, there are many feasible allocations, which belong to the core, but cannot be represented as a Lindahl equilibrium (cf. [8] for a general discussion). Moreover, similarly to the case of equilibrium allocations, core allocations are dependent on the distribution of the initial endowments. The following example demonstrates these facts. Example 7.2. This example takes up again the assumptions of Example 7.1 with utility functions u1 (x, y) = x·y and u2 (x, y) = x·yα with α = 0.5. From the ﬁrst-order conditions for efﬁcient allocations (cf. Note 7.1) one obtains: x1 + 0.5x2 − y = 0. Combining this with the feasibility constraint x1 + x2 + y = 2 yields: x1 = 3y − 2 and x2 = 4 − 4y. With xi ≥ 0 the set of the Pareto-efﬁcient allocations of the economy is given by: {z = (x1 , x2 , y) = (3y − 2, 4 − 4y, y) : 2/3 ≤ y ≤ 1}. In order to obtain the set of core allocations, one has to exclude those allocations, which can be improved upon by each √ consumer alone. For the ﬁrst consumer all allocations with 2/3 ≤ y ≤ 1/3 + 7/6 ≈ 0.77 have thus to be removed from the above set of efﬁcient allocations. Analogously, for the second consumer this con√ cerns all allocations with (4 − 4y) y ≤ (2/3) 1/3. These are, approximately, all allocations with y ≥ 0.9 (cf. also Note 7.4 below). Thus, one obtains, again approximately, the core of the economy as the set of allocations z with {z = (x1 , x2 , y) = (3y − 2, 4 − 4y, y) : 0.77 ≤ y ≤ 0.9}. The Lindahl equilibrium, which is unique in this case, is determined by yL = 5/6 and belongs to the core, as already mentioned above. Note 7.4. In order to describe all allocations which can be improved by consumer 1 alone, determine the maximum utility level attainable for consumer 1 under this condition. Maximizing u1 (x1 , y) = x1 · y such that x1 + y = 1 yields utility level 1/4 with x1 = y = 1/2. Therefore, all feasible allocations with u1 (x1 , y) = x1 · y < 1/4 have to be excluded. This implies that allocations with x1 · y = (3y − 2) · y < 1/4 are not 2 elements of the core. Solving √ the quadratic equation 3y − 2y = 1/4 shows that y has to exceed 1/3 + 7/6 ≈ 0.77. A similar procedure applies for consumer 2. Maximum utility, which can be attained by this consumer alone, is calculated to (2/3) 1/3 with x2 = 2/3 and y = 1/3. Thus, for the core one has to exclude all efﬁcient allocations with (4 − 4y) · y < (2/3) 1/3. This refers to all efﬁcient allocations with y ≥ 0.9 (approximately). Example 7.2 shows clearly that Lindahl equilibria are characterized, but not determined by the core property. There are other allocations, which are “stable” in the sense that they belong to the core, but cannot be represented as Lindahl equilibria.

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111

Therefore, the “observation” of a stable allocation alone is not sufﬁcient to refer to a Lindahl equilibrium. This conclusion remains true for “large” economies (“large” with respect to the number of consumers) with a public good, in contrast to the situation for private goods economies, for which the core “converges” to the set of market equilibria for large economies (cf. [8] and [3], Ch. 5). The reason for this difference lies in the intrinsic nature of the public goods: in a public goods economy it is more difﬁcult for a coalition S to improve a proposed allocation, because this coalition cannot and should not take into account potential contributions (and, thus, externalities) regarding the public good from the agents outside S. In the following subsections the issue of core equivalence will be analyzed in the context of the public goods economy considered here. First, the concept of a costshare equilibrium will be introduced as an alternative allocation mechanism for an economy with public or environmental goods.

7.2.2 The Cost-Share Equilibrium The idea of “sharing the burden” for a common goal can be found, for example, in fees for public services, in particular public utilities, with fees often proportional to the amount of services consumed. However, for a variety of public services the most important principle seems to be “covering the costs” for providing these services. Thus, one often ﬁnds ﬁxed fees for a household, independent of demand or consumption.4 Once costs threaten to exceed the fees, fees will be raised and/or costs will be cut to reestablish “equilibrium”.5 Clearly, one should not expect an efﬁcient outcome from such simple allocation mechanisms. Often a combination between a ﬁxed fee and a variable tariff, depending on consumption, is applied to pay for public utilities such as provision of drinking water or treatment of waste water. It should be noted that the ﬁxed fee can then be used to differentiate (or even “discriminate”) among consumers depending on the size of the households for example. On the international level a more or less proportional burden sharing applies to ﬁnancing the United Nations, NATO, or the European Union. The GDP, the gross domestic product, is often used as a proxy for the “consumed” quantities of the services or public goods, which are produced and provided by these organizations (cf. [12]). The concept of a cost-share equilibrium, which presents a mechanism to share the (ﬁnancial) burden of supplying a public good, is more general than the concept of a Lindahl equilibrium and more attractive for practical purposes. The following theoretical analysis, which helps to deﬁne criteria to solve the cost sharing problem 4

Waste collection usually presents a good example for this policy, although the “pay-as-you-throwprinciple” or related principles gradually ﬁnd application in an increasing number of communities world-wide (cf. [1]). 5 This procedure is characteristic for public policy in various economically relevant sectors. For example, in several countries the health care sector is “regulated” by controlling expenses in the ﬁrst place.

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“. . . in a just, equitable, fair, and reasonable manner” ([13]), draws from Weber/ Wiesmeth (cf. [11]). In general, the equilibrium approach presented here is based on work by Kaneko (cf. [4]), Mas-Colell (cf. [5]), and Mas-Colell/Silvestre (cf. [6]) with the concept of the balanced linear cost-share equilibrium, introduced by Mas-Collel/Silvestre in 1989, playing a particular role (cf. [6]). This concept helps to bridge the gap between more axiomatic approaches to cost sharing, which were advanced, for example, by Moulin (cf. [7]), and the equilibrium concepts. The following analysis refers again to the context of an economy with a private and a public good, constant returns to scale, and two consumers with initial endowment ω1 and ω2 respectively of the private commodity (cf. Example 7.1 or Example 7.2): Deﬁnition 7.3 (Cost Sharing Method). A cost sharing method for the provision of the public good t is given by a system φ = (φ1 , φ2 ) of piecewise continuously differentiable mappings φi : [0, ω] → [0, ωi ] with φ1 (t) + φ2 (t) = t for 0 ≤ t ≤ ω, and ω := ω1 + ω2 . For a given value of t, the (feasible) allocation (φ1 (t), φ2 (t),t) is called φ -allocation. A cost sharing method therefore deﬁnes feasible individual contributions φi (t) of consumer i, i = 1, 2, which are also sufﬁcient to produce the corresponding feasible level t of the public good. The following remark demonstrates that the concept of a Lindahl equilibrium is closely related to the concept of a cost sharing method, that a Lindahl equilibrium can also be represented as a cost-share equilibrium to be introduced below: Remark 7.1. A special cost sharing method is the proportional method φip (t) := λi ·t, with λi positive and λ1 + λ2 = 1, for values of t such that φip (t) ≤ ωi , i = 1, 2. If zL = (x1L , x2L , yL ) represents a Lindahl equilibrium with prices pL = (px , p1y , p2y ), then (φ1p , φ2p ) with φip (t) := (piy /px )·t is the proportional cost sharing method associated with zL . Obviously, φ1p (t) + φ2p (t) = t (or φ1p (y) + φ2p (y) = y) and, in particular, φ1p (yL ) + φ2p (yL ) = yL . The next step is now to introduce the concept of a cost-share equilibrium. For this deﬁnition observe that a cost sharing method φ deﬁnes a budget set for each consumer. The budget set in the context of a Lindahl equilibrium: {(xi , y) ∈ IR2+ : xi + (pyi /px )y ≤ ωi }, is thereby replaced by {(xi , y) ∈ IR2+ : xi + φi (y) ≤ ωi }. An equilibrium results, if the identical quantity of the public good maximizes utility in the budget set of each consumer. This is the content of the following deﬁnition: Deﬁnition 7.4 (Cost-Share Equilibrium). Consider the modiﬁed utility functions wi (t) := ui (ωi − φi (t),t) for i = 1, 2, t ∈ [0, ω] and the cost sharing method φ . The φ -allocation (φ1 (t ), φ2 (t ),t ) is a φ -cost-share equilibrium, if t maximizes both w1 (t) and w2 (t) on the interval [0, ω]. The relationship between Lindahl equilibria on the one hand, and cost-share equilibria on the other will now brieﬂy be explored. The results show that each Lindahl

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113

equilibrium can be represented as a cost-share equilibrium to a proportional cost sharing method and vice versa.

Note 7.5. Assume ﬁrst that zL = (x1L , x2L , yL ) represents a Lindahl equilibrium with price system pL = (px , p1y , p2y ) and the associated proportional cost sharing method φ p = (φ1p , φ2p ) with φip (t) = (piy /px ) · t. Then the φ p -allocation (φ1p (yL ), φ2p (yL ), yL ) represents also a φ p -cost-share equilibrium, as the consumption bundles (xiL , yL ) maximize utility on the budget sets of the consumers. Therefore, they also maximize the functions wi (t) at t = yL . Next, if the φ p -cost-share equilibrium (φ1p (t ), φ2p (t ),t ) is given with a proportional cost sharing method φ p such that φip (t) = λi · t, then the allocation (x1L , x2L , yL ) with xiL := ωi − ti and yL := t is also a Lindahl equilibrium at prices (px , p1y , p2y ) := (1, λ1 , λ2 ). Of course, not every φ -cost-share equilibrium can be represented as a Lindahl equilibrium, the set of Lindahl equilibria is normally a proper subset of the set of φ -costshare equilibria. Theorem 7.1 (Efﬁciency of Cost-Share Equilibria). A φ -cost-share equilibrium (φ1 (t ), φ2 (t ),t ) represents an efﬁcient allocation of the public goods economy. Proof. Consider a φ -cost-share equilibrium (φ1 (t ), φ2 (t ),t ) and observe that the φ marginal rate of substitution MRSi (t) of consumer i, i = 1, 2, with respect to the cost sharing method φ is given by: φ

MRSi (t) :=

∂ ui (ωi − φi (t),t)/∂ y for i = 1, 2. ∂ ui (ωi − φi (t),t)/∂ xi

The Samuelson Condition, which is necessary and sufﬁcient in the context considφ φ ered here (cf. Subsection 7.1.1), stipulates MRS1 (t ) + MRS2 (t ) = 1 for efﬁciency of the allocation (φ1 (t ), φ2 (t ),t ). This has to be shown. Differentiating the modiﬁed utility functions wi (t) = ui (ωi − φi (t),t) at t = t yields for i = 1, 2: dwi (t ) ∂ ui (ωi − φi (t ),t ) ∂ ui (ωi − φi (t ),t ) = − · φi (t ). dt ∂y ∂ xi φ

With the ﬁrst-order condition one obtains MRSi (t ) = φi (t ), and from this one arrives at the Samuelson Condition with φ1 (t ) + φ2 (t ) = 1. This concludes the proof as the second-order conditions are fulﬁlled, given the assumptions on the utility functions. Therefore, φ -cost-share equilibria are Pareto-efﬁcient. Moreover, these equilibria belong to the core of the economy: in a φ -cost-share equilibrium (φ1 (t ), φ2 (t ),t )

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the consumers maximize their utility on the budget set given by the cost sharing method φ . Thus, none of the consumers can be better off by acting alone. In addition, as the equilibrium allocation is Pareto-efﬁcient, the two consumers together cannot improve their utility simultaneously, and the equilibrium allocation is in the core. This result holds also for an economy with more than two agents (cf. [11] for the details). It remains mentioning that these equilibria are characterized by further efﬁciency and fairness properties. Cf. [7]) and [11] for more details on the axiomatic approach to cost sharing. To some extent and with some justiﬁcation the concept of a Lindahl equilibrium was rejected as a practical allocation mechanism for public goods, due to problems with incentive compatibility. However, Lindahl eqilibria are also cost-share equilibria. What are then the special properties of cost-share equilibria, which render them more appropriate for practical cost sharing issues, in particular also for environmental commodities with characteristics of public goods? The following section introduces the concept of core equivalence, which is of relevance for cost-share equilibria.

7.2.3 Core Equivalence and Cost-Share Equilibria Core equivalence is ﬁrst of all an important property of the set of equilibria of a “large” economy with private commodities (cf. [3], Chapter 1).6 This property justiﬁes the application of the “anonymous” market mechanism to solve the “socially” relevant allocation problems. If core equivalence holds, then equilibrium allocations can also be attained through the core mechanism, an alternative allocation mechanism, which is based on “social” exchange activities. What does core equivalence mean in the context of a public goods economy? The relevant equilibrium concepts, such as the Lindahl equilibrium or the cost-share equilibrium are all substantially based on private information, which is in general not available to and not completely revealed to a public planner. Therefore, all these equilibrium concepts are characterized by incentive compatibiliy problems, and additional properties, such as core equivalence, are needed to justify the practical applicability of a particular equilibrium notion. As core equivalence will be shown to hold for the set of cost-share equilibria, a “stable”, or “observable” allocation7 can also be represented as a cost-share equilibrium. This fact ranks cost-share equilibria ahead of Lindahl equilibria and has some consequences for practical applicability (cf. also Section 7.3 for a discussion of the Kyoto Protocol in this context). 6

To be more precise, core equivalence holds for private goods economies with a continuum of economic agents. This is a formal requirement corresponding to the ideal case of “perfect competition”. 7 It is assumed here that only stable allocations, i.e., core allocations, are observable, are persistent over some period of time.

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115

The ﬁnal step is now to prove core equivalence for cost-share equilibria. As these equilibria belong to the core (cf. Subsection 7.2.2), it remains to be shown that an arbitrary core allocation (t1 ,t2 ,t ) can be represented as a φ -cost-share equilibrium for an appropriate φ -cost sharing method. The construction is carried out for the model economy with two consumers introduced in Subsection 7.2.1. However, the result holds, with some additional assumptions, in a more general framework with an arbitrary number of consumers (cf. [11] for more details).

1.2 6

x1

... ... ... .. ω1 ..................................................................................................................................................................................................................................................................................................................................................... ... ....... .... ...... ... .... ..... .. ... ... .. .. . .... ... . ... . .. . . .... . ... d1 ................. ............... ... ...... . . ... . . ...... . . . . . . . .... ...... . .. .. . .. ...... . . ... . ...... . . ... . φ1 (t ) = t1 = ω1 − x1 ...... . . . .... .. . ...... . . ... .. ... .. . .. .. .. . ... . . . . . . . . . . . .. .. 0.6 .. ... ..... .... .. .. .... ..... .. .... .. ... .. .. ....... .. .. .. .... ... ... .. .. .... . .. ... ... ... .. .. .. .. . . ... .. . .. . .. .... . .. . ... ... .. ... .. . . . . . . . . . . ... .. .. .. .. .. . .. .. .. . . . . . ..u .. . .. . .. x1 . .. ... .. .. . .. ........................... .. ........ ....................... ... ... ... .. .............. .. .. ... .. .. .. ... .... .. .. ... .................. .. .. ... .. .. .. ... .. .. ... ........................ .. .. .... .. ... .. .. ... .. .. .. ................................... ... 0.2 .. ... .. .. .. ... .... .. ............................. .. .. ... .. .. . ... .. ... . . . . . . . .... φ1 (y) ............................. . .. .. .. ... .. .. ... .. .. .. .. ... .. ... ....................................................

... ..

0

0

tˆ

t = 0.8

1.2

t¯1 = 1.6

2.0

-

2.4

y ...... d2 ..6 ...... ...

ω2 x2 x2

0.6 0.4 0.2

... ... ... .... .... .... ...... ..... ....... ........ φ (t ) = t = ω − x ...u ......... .......... ........... ............ .............. ................ .................... ........................ ............................. ..

...... ...... ...... ...... ...... ...... ...... ... .. ... .. ... .. .. .. .. .. .. .. ... .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. ... .. .. .. .. .. .. .. .. .. .. .. .. .. .. ... ... ... .. ... ........................................................................................................................................................................................................................................................................... .. .. .... ... ..... .. .. ... ... .. .. ... .. .. .... ... ... .. .. .. ... .. .. ... .. .. .... ... .. .. .. .. ... .... . . . ... . ..... .. ... 2 2 .. .. 2 2 ... . . ... . ... ... .. .... .. ... .. .. ... .. .. ..... .. .. . . . . . . . .... ... .. .. .. .. .. ... .. .. ... .. .. ... .. .. ... .... .. .. .. ... .. .. . ... .. .. ... .. ... .. .. .... ... .. .. .. .. ... . .. ... .. .. .. ... .. .. .... ... .. .. ... .. .. .. .. ... .. .. ... .. .. ... ... .. ... .. .. .. ... .. .. ... .. .. .. ... .. .... .. ... .. .. ... . .. ... .. .. .. ... .. .. ... ... .. .. .. .. ... .. .. ... .. .. ...... ... ............. .. .... ......... .... .... ........ .. ..... ......... .... .... ........... .. .... .... .... ................. .. .... ...... ...... .... .... ...... . .... ...... ...... ..... .... ...... . 2 ...... .... ...... .... .... ...... . ..... ...

φ (y)

0

0

tˆ = 0.4

t

1.2

t¯1

2.0

t¯2 = 2.4

y Fig. 7.1 Core equivalence for cost-share equilibria (cf. Example 7.3 for the necessary details of the construction.)

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Theorem 7.2 (Core Equivalence). Under the assumptions on the model economy introduced in Subsection 7.2.1, the set of cost-share equilibria is equal to core. Proof. It has already been shown that a cost-share equilibrium for a given cost sharing method φ belongs to the core. Therefore, assume that (t1 ,t2 ,t ) is a core allocation. Then individual rationality8 implies ui (xi ,t ) = ui (ωi − ti ,t ) ≥ ui (ωi − τi , τi ) for τi ∈ [0, ωi ] and i = 1, 2 (cf. Figure 7.1: the utility maximizing consumption bundle is located above the dotted “individual” budget line). Moreover, the marginal rates of substitution of the consumers are given by MRSi := MRSi (ωi − ti ,t ) for i = 1, 2. Efﬁciency of the core allocation (t1 ,t2 ,t ) implies the Samuelson Condition: MRS1 and MRS2 add up to 1. Consider the straight lines t → ti + (t − t ) · MRSi for i = 1, 2. t¯i := (ωi − ti )/MRSi +t for i = 1, 2 are then the values of t where these lines intersect the horizontal axis, i.e., assume the values ωi . Similarly, tˆi := −ti /MRSi + t for i = 1, 2 denotes the values of t, where these lines intersect the horizontal lines xi = ωi , i.e., assume the value 0, i = 1, 2 (cf. Figure 7.1). Assume that t¯1 ≤ t¯2 and and deﬁne tˆ := max(tˆ1 , tˆ2 ) (cf. Figure 7.1). Observe that with ωi − di := ti −t · MRSi for i = 1, 2 one obtains (ω1 − d1 ) + (ω2 − d2 ) = 0 (cf. again Figure 7.1). With ω := ω1 +ω2 the cost sharing method φ is then constructed in the following way (cf. again Figure 7.1): ⎧ t for t ∈ [0, tˆ] ⎨ φ1 (t) = t1 + (t − t ) · MRS1 for t ∈ [tˆ, t¯1 ] ⎩ for t ∈ [t¯1 , ω] ω1 φ2 is deﬁned analogously: φ2 (t) =

⎧ ⎨

0

t + (t − t ) · MRS2 ⎩2 t − ω1

for t ∈ [0, tˆ] for t ∈ [tˆ, t¯1 ] for t ∈ [t¯1 , ω]

The construction implies φ1 (t) + φ2 (t) = t for t ∈ [0, ω]. Observe that in particular individual rationality of the core allocation (t1 ,t2 ,t ) enables this construction. As a result, one obtains a piecewise linear cost sharing method φ , which allows a representation of the core allocation (t1 ,t2 ,t ) as a φ -cost-share equilibrium. The following example provides the details for Figure 7.1: Example 7.3. Consider the assumptions of Example 7.2 with the core allocation zc corresponding to yc = 0.8 as the level of the public commodity: zc = (x1c , x2c , yc ) = (0.4, 0.8, 0.8) (cf. Figure 7.1). This allocation is not the equilibrium allocation associated with the Lindahl equilibrium, which is in this case uniquely determined with yL = 5/6. Applying the construction method developed above one obtains (cf. again Figure 7.1): 8

Individual rationality in this context means that none of the agents can improve a core allocation alone.

7.3 Implications for the Kyoto Protocol

φ1 (t) =

117

⎧ ⎨

t for t ∈ [0, 0.4] 0.2 + 0.5t for t ∈ [0.4, 1.6] ⎩ 1 for t ∈ [1.6, 2]

and similarly for φ2 : φ2 (t) =

⎧ ⎨

0 for t ∈ [0, 0.4] −0.2 + 0.5t for t ∈ [0.4, 1.6] . ⎩ t −1 for t ∈ [1.6, 2]

A mechanism to support a planning agency to attain a φ -cost-share equilibrium is constructed in Weber/Wiesmeth (cf. [11]). It has to be assumed that the planning agency is perfectly informed about the individual endowments of the consumers; information on preferences is, however, not required. Then a non-cooperative game can be deﬁned with a cost-share equilibrium emerging as a Strong Nash equilibrium of this game (for details cf. [11]).

7.3 Implications for the Kyoto Protocol The Kyoto Protocol can, with some straightforward modiﬁcations to the relevant deﬁnitions, be interpreted as a cost sharing agreement. The delegates present at the conference in Kyoto in 1997 (cf. Subsection 3.2.3) agreed to collectively reduce the amount of greenhouse gases emitted by developed countries by 5.2% of 1990 levels with the target period 2008-2012. Each of the participating countries i, i = 1, . . . , n, declared its willingness to reduce its emissions by an individual share. Observe that these reductions have the characteristics of a public commodity: each ton of CO2 emissions avoided beneﬁts all countries, including, of course, the parties to the Kyoto Protocol. Let the quantity of t tons of CO2 correspond to the goal of a global reduction of 5.2% of the greenhouse gases emitted in 1990, and denote the costs associated with these reductions incurred by country i by φi (t ), i = 1, . . . , n. Of course, as different countries have, in general, different marginal rates of transforming private commodities into the public commodity “emission reduction”, which are, moreover, different from 1, these individual “contributions” (measured, for example, in units of an aggregate private commodity) need not add up to t units, as assumed in Deﬁnition 7.3 for simplicity. This fact will be taken into account formally below and in Chapter 12. The details of an international agreement such as the Kyoto Protocol are negotiated before its enactment. One could therefore expect that such an agreement is characterized by certain stability properties. Obviously, the core property provides an appropriate approach to stability in this context: the participating countries can be assumed to agree to their “burden” to produce the public commodity, if no other coalition, including staying alone, promises a better result.

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7 Public Goods in Environmental Economics

The following newspaper report on the Copenhagen climate talks in December 2009 illustrates, among other things, the relevance of each country’s position before a “deal” will be closed. Similarly, incentives to “block” a deal (because an improvement seems to be feasible) play a crucial role. This issue will be reconsidered in Chapter 12. Sunita Narain:9 “India virtually isolated at Copenhagen” The Times of India, Ahmedabad, December 14, 2009 It is a week into the Copenhagen climate conference. The clock is ticking to Friday, when heads of state will descend, all to sign a global “accord” or at least some agreement on how the world will cut emissions. Things are deadlocked, seemingly stalled. But this is only for the eyes of the uninitiated. The fact is that the spin-masters are at work, feverishly building momentum for the blamegame to culminate – ﬁnger-pointing to countries, which are blocking the deal, destroying the one chance the world has to save the planet. India is already moving to the top of that list. This when the industrialized world has refused to put anything meaningful on the table – no reduction at home, no money or technology transfer agreements. Instead, the two draft agreements for negotiations only harden their position. They demand, ﬁrst, that developing countries (India) take on emission reduction targets, without any ﬁnancial assistance. That is not a problem. Our minister has already “offered” that India will cut its carbon intensity by 2025% by 2020. We have accepted the white man’s burden as our own. But what the minister did not perhaps know is that he has now 9

stepped on a slippery slope. The next demand is already ratcheting up. Industrialized countries have now demanded in no uncertain terms that all actions done domestically must be internationally monitored, reported and veriﬁed. The reason is simple as by doing this, domestic targets become legally binding global commitments. The language is getting nasty as well. “We cannot trust these nations,” is what US envoys said. Others repeat. The call is growing that India wants its right to pollute. In all this, the worst fears of the Indian establishment are bound to come true: we will get isolated and blamed for the failure of the global agreement. We will be hated in the rich man’s world. This situation is of our own making. The fact is that when the minister declared the domestic target in Parliament, he changed the goalpost. He accepted that India must switch sides to join the league of polluters, instead of being able to demand its right to development. He accepted that there is no distinction between the countries which have been historically responsible for creating the problem, and the rest, who need funds and technology to make the

Sunita Narain, Director General of the Centre for Science and Environment (CSE) in New Delhi, kindly granted permission to reuse this article.

7.3 Implications for the Kyoto Protocol

low-carbon leapfrog so that the world can avoid emissions. He, therefore, also implicitly rejected the notion of an agreement based on equalburden sharing. The carbon sums are clear, any which way: From 1890 to 2007, rich countries contributed some 60% of the carbon dioxide emissions into the atmosphere; India some 3%. US, with just 5% of the world’s population, alone is responsible for some 30% of the carbon dioxide in the global atmosphere. But forget the past. If you factor in the targets of the rich world (and US), which Copenhagen is poised to endorse, industrialized countries will still occupy some 50% of the global carbon budget till 2020. US, assuming for a moment that their Senate endorses the 3% reduction over its 1990 levels, will still use up a ﬁfth of the world’s carbon budget between 1890 and 2020. Worse, India with its self-imposed domestic target will get some 4% of the global carbon budget between 1890 and 2020 for its people who add up to 17% of the world’s popula-

119

tion. This agreement, therefore, will freeze inequity in the world. This when it is known that these negotiations are about the right to development. No country, as yet has delinked the growth of its economy from emissions of carbon dioxide. So. we can now cry wolf. But this is an outcome of the “pragmatic global diplomacy” that many in the government believe is the need of the day. They openly reject the idea that global agreements can and should be based on principles of equity or justice. They say this is oldfashioned and idealistic, not ﬁt for the real world. Their world is about global deals that give and take. The question we in India must ask is what did we get: other than the ofﬁcial stamp of a third-class citizen of the world? The circle has closed. Gandhi took on the British Empire when he was thrown out of the ﬁrst-class compartment. He refused to be a thirdclass citizen. In Copenhagen we may just decide that we must wear that shame forever.

For a more formal presentation describe a party i, i = 1, . . . , n, to the international climate negotiations by its utility function ui (xi , y) (or, alternatively, ui (ωi − ti ,t)) for consumption of the (aggregate) private commodity xi (or ωi − ti ), and the public commodity (global reductions of greenhouse gas emissions) y (or t). The countries are different with respect to their endowments ωi of the private commodity, their marginal rates of substitution MRSi (xi , y), i.e., their “attitude” towards the issues of climate change, and the marginal rates of transformation between the private and the public good, i.e., their costs of producing the public good. For simplicity assume that country i can produce βi units of the public good with one unit of the private good. A feasible allocation z = (x1 , . . . , xn , y), resp. (t1 , . . . ,tn ,t), of this system satisﬁes the following constraint:

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7 Public Goods in Environmental Economics

β1 (ω1 − x1 ) + . . . + βn (ωn − xn ) = y, resp. β1 t1 + . . . βntn = t. Similarly, a cost sharing method φ = (φ1 , . . . , φn ) deﬁnes the feasible φ -allocation (φ1 (t), . . . , φn (t),t) with β1 φ1 (t) + . . . + βn φn (t) = t (cf. Deﬁnition 7.3). The concept of a cost-share equilibrium in this more general case is then immediately adapted from Deﬁnition 7.4. Again, core equivalence holds under the assumptions of Theorem 7.2 (cf. also [11]). A core allocation z = (x1 , . . . , xn , y), resp. (t1 , . . . ,tn ), characterizes a stable outcome of these negotiations. Whether such an allocation will be implemented is, of course, still dependent on other issues. The Prisoners’ Dilemma (cf. Subsection 5.3.1) for example may, in the absence of a supranational governing institution, prevent such an agreement to be fully implemented. Once some countries start to fulﬁll their obligations regarding the emissions of greenhouse gases, the Prisoners’ Dilemma induces other participating countries to reduce their efforts. This explains the observable “deviations” from the presumably stable allocation, negotiated in the Kyoto Protocol (cf. Remark 7.3).10 The following examples illustrate relevant properties of the core in this context. Moreover, they will provide ﬁrst hints how to “motivate” a country to participate adequately in such negotiations. These reﬂections will be analyzed more carefully Chapter 12. Example 7.4. Consider an economic system with two participating countries i = √ 1, 2 with u1 (x1 , y) = x1 · y, resp. u2 (x2 , y) = x2 · y, and ω1 = 1, resp. ω2 = 2. The marginal rates of substitution are given by: MRS1 (x1 , y) =

∂ u1 (x1 , y)/∂ y x1 ∂ u2 (x2 , y)/∂ y x2 = = . and MRS2 (x2 , y) = ∂ u1 (x1 , y)/∂ x1 y ∂ u2 (x2 , y)/∂ x2 2y

Thus, MRS1 (x, y) = (1/2) · MRS2 (x, y) for all (x, y) ∈ IR2++ , and country 2 has the lower marginal rate of substitution at any bundle (x, y). It may be considered as the country with the “lower environmental awareness” (cf. Subsection 4.1.1 for some justiﬁcation for this categorization). Moreover, it is assumed that one unit of the private commodity can be turned into one unit of the public commodity in country 1, but into two units of the public commodity in country 2: β1 = 1 and β2 = 2. It is therefore “cheaper” to produce the public commodity in country 2, it is cheaper to reduce greenhouse gas emissions in the country with the in this case lower environmental awareness. Country 2 may thus be considered to be a “developing” country, whereas country 1 is an “industrialized” country.11 10 Observe that in a core allocation the possible contributions of the countries outside a particular coalition are not taken into account. In the case of the Prisoners’ Dilemma, however, the deviation is stimulated through the contributions of some countries. 11 Of course, this is a strong and “stylized” simpliﬁcation. To some extent it is, however, justiﬁed by the empirical facts that a lower per capita income seems to be correlated to a lower environmental awareness (cf. again Subsection 4.1.1), and that cheaper production possibilities for the

7.3 Implications for the Kyoto Protocol

121

The ﬁrst-order conditions for a Pareto-efﬁcient allocation z = (x1 , x2 , y) are then given by: MRS1 (x1 , y) + 2 · MRS2 (x2 , y) = 1 and (1 − x1 ) + 2 · (2 − x2 ) = y. The ﬁrst condition is a modiﬁed “Samuelson Condition” (cf. Subsection 7.1.1), the second condition is the feasibility constraint under the different production possibilities in the two countries. With the boundary conditions for each country (cf. Note 7.6) one then obtains the set of core allocations of this economy (the lower and upper bounds for y are approximate values only; observe Note 7.6 for more details): C = {z = (x1 , x2 , y) : x1 = 3y − 5, x2 = 5 − 2y, 1.715 ≤ y ≤ 1.95}. Negotiations between the two countries are therefore assumed to lead to an allocation (x1 , x2 , y) or (t1 ,t2 ,t) in the core. Chapter 12 will revisit this example to explore strategies to affect the outcome in one way or the other. Taking into account the core property or core equivalence of cost-share equilibria, it is also possible to arrive at a core allocation by applying a cost sharing method. The participating countries have then to agree on a certain cost sharing method φ , which integrates relevant characteristics of a country such as, for example, GDP per capita or CO2 emissions per capita. The ﬁnal decision refers to the level of the public commodity, i.e., the level of global emission reductions. The climate summits referring to a second commitment period to the Kyoto Protocol after 2012 illustrate relevant details of the efforts to share the ﬁnancial burden (cf. the report on the Copenhagen climate conference on p. 118).

Note 7.6. The boundary condition for country 1, for example, postulates that utility derived from the allocation z must be at least as high as utility attainable with umax following by this country alone. Consequently, u1 (x1 , y1 ) ≥ umax 1 1 from max(x1 ,y1 ) u1 (x1 , y1 ) such that 1 − x1 = y1 with y1 the level of y, which country 1 will provide alone. Thus, umax = 0.25 yielding y ≥ 1.715 (approxi1 mately) for an efﬁcient allocation z = (x1 , x2 , y) fulﬁlling this constraint. With x1 = 3y − 5 one obtains the corresponding minimum level for the private commodity: x1 ≥ 0.145 (again approximately). The following remark refers to the applicability of the concept of a Lindahl equilibrium in the context considered here. Remark 7.2. Due to different production possibilities for the public good in the various countries, the application of the concept of a Lindahl equilibrium creates some environmental commodity in a developing country often result from reducing production inefﬁciencies.

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7 Public Goods in Environmental Economics

difﬁculties. The personal prices for the public commodity, characteristic of a Lindahl equilibrium, are not straightforwardly compatible with utility and proﬁt maximization across the participating countries. In particular, the requirement of proﬁt maximization would postulate to shift production of the public commodity to the lower cost regions. In the case of the above example this would result in reductions of greenhouse gas emissions only in the developing country. Although the households of the industrialized country would have to “buy” the public commodity with a resulting compensation for the developing country, such a solution seems, at least for the time being, politically not feasible.12 The next remark deals once more with the Prisoners’ Dilemma affecting the realization of an already agreed (core) allocation. Remark 7.3. Assume that a core allocation results from international negotiations on greenhouse gas emissions (“Kyoto Protocol”). This core allocation is then “stable” in the sense that no coalition can improve this outcome for its members with its own means. However this does not rule out beneﬁting from the efforts of the others, as formulated in the Prisoners’ Dilemma (cf. Subsection 5.3.1). As a consequence, an inefﬁcient allocation may result, a Nash equilibrium, for example, with each country optimizing its own decisions given those of the other countries. The current state of the Kyoto Protocol is perhaps a result of such considerations. An issue which is of great importance for the current and future climate talks is the appropriate integration of rapidly developing countries such as China and India into the worldwide efforts to reduce greenhouse gas emissions. These efforts characterized already the Copenhagen meeting in December 2009 (cf. the report on p. 118) and the Cancun meeting in 2010 (cf. Subsection 3.2.4), and will substantially affect the following climate summits. The above example illustrates the challenge: the core obviously allows allocations with a high and a low quantity of the public commodity, i.e., with a high and a low level of emission reductions. Is it possible to affect the ﬁnal outcome by appropriate negotiation techniques? Is it, in particular, possible, to “motivate” the developing countries to increase their reduction efforts? This issue will be addressed in Chapter 12 in the context of environmental policy, which constitutes the general topic of Part III.

References 1. Bilitewski B et al (eds) (2004) Handbook on the implementation of pay-as-you-throw as a tool for urban waste management. Verlag & Druckerei Tierbs, Pirna 2. Chiang AC (1987) Fundamental methods of mathematical economics, 3rd edn. McGraw-Hill, New York 12

The current efforts of China to develop the Carbon Capture and Storage (CCS) technology, point, however, in this direction. It might well happen that China will offer (and sell) the technology or the associated services to the industrialized world not too far in the future.

References

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3. Hildenbrand W, Kirman AP (1976) Introduction to equilibrium analysis. North-Holland, Amsterdam 4. Kaneko M (1977) The ratio equilibrium and a voting game in a public goods economy. J Eco Theory 16:123–136 5. Mas-Colell A (1980) Efﬁciency and decentralization in the pure theory of public goods. Quart J Eco 94:625–641 6. Mas-Colell A, Silvestre J (1989) Cost-share equilibria: a Lindahlian approach. J Eco Theory 47:239–257 7. Moulin H (1987) Egalitarian-equivalent cost sharing of a public good. Econometrica 54:963– 976 8. Muench T (1972) The core and the Lindahl equilibrium of an economy with public goods. J Eco Theory 4:241–255 9. Siebert H (2008) Economics of the environment, 7th edn. Springer, Berlin 10. Varian HR (2006) Intermediate microeconomics, 7th edn. Norton, New York 11. Weber S, Wiesmeth H (1990) On the theory of cost sharing. J Eco 52:71–82 12. Weber S, Wiesmeth H (1991) Burden sharing in NATO: an economic analysis. In: Avenhaus R et al (eds) Defense decision making. Springer, Berlin 13. Young P (ed) (1985) Cost allocation: methods, principles, applications. North-Holland, Amsterdam

Part III

Environmental Policy

The third part of this monograph addresses environmental policy, grounded in economic theory. The challenges associated with the attempts to apply the theoretical results obtained in Part II to practical issues in view of information deﬁcits will dominate the ﬁrst chapter. It will become clear that the necessary introduction of environmental standards supports the wide-spread dichotomy between ecology and economy. The following chapters present the “classical” instruments of environmental policy starting with relevant features of a command-and-control policy, which dominates environmental policy in most countries. Incentive compatibility of regulations will be investigated by means of examples, and the concept of economic feasibility, or economic reasonableness, of certain policies will be analyzed in a formal context. Thereafter, integrated approaches to environmental policy will be considered, among them extended producer responsibility (EPR) with applications to regulations for waste electrical and electronic equipment (WEEE) in various countries. Integrated waste management (IWM) and policies to promote renewable energy sources complete the chapter. The next chapter of this part studies instruments of a market-oriented environmental policy such as the pollution tax and the ecotax, which has been introduced in various countries with the expectation of achieving a double dividend. Markets for tradeable emission certiﬁcates also belong to this category of price-standard approaches with the concept of achieving the environmental standards with market instruments. Practical examples are the EU Emission Trading System (EU ETS) and the US Cap and Trade Policy, which, however, could not be installed after negotiations in the US Senate in September 2010 failed. A brief glance at attempts to install cap and trade policies in other countries concludes the chapter. The ﬁnal chapter addresses once more the allocation of global environmental commodities, such as the reduction of greenhouse gas emissions, through international negotiations. Questions of a strategic positioning to achieve a maximum reduction of global greenhouse gas emissions will be addressed.

Chapter 8

From Theory to Policy: Information Deﬁcits

Abstract The results obtained in Part II demonstrate that solutions to “market failure” associated with and resulting from environmental effects or public environmental commodities, are in principle available. The main tools recommend completing the market system with instruments such as the Pigou Tax or a market for tradeable emission certiﬁcates. Alternatively, the assignment of property rights in the context of the Coase Theorem can prove helpful to redirect the market forces to an efﬁcient allocation. In view of this theoretical framework, this chapter illustrates the role of the information which is required by the public administration to internalize the externalities. It will become clear that environmental policy is substantially affected by a lack of required information. In particular, information is missing with respect to the detailed structure of relevant markets, information is often missing regarding potentially hazardous materials or processes, and there is typically not enough information on the effectiveness of certain policies in an international context. These information deﬁcits then have immediate consequences for environmental policy aimed at preventing pollution on a local or global level.

8.1 Informational Requirements Regarding the Structure of the Markets Informational requirements characterize and affect environmental policy in a variety of ways. One of them, and probably the most important of them, is the information on the detailed structure of the markets relevant for the problem at hand. This becomes obvious when one considers the information needed to implement a Pigou Tax on a market in order to internalize an externality. Section 6.2 illustrates these requirements, which are not only based on the details of the actual equilibrium with external effects, but also on supply and demand functions including marginal social costs. In principle, complete knowledge on the details of the efﬁcient allocation to be achieved has to be assumed in theory – which is clearly not available in practice.

H. Wiesmeth, Environmental Economics: Theory and Policy in Equilibrium, Springer Texts in Business and Economics, DOI 10.1007/978-3-642-24514-5_8, © Springer-Verlag Berlin Heidelberg 2012

127

128

8 From Theory to Policy: Information Deﬁcits

A similar, but even more complex situation is given for environmental commodities with properties of public commodities. The informational requirements, especially on individual preferences, of a Lindahl equilibrium or also a cost-share equilibrium (cf. Chapter 7) are far beyond the information which is available to the public administration or which can be gathered by the public administration. Nevertheless, core equivalence, characterizing cost-share equilibria (cf. Subsection 7.2.3), does play some role in a practical context. In contrast to the simple economic framework conditions discussed and used for theoretical considerations, practical or real-life situations tend to be much more complicated. In particular, in order to avoid paying a Pigou Tax agents in the theoretical models of Part II were implicitly assumed to have only one strategy: they could only lower the level of the polluting activity in order to reduce the tax load. In practice, however, there are typically many so-called avoidance strategies, and not all of them are, by necessity, environmentally friendly. Thus, introducing fees (in the sense of a Pigou Tax) based on the individual weight of domestic garbage may well induce some households to dispose of their waste in the forests. This is clearly an avoidance strategy, but not one which was intended in the ﬁrst place. Thus, the limited information for some environmental measures on possible “avoidance strategies” poses an additional challenge for the public administration in charge of environmental policy. The reason for these information deﬁcits can again be found in the problem of missing markets resulting from external effects or public commodities. Therefore, the required information, which is in principle available in a decentralized way, cannot, as in a regular market context, be revealed through economic decisions of the individual economic agents on these (missing) markets. Moreover, the economic agents have, in general, no reason to reveal this information straightforwardly. Of course, it is always possible to simply ask individuals about their preferences, their attitude towards a particular environmental issue, or the damages afﬂicted on them by some pollution. However, there are clear incentives to exaggerate the effects of a particular environmental issue in order to accelerate public action, or to understate the beneﬁts of an environmental commodity with properties of a public good in order to reduce individual contributions. Therefore, if at all, one has to look for more sophisticated instruments to motivate individual agents to reveal the information which they have and which is relevant for tackling a concrete environmental issue. Economic theory provides various “incentive-compatible” mechanisms which induce economic agents to truthfully reveal their preferences. A prominent example is the Groves-Ledyard mechanism, which was developed for the allocation of public commodities (cf. [7]). However, according to Mäler’s judgment, these “mechanisms, although theoretically very elegant, are quite complicated and not ... empirically tested” ([11], p. 47). A simpler method is the competition-price mechanism proposed by Weimann (cf. [15], p. 145ff.). But also for this example of a “demand revealing mechanism” it will become clear that its applicability for practical problems in environmental economics is very limited. As a consequence, environmental policy will have to cope with these informational deﬁcits.

8.1 Informational Requirements Regarding the Structure of the Markets

129

8.1.1 The Competition-Price Mechanism Assume that in a simple environmental context the structure of the aggregate marginal damage curve of a certain polluting activity is known to the authorities. The competition-price mechanism can then be used to derive the aggregate marginal proﬁt curve. The intersection of these two curves provides the information needed for the appropriate value of the Pigou Tax to internalize the externality. Figure 8.1, adapted from Weimann ([15], p. 145), shows the details. 6

Revelation of a false

.............. marginal prot curve . ............ . . .............. . ............ . . ............ . ............ . . ............ u . ...... . . . false . . . . . . . . . . . . . . . . . u u . . t . . ............................................................... ............... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . prot . . transfer . . . . . . . . . . . . . . . . ................................................................................................................................................................................. t Gi Gi Gki true

........ ........ ........ . ........ .... ........ ........ ... ........ ... ........ ........ ... ........ ... ........ ........ ... ........ ........ ... ........ .. .. ........ ........ ... ... .......... ... .. ....... ........ . . ... ........ .......... .. .......... . . ... . . ........ . . .......... . . . . . . . . ... . .......... ........ . . .......... . . . . ... . . ........ .......... .. ........ .. .......... . . ... ........ .......... .. ........ .... .......... ... ........ .......... . ... . . ........ .......... .. ........ ... .......... . ... .......... .. ........ . . ............................................................................................................................................................................................................................................................................................................................ .. ............ ... ......... .. ........ .......... .. ... .......... ........ .......... ........ ... ... .. .......... ........... .. .......... ... .... .......... .... ............... ... .......... ........ ... .......... ... ... ........ .......... .. .... .......... ... ... ... ... .................. ... .......... . . . ... .......... .. ............ ... .. .. ................... ... .. .......... ... .... ... ... .... ... ... ... ... ... ... . . .

6

Revelation of the true

marginal prot curve . .................. . ............ . . ............ . ............ . . ............ . ............ . transfer . ............ . . . . false ............ . ............ . . ............ . ............ . ? ............ . . ............ u . t . . ................................ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . prot . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...................................................................................................................................................... . . . t k Gi = G i Gi true

........ ........ ........ ........ .... ........ ........ ........ .... ........ ........ . ........ ........ . ........ .... ........ ........ ........ ........ ... ........ .. ........ .. .......... ........ .. .. .......... ........ .......... ........ ... .......... ........ .......... .... ... . ........ . .......... . . . . ... . ........ .......... . ........ .. .......... . . ... ........ .......... . .. . .......... . ... . . ........ . .......... . . . . . . ... . . ........ .......... . .......... .. . . . . . ... . . . ........ .. .......... . . . . . . . . . ........................................................................................................................... ........................................................................................................................ ................................................................. . ....... .. .. .............. . ........ . .......... . . . .. . ........ .......... ........ ... .......... .... .... .......... .......... . . .......... .......... . . .......... . . ... ............. .. .......... . ........ .......... .. ... ........ .......... .... .. . . . .. .......... ..... .... ... ................. .......... . ... . .......... .. .......... .. ... .. ... .... .................... .......... ... ... . ... .... ... ... ... ... .... .... .

Fig. 8.1 Competition-price mechanism (Source: adapted from [15])

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In order to interpret Figure 8.1 consider production functions F = f (LF , G) and i ) with many small G companies. p − p /g (g−1 (G )) represents then Gi = gi (LG G L i i the marginal proﬁt curve of company i at production quantity Gi . For the sake of simplicity assume that the total quantity of the polluting emissions of the G industry corresponds to the total production quantity G. Each company i of the G industry is now assigned a “critical” level of emissions Gki by the public authorities. Following the question to the G companies regarding the structure of their marginal proﬁt curve, a tax rate t will be announced. Moreover, company i is assigned the production quantity Gti with marginal proﬁt at Gti corresponding to tax rate t. If Gti ≥ Gki , the amount t · (Gti − Gki ) has to be paid to the authorities. If Gti ≤ Gki , then company i receives the amount t · (Gki − Gti ) from the authorities. Figure 8.1 shows that quantity Gi yields the actual marginal proﬁt t. However, Gti = Gi holds only for the case of a correct declaration of the marginal proﬁt curve. Altogether, the tax rate t has to be chosen such that the efﬁcient allocation, given by the intersection of the (known) aggregate marginal damage curve with the aggregate marginal proﬁt curve derived by means of this mechanism, can be achieved. Each company is completely informed about this procedure, and each company knows that, given the assumed large number of companies in the industry, it alone is too small to affect the tax rate t through its decisions. Therefore this mechanism is deﬁned as a competition-price mechanism. Straightforward graphical considerations based on Figure 8.1 demonstrate then that it is always better for a particular G company to truthfully declare the structure of its marginal proﬁt curve. The marginal proﬁt curve of company i is declared falsely in the upper part of the ﬁgure, and truthfully in the lower part. With the false declaration, company i receives net income (proﬁt and transfer) indicated by the framed area. The framed rectangle corresponds to transfer payments t ·(Gki −Gti ), the remaining area, the area under the marginal proﬁt curve, is total proﬁt. If, however, the company announces the true marginal proﬁt curve, proﬁt increases. In the lower part of Figure 8.1 proﬁt corresponds to the area below the marginal proﬁt curve between 0 and Gi , transfer payments are reduced to t · (Gki − Gi ). Analogous considerations hold for the case Gki < Gti or for different structures of the true or false marginal proﬁt curve. Observe that the public authorities can, through the choice of the critical emission levels, exert some control on the budget required for the execution of this procedure. However, if the critical emission levels are too high, there will be a drain on the public budget. Therefore, in order to propose the appropriate levels, further information is needed, which is, again, not generally available. This also refers to the structure of the aggregate marginal damage curve, which has to be assumed to be known for this mechanism, and to the individual marginal proﬁt curves, which have to be known to the companies. Another problematic aspect of this competition-price mechanism is the assumption of a framework of complete competition, implying that none of the ﬁrms can affect the tax rate t through its economic decisions. If a larger company is in a position to affect t, then strategic decision-making can probably not be excluded. The

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mechanism will not function properly, and an efﬁcient outcome can no longer be expected (cf. again [15], p. 151ff.). The last remark in this context refers to the pollution rights associated with speciﬁc property rights as investigated in Section 6.5. If, as in the examples of this subsection the marginal damage curve is downward sloping, if therefore the production of the ﬁrst unit of a particular commodity leads to the highest marginal damage, then this mechanism will probably not work satisfactorily either. Thus, more information is required to guarantee the functioning of this and comparable mechanisms. The main conclusions to be drawn from these considerations refer to the relevance of information deﬁcits in applied environmental economics and environmental policy. The above discussion of the competition-price mechanism, which in some sense represents the “preference-revealing” or “demand-revealing” mechanisms, indicates that feasible and applicable mechanisms are not readily available. Environmental policy therefore has to do without reliable ﬁrst-hand information on preferences, marginal proﬁt and marginal damage curves, or has to try to gather at least some of the required information through other channels and other methods. This is, in particular, an issue in an international context, which is addressed in the following section.

8.2 Information Deﬁcits in International Environmental Policy International environmental policy faces, for a variety of reasons, serious difﬁculties. Besides the lack of information on relevant market structures as discussed above, insufﬁcient information on the behavior of the economic agents in the target countries and insufﬁcient means to control their actions provide the greatest difﬁculty. Chapter 12 will address some of these issues in the context of a principalagent approach. Moreover, attempts to use international trade as a means to affect environmental decision-making in other countries will be investigated in Chapter 15 in Part IV. In general, however, the information required to make intense use of the principalagent approach in international environmental policy or to apply trade policy as a strategic tool is simply not available. Therefore, the challenge of an international environmental policy to successfully address local or cross-border environmental problems remains. The EU introduced programs such as IPA (Instrument for Pre-Accession Assistance) to assist countries with the accession process to the EU. One of the aims of this program is “to enhance the efﬁciency and coherence of aid by means of a single framework in order to strengthen institutional capacity, cross-border cooperation, economic and social development and rural development” ([3]). Moreover, many industrialized countries have established special organizations to provide help for a variety of issues affecting the development of transformation countries. To clean up the environment and to support these countries regarding the

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prevention of future environmental degradation is typically one of the concerns of these organizations. Two of them are brieﬂy presented here: USAID: This US American organization takes an integrated approach to the management of natural resources. Its programs in natural resources management are in particular linked with programs to mitigate or adapt to climate change (cf. [13]). USAID runs various programs such as the MERC (Middle East Regional Cooperation) Program, which funds, among other things, research projects on the environment (cf. [14]). GIZ: This German based organization was formed in January 2011. It brings together the expertise of various other institutions, among them the GTZ (German Technical Cooperation). GTZ’s work is guided by the concept of sustainable development (cf. [6]). A special program carried out by GTZ is, for example, the “Caucasus Initiative” with economic promotion being one of the technical cooperation projects with the countries in South Caucasus (cf. [4]). Despite these remarkable efforts, there always remain the problems of adverse selection or moral hazard with the selection of appropriate projects in the target countries and with the effectiveness of implementing these programs after the funds are granted. Some of these issues regarding an international environmental policy can be found in the not overly promising results of the ﬁrst commitment period of the Kyoto Protocol (cf. also Subsection 5.3.2 and Section 7.3). The current negotiations on global reductions of greenhouse gas emissions also provide an excellent example of international attempts to reach a tolerated and respected agreement given the information deﬁcits mentioned above. Sections 7.3 and 12.2 investigate this issue with the core as allocation mechanism, replacing the market mechanism in the international context.

8.3 Information Deﬁcits Regarding Hazardous Materials and Processes Potentially hazardous materials and hazardous production processes constitute another challenge for environmental policy. Commodities and production technologies, which are deemed safe today, may prove dangerous, sometimes extremely dangerous a couple of years from now. With respect to dumping household and industrial waste, this has happened on a global level over the last decades. What used to be common practice over a long period of time turned out to pollute groundwater aquifers and have other negative effects. As a consequence, there are worldwide attempts to sanitize dump sites with substantial ﬁnancial means. The excerpt below, taken from a textbook by Bilitewski et al., indicates the dimension of this challenge (cf. [1], p. 4). Moreover, with the advancement of recycling activities, “waste” itself has gradually become a valuable resource. The concept of integrated waste management (cf.

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Section 10.2) emerged from this perception and integrated “waste” into the economic allocation problems (cf. Subsection 4.1.2). Bilitewski et al. introduce these concepts with a detailed description of the technical means for recycling ([1], Ch. 6) and an explicit focus on appropriate framework conditions for waste avoidance ([1], Ch. 7).

History of Waste Management in Germany (excerpt from [1], Sec. 1.1) . . . a substantial number of the original 50,000 dumps were closed and continuous improvements were made in the technological standards for landﬁlls. By 1980, only 530 landﬁlls were in operation, and by 1984 only 385 existed, handling about 70% of all municipal solid waste (MSW). Despite the fact that today’s landﬁll technology has advanced to the sophisticated multibarrier concept intended to safeguard the environment and the public for a given period of time, the functioning of the barrier systems cannot be guaranteed over the long term. An example of this is the Georgswerder landﬁll in Hamburg which was in operation until 1979 and accepted co-disposal of MSW and hazardous waste using state-of-the art technology at that time. By 1983, leachate was already found to contain numerous contaminants and high dioxin concentrations. Remediation was required at the landﬁll with costs running as high as several hundred million DM. . . .

On an international level, there are still serious disputes on the relevance of greenhouse emissions for global warming. This holds especially true for the US, where the prospects for decisive action on climate change were substantially lowered when the American Clean Energy and Security Act, also known as the Waxman-Markey Bill, which would have imposed a nationwide cap on greenhouse gas emissions, was not accepted by the Senate, after having been approved by the House of Representatives in 2009. Nevertheless, some members of the House of Representatives seem to dismiss the dangers of climate change. Kolbert provides an insight into the opinion of various representatives regarding climate change in a comment, published in The New Yorker in late 2010 (cf. [9], p. 53f.). Another international environmental issue refers to the growth-promoting hormones in meat, in particular beef. In the early 1980s the EU enacted a ban on both the production and importation of meat derived from animals treated with growthpromoting hormones. The ban, which went into effect at the beginning of 1989, restricts the use of natural hormones to therapeutic purposes, bans the use of synthetic hormones, and prohibits imports of animals and meat from animals that have been administered the hormones ([8], p. 2). Whereas both the US Food and Drug Administration (FDA) and the US Department of Agriculture (USDA) maintain that hormones in beef from an implanted animal have no physiological signiﬁcance for humans, the ban reﬂects the EU’s approach to food safety policy, characterized by the precautionary principle, which

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justiﬁes or even supports a protective action before there is sufﬁcient scientiﬁc proof of a risk (cf. again [8], p. 2). The EU Commission thus views the ban as necessary to protect consumer health and safety. Only further research will show, whether the precaution taken by the EU is in contradiction to the WTO principles, which – among other things – do not allow discrimination on the basis of differing production processes. Up to now, WTO consultations, panel decisions, and appeals in the case, were not able to solve the dispute (cf. Section 13.2). Possible consequences of these information deﬁcits are – besides a variety of WTO disputes – restrictive legal regulations and potentially unnecessary precautionary measures. In particular, it is probably not always true that an alternative decision, based, for example, on the precautionary principle, is by necessity more environmentally friendly. This argument is also included in the current discussions in Germany and elsewhere on the future of nuclear power stations following the catastrophe in Japan in March 2011. What remains is a “walk on the knife’s edge”, which each generation has to start anew on the basis of the then available scientiﬁc knowledge. Due to the continuing advances in science and technology, a variety of decisions taken years ago will turn out to be problematic in retrospect. And even strategic changes in a policy adopted some time ago, which are in agreement with the precautionary principle, need not guarantee a satisfactory outcome.1

8.4 Consequences for Environmental Policy The information deﬁcits discussed above have serious consequences with respect to an immediate and straightforward application of the tools and instruments of theoretical environmental economics introduced and discussed in Part II. A direct transfer of these concepts from theory to practice is, in general, impossible, and environmental policy can only be explained and understood by taking these informational problems into account. Remediation of Environmental Damage: Cleaning up the environment after the perception of environmental damage was characteristic for the environmental policies at the beginning of the “ecological revolution” in the 1960s and 1970s. Today, remediation activities often refer to the “leftovers” from economic activities, which were – some time ago – deemed harmless for humans and the environment, but which proved risky or even hazardous later. Due to the information deﬁcits on hazardous materials and production processes, these kind of 1 With the opening of the ﬁrst railroads in the 1830s, life became “accelerated”. Medical doctors were afraid of speeds of 30 km/h, or even 50 km/h, which were deemed hazardous to health. In particular, the trees ﬂying past the windows, would endanger the faculty of vision. Therefore, they recommended that the railways be fenced in ([12]). What would our world look like today, if such precautionary measures were taken then . . . ?

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“reactions” to environmental damage will continue to affect our lives and our economies. Of course, these remediation measures are necessary and often very expensive and extremely challenging from a scientiﬁc or engineering point of view.2 With respect to environmental policy, however, which is directed towards preventing environmental pollution and which has to focus on preventing environmental damage, they are, for obvious reasons, less interesting. Therefore, besides the issue of overﬁshing3 in Chapter 14, remediation policy will not play a major role in this text. Command-and-Control Policy: Command-and-control policies dominate environmental policies in many parts of the world. With respect to the environment these policies rely on regulations, which permit or forbid certain activities. According to general opinion, they allow precise and quick measures to stop pollution and prevent environmental damages and disasters. Among the instruments are special environmental laws, acts and ordinances, both on a local, national and global level. In the communities there are, for example, zoning regulations, countries use waste management directives for treatment of municipal solid waste, and the “Law of the Sea” covers, among other things, ﬁshing outside the exclusive economic zones of the individual countries (cf. Section 14.6). The ecological efﬁciency of the command-and-control policy is usually cited as one of the advantages characterizing this policy. But commands and controls also constitute tools of a discretionary environmental policy, which provide opportunities for politicians to demonstrate their environmental awareness to the voters. In summary, there are various reasons for the prevalence of command-and-control policies, information deﬁcits being one of them. The idea of preventing environmental damages is, in general, one of the key issues of a command-and-control policy. The German “Federal Immission Control Act” (BImSchG) postulates in Section 1: “It is the purpose of this Act to protect human beings, animals and plants, soil, water, the atmosphere as well as cultural objects and other material goods against any harmful effects on the environment and to prevent the emergence of any such effects” (cf. [5]). In this context, the precautionary principle plays an important role in the environmental legislation of the EU and Germany. Again, the German “Federal Immission Control Act” postulates that precautions to prevent harmful effects on the environment are taken by measures, which are appropriate according to the best available techniques ([5], Section 3 (6)). In order to save costs this particular regulation can, 2

The steel casing, which will probably be completed by 2012 or 2013 to enclose the supposedly unstable “sarcophagus” and to contain the radiation emanating from the damaged nuclear power plant in Chernobyl, Ukraine, is supposed to last for a period of 100 years. By then, lower radiation levels and advanced technologies are expected to allow a clearing and a remediation of the site of the nuclear power plant till 2065 ([2]). 3 Policies to reduce or stop overﬁshing could – to some extent – be interpreted as a remediation policy, although the remediation is achieved by the biological system. In this and in other cases of natural attenuation (cf. [10]) environmental policy should, thus, aim at allowing natural or biological remediation.

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however, affect incentives of the companies regarding the diffusion of innovative technologies. After all, private business companies have some possibilities to determine and inﬂuence the “best available technique” for a particular purpose. Thus, with these regulations there is the danger of an incentive structure which does not sufﬁciently support the goals of the environmental policy. The multitude of references to permissible loads, to maximum mass concentrations, daily immission levels, emission reduction ratios and other quantities of pollutants or contaminants, a signature of command-and-control policies, results from the information deﬁcits regarding the detailed structure of the relevant markets. Environmental policy thus requires separate and detailed goals and, therefore, “gains” independence from general economic policy. The dark side of this development is that the close relationship between the environment and the economy, which proved to be characteristic for theoretical environmental economics, is moved to the background – providing room for the sometimes harsh competition between environmental and economical policy goals, for the largely acknowledged dichotomy between ecology and economy. Market-Oriented Environmental Policy: Market-oriented environmental policies make use of the information which is available in the relevant markets in a decentralized way. This can help to alleviate the information problem to some extent, although environmental or external effects are characterized by “missing markets” (cf. Section 6.1). The pollution tax and tradeable emission certiﬁcates are the most prominent instruments of this policy. This “economically grounded” environmental policy affects the behavior of the economic agents through the “polluter pays principle”. However, an immediate application of the instruments derived from theory, is not feasible – again a consequence of the persistent information deﬁcits. Environmental standards have to assume the role of the efﬁcient production and emission levels relevant in theory. These standards will then be achieved through market signals, resulting in the price-standard approach (cf. Chapter 11). This is in some contrast to the command-and-control policy, which enforces the environmental standards through rigorous controls and legal procedures. Thus, the “centralized” approach of the command-and-control policy has to be contrasted to the more “decentralized” approach of the market-oriented environmental policy. The following chapters discuss the most important aspects of command-andcontrol policies and price-standard approaches to environmental issues. Examples of environmental policies from various countries will enrich the presentation and will point to various challenges associated with environmental policy.

References 1. Bilitewski B et al (1994) Waste management. Springer, Berlin 2. Chernobyl Nuclear Power Plant Decommissioning, Ukraine http://www.power-technology.com/projects/chernobyl. Cited May 2011

References

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3. EU (2006) Instrument for Pre-Accession Assistance (IPA) http://europa.eu/legislation_summaries/agriculture/enlargement/e50020_en.htm. Cited Apr 2011 4. Germany (2008) Caucasus Initiative of GIZ http://www.gtz.de/en/weltweit/europa-kaukasus-zentralasien/2829.htm. Cited Apr 2011 5. Germany (2009) Federal Immission Control Act (BImSchG), amended 2009 http://www.bmu.de/ﬁles/english/pdf/application/pdf/bimschg_en_bf.pdf. Cited May 2011 6. Germany (2011) Deutsche Gesellschaft für Internationale Zusammenarbeit (GIZ) GmbH http://www.giz.de/en/home.html. Cited Apr 2011 7. Groves T, Ledyard J (1977) Optimal allocation of public goods: a solution to the “Free Rider” problem. Econometrica 45:783-810 8. Johnson R, Hanrahan CE (2010) The U.S.-EU Beef Hormone Dispute. Congressional Research Service 7-5700 http://www.nationalaglawcenter.org/assets/crs/R40449.pdf. Cited May 2011 9. Kolbert E (2010) Comment: uncomfortable climate. The New Yorker, Nov. 22, 2010, p. 53-54 10. Lingner S (2003) Legitimacy of tolerating limited environmental pollution? The case for natural attenuation. Poiesis Prax 2:73–78 http://dx.doi.org/10.1007/s10202-003-0038-1. Cited Dec 2010 11. Mäler K-G (1985) Welfare economics and the environment. In: Kneese AV, Sweeney JL (eds) Handbook of natural resource and energy economics, vol. I. North-Holland, Amsterdam 12. Pluta W (2006) Triebwagen im Temporausch. In: Bild der Wissenschaft online, Ausg. 1/2006, p. 102 http://www.bild-der-wissenschaft.de/bdw/bdwlive/heftarchiv/index2.php?object_id =30561184. Cited May 2011 13. USAID: United States Agency for International Development http://www.usaid.gov/our_work/environment. Cited Apr 2011 14. USAID: Middle East Regional Cooperation Program (MERC) http://www.usaid.gov/our_work/merc/program_description.html. Cited Apr 2011 15. Weimann J (1990) Umweltökonomik. Springer, Berlin

Chapter 9

Command-and-Control Policy

Abstract This chapter provides insights into relevant features of command-andcontrol policies in an environmental context. The ﬁrst section refers to environmental standards, which replace the generally unknown efﬁcient levels of certain environmental commodities. The necessity to choose appropriate standards contributes substantially towards environmental policy developing into a separate policy area, competing with economic policy, labor market policy and others for ﬁnancial and public support. The US Clean Air Act (CAA) and the German Federal Immission Control Act (BImSchG) will help to analyze the concept of ecological efﬁciency. Thereafter, framework conditions, mostly for stimulating consumers and motivating private business companies to engage in environmental activities, will be investigated. The Private Finance Initiative (PFI) applied to environmental policy characterizes the orientation of this section. The incentive compatibility of commands and framework conditions will be addressed by means of the reﬁllables quota issue. In addition, standards and framework conditions should be economically feasible or economically reasonable. This concept appears in a variety of legal papers, acts and ordinances related to environmental policy. What does it mean and what are its implications from an economic point of view?

9.1 Environmental Standards and Framework Conditions Due to the persistent information deﬁcits with which environmental policy has to cope in general – as discussed in detail in Chapter 8 – the efﬁcient levels of the quantities of environmental commodities, or rather the quantities of regular commodities, the production of which exerts environmental effects, have to be approximated by standards. These environmental standards, among other things, represent maximum allowable concentrations of pollutants, provide limits for immission levels for certain contaminants, postulate minimum quotas for recovery and recycling activities, and stipulate shares for renewable energy sources in the generation of electrical energy. H. Wiesmeth, Environmental Economics: Theory and Policy in Equilibrium, Springer Texts in Business and Economics, DOI 10.1007/978-3-642-24514-5_9, © Springer-Verlag Berlin Heidelberg 2012

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Command-and-control policies can be and are typically used to enforce explicit standards regarding allowable concentrations of possibly hazardous pollutants or ceilings for immissions. In contexts involving a large number of households and business companies, however, appropriate framework conditions may prove advantageous: in order to reach a certain share of electrical energy generated from renewable sources, for example, guaranteed prices might help to achieve this goal (cf. Section 10.3).

9.1.1 Standards in Economic Systems The introduction of environmental standards is important for environmental policy and the perception of environmental policy. Consider the following monotonicity property: if the equilibrium quantities of the regular consumption commodities can be provided at higher environmental standards, i.e., without higher costs but with lower environmental pollution, most, if not all economic agents are likely to prefer this more environmentally friendly situation. However, as soon as stricter environmental standards result in lower quantities of some commodities, for example limited private transport activities due to ﬁne dust action plans, a kind of competition arises between economical and environmental concerns. This situation documents the birth of the Ministry for the Environment, which defends and which has to defend its standards or changes thereof, and which has to justify its budget, similar to the Ministry for Economic Affairs in general, or the Ministry for Labor Market Policy in particular. Not much remains of the “harmony” between the environment and the economy, which is manifest in the Pareto Criterion, guiding the allocation of all commodities, including the environmental commodities. In particular, in case of a critical decision, it need not always be the environment, which is on the winning side.1 Thus, the intrinsic relationship between ecological and economical issues known from the theory of environmental economics, breaks apart into a dichotomy between ecology and economy – due to information deﬁcits. In a more general context, environmental policy based on standards is similar to economic policy based on appropriate growth rates, or monetary policy based on target inﬂation rates, or labor market policy based on low unemployment rates, etc. And countries which are integrated into the global trading system also start competing against each other with regard to their environmental standards. This nourishes anxieties about a race towards the bottom in terms of these standards (cf. Section 15.1 for an analysis of this competition regarding environmental standards). And – again similarly to the situation in other policy areas – environmental policy develops instruments and tools which are not always close to the principles of a market economy. In many countries environmental policy is developing more and more into a bottom-up policy inspired and driven by grassroots lobbyists. This means that 1

An economic recession with rising unemployment typically supports opponents of a stricter environmental policy.

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political or environmental institutions are less frequently primarily responsible for a variety of decisions concerning the protection of the environment, rather interest groups affect the decision-making process profoundly. This need not be bad, but is nevertheless often more than a step away from traditional political principles and procedures.2

9.1.2 Ecological Efﬁciency of Standards: Examples In many cases the concrete values of environmental standards are justiﬁed by health concerns, by scientiﬁc analyses, or by precautionary considerations. From time to time, standards are adjusted or have to be adjusted to allow for new insights gained with respect to the risk potential of a product or production process. For similar reasons, additional standards, such as maximum concentrations for ﬁne dust, are introduced.3 The principle of ecological efﬁciency, usually associated with a command-andcontrol policy, implies that the instrument at hand targets an environmental issue with “ecological precision”, and, if compliance of the economic agents is monitored, then the goal can be achieved. Of course, this principle refers only to attaining the environmental standards, and not to arriving, by necessity, at economic efﬁciency – due to information deﬁcits. Clearly, ecological efﬁciency also requires the regular adjustment of the standards to allow for new insights and technical innovations. Both the Clean Air Act (CAA) of the United States of America and the Federal Immission Control Act (BImSchG) of the Federal Republic of Germany, among many others, deal with this important issue, and both acts refer to best available techniques or best available control technologies. The Clean Air Act: The CAA is the comprehensive federal law in the US that regulates air emissions (cf. [15]). It authorizes the Environmental Protection Agency (EPA) to protect public health and public welfare and to regulate emissions of hazardous air pollutants. Section 169 “Deﬁnitions” of the CAA provides a deﬁnition of the term “best available control technology”: “The term best available control technology means an emission limitation based on the maximum degree of reduction of each pollutant subject to regulation under this Act emitted from or which results from any major emitting facility, which the permitting authority, on a case-by-case basis, taking into account energy, 2

Grassroots activists have contributed considerably towards the political decisions to shut down the nuclear power plants in Germany earlier than initially intended. Also Stuttgart 21, a rail project to integrate the main station of the City of Stuttgart in southwestern Germany better into the German and European high speed railway system, has become almost synonymous with the “power” of environmentalists and other groups over the political establishment. 3 Fine dusts and ultra-ﬁne particles penetrate into the lungs, and may even enter the bloodstream. As a consequence, several cities in Germany have recently set up clean air action plans for the case that the ceiling of 50 microgrammes ﬁne particulate matter is exceeded on more than 35 days a year. For this and more details see [5].

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environmental, and economic impacts and other costs, determines is achievable for such facility through application of production processes and available methods, systems, and techniques, including fuel cleaning, clean fuels, or treatment or innovative fuel combustion techniques for control of each such pollutant. . . . ” It is important to note that in the case of the CAA the “permitting authority” is in charge for determining the relevant parameters for the best available control technology based on the maximum degree of reduction of the pollutants. The Federal Immission Control Act: The purpose of this Act is to ensure integrated prevention and control of any harmful effects on the environment caused by emissions to air, water and soil by securing the participation of the waste management sector in order to achieve a high level of protection for the environment as a whole and the taking of precautions against any hazards, signiﬁcant disadvantages and signiﬁcant nuisances caused in any other way (cf. [8]). Section 3 “Deﬁnitions” provides in Subsection (6) a deﬁnition of the term “best available technique”: “Best available techniques” as used herein shall mean the state of development of advanced processes, establishments or modes of operation which is deemed to indicate the practical suitability of a particular technique for restricting emission levels to air, water or soil, for guaranteeing installations safety or for preventing or reducing any effects on the environment with a view to achieving a high level of protection for the environment as a whole. . . . ” A list of criteria for determining best available techniques is speciﬁed in the Annex to the Federal Immision Control Act. Criteria to be taken into account when determining best available techniques, shall in particular bear in mind the cost and beneﬁt of any measures considered and the principles of precaution and prevention (cf. [8], Annex). There is an issue, of course, with determining the “best available technique”: these regulations might, at least occasionally, “motivate” engineers and scientists to reduce their efforts to develop innovative environmental technologies. Consequently, appropriate framework conditions are required to enhance innovation activities and to raise the environmental standards. The role of framework conditions in this context will be brieﬂy illustrated in the following subsection.

9.1.3 Framework Conditions, Standards and the Private Finance Initiative Framework conditions can be used to initiate and stimulate environmentally friendly actions to attain and maintain environmental standards. They can, in particular, help to establish cooperations between the public and the private sector: acts and ordinances, set by the public authorities, can open interesting investment opportunities

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for private ﬁnance and private capital for projects, which are important for the protection of the environment. If particular environmental standards, such as the share of renewable energy sources in the generation of electrical energy or the share of recycled commodities, can only be attained through actions and the support of a large number of economic agents, then the motivation to participate in appropriate actions can be stimulated through framework conditions. In this sense, framework conditions are a means to guide economic agents to attaining certain standards. In case these framework conditions open investment opportunities for private business, then special public-private partnerships (PPP) are established, which induce projects for the protection of the environment and which are, in general, completely ﬁnanced by private consumption and production activities. This describes a particular case of the Private Finance Initiative (PFI), which was introduced by the government of the United Kingdom in 1992 as a systematic approach to publicprivate partnerships with a focus on “value for money” and an appropriate allocation of ﬁnance and risk for alternative ways of procuring public sector facilities (cf. [18]. Despite numerous successful projects, there nevertheless have been some spectacular failures of PFI projects with serious impacts on, for example, health services in England (cf. [12]). After some of these PFI projects failed, the public sector had to bail out the private partners, and carry the ﬁnancial burden including further ﬁnancial risk. Of course, in the context of the protection of the environment some questions should be asked, too: is PFI a meaningful instrument for environmentally sensitive areas such as, for example, waste management with potential hazards for public health? Put in a more general way, should waste management be open for private capital and private ﬁnance beyond simple waste collection and perhaps waste segregation and incineration? If so, how can one then establish framework conditions, which allow a fruitful cooperation between the public and the private sector without repeating the mistakes of earlier PPP and PFI projects? Chapter 10 will investigate the role of framework conditions for PFI in the context of some integrated approaches to environmental policy. Before that, however, the following section will provide an example of a failed attempt to attain a certain standard, a quota for reﬁllable drinks packages, through framework conditions. This quota played and still plays an important role in the German Packaging Ordinance and is also relevant for waste management in other regions, for example Ontario. The experience in Germany demonstrates that it is not always easy and straightforward to stimulate the economic agents to act in accordance with the goals and the standards of an environmental ordinance.

9.2 The Reﬁllables Quota Issue One-way drinks containers that are recycled into new containers or new products are easing the burden on the environment, but recycling is often considered a “second-

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best” solution in the context of waste management. Reusable or reﬁllable drinks packaging is, in general, assumed to be more environmentally friendly than recycling.4 The following subsections investigate various aspects of the reﬁllables quota issue in Germany, the US, and Canada (Ontario). The role of the different framework conditions to attain standards for reusing or recycling will be illustrated.

9.2.1 Facts and Developments Regarding Reﬁllable Packaging The 1991 German Packaging Ordinance (“Verpackungsverordnung”) with its various amendments is a prototype for legislation designed to close substance cycles in waste management (cf. also Section 10.2). As one-way drinks packages constitute a major share of packaging waste, Section 1(2) of the current version of the Ordinance (cf. [9]) deﬁnes the environmental standard regarding drinks packaging: “This Ordinance aims to increase to at least 80 per cent the share of beverages ﬁlled into reusable drinks packaging and ecologically advantageous one-way drinks packaging.” This is an ambitious goal and to some extent it also depends on the deﬁnition of what is understood by ecologically advantageous packaging, whether and to what extent this goal will be achieved. In 2009, approximately 2.6% of all drinks in Germany were ﬁlled in ecologically advantageous disposable packaging, down from almost 5% in 2004 (cf. Table 9.1).

QuotaofReusableandEcologicallyAdvantageousOneͲ WayDrinksPackaginginGermany(%) Year Beer MineralWater SoftDrinks MixedAlcoholicDrinks AllBeverages reusable ecologicallyadvantageousoneͲ waypackaging

2007 85.2 47.3 42.8 23.1 54.6 51.2

2008 87.2 45.4 38.3 21.2 52.6 49.5

2009 88.5 43.8 37.4 15.7 51.8 49.2

3.4

3.1

2.6

Table 9.1 Source: GVM Gesellschaft für Verpackungsmarktforschung ([10]). GVM kindly granted permission to use this table.

Other countries seem to have less ambitious goals. According to the Container Recycling Institute, the packaged beverage sales in the US rose from 190 billion units in 2000 to 224 billion in 2006, with the national container recycling rate at 34% 4

Ecologically advantageous one-way drinks packaging is gaining increasing importance in various countries. However, complicated life-cycle assessments have to be conducted in order to award this designation to packaging.

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down from 54% in 1992. Moreover, probably less than half of all beverage containers purchased in the US are recycled ([16], p. 9). The following table demonstrates this development starting some 60 years ago. Today the share of reﬁllable drinks packaging in the US is in the low single digits. However, one has to admit that there has not really been a policy to increase the share of reﬁllable containers in the US. Moreover, the recycling requirements that have been introduced in various states and cities across the US, are gaining importance, but still need some time to become fully effective.5

SoftDrinkContainerMixintheU.S. (asapercentoftotalvolumesold) Year 1947 1960 1969 1980 1984 1998

Refillable Bottles 100.0 95.0 67.0 31.0 20.0 0.4

Cans 0.0 4.0 20.0 37.0 41.0 48.3

PlasticBottles 0.0 0.0 0.0 18.0 24.0 50.9

Table 9.2 Source: Container Recycling Institute (CRI, [17]). CRI kindly granted permission to use this table and the following article.

“The Decline of Reﬁllable Beverage Bottles in the U.S. (1938-1998)” Container Recycling Institute (cf. [17]) Before the introduction of one-way, disposable containers all fountain soft drinks and draught beer were sold in reﬁllable glass bottles. The disposable steel can made its debut in 1938 and in less than 10 years cans comprised 11 percent of beer market share. Non-reﬁllable glass bottles made up 3 percent and reﬁllable bottles had dropped to 86 percent. By 1984 only 8 percent of beer volume was packaged in reﬁllable bottles. Reﬁllable market share is now less than 4 percent of packaged beer volume. The soft drink industry was slower to move from a reﬁllable, reusable sys5

tem to a one-way, disposable system. In 1960 nearly one-half (47 percent) of beer was sold in one-way containers while only 6 percent of soft drinks were sold in one-way bottles and cans. Today less than 1 percent of packaged soft drink volume is sold in reﬁllable bottles. Economic instruments such as deposits allow reﬁllables to compete in the marketplace with one-way, disposable cans and bottles. This is evidenced by data from the Beer Institute which shows that most states with mandatory container deposits have a higher percentage of reﬁllable beer bottles than states with-

For example, Florida established a new statewide recycling goal of 75% to be achieved by the year 2020. Cf. http://www.dep.state.ﬂ.us/waste/recyclinggoal75.

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out deposit laws. According to the Beer Institute, the market share for reﬁllables dropped to 3.3 percent in 1998. However, in 1998 11 states had a reﬁllable market share of 7 percent or more. Of those 11 states,

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7 require deposits on one-way, nonreﬁllable beer and soft drink containers. In one of the deposit states (Massachusetts), 18 percent of total beer volume was sold in reﬁllables in 1998.

In contrast to these numbers, reﬁllable containers comprise 72% of total beer containers sold in Ontario, and Ontario beer consumers return almost 98% of reﬁllable containers, a consequence of the beer industry’s “100% packaging take-back commitment”: the industry has committed to continuing efforts to recover, through its retail channels, all of its packaging wastes. This standard regarding reﬁllable beer bottles enjoys the highest return rate of any package in the world. These bottles can be reﬁlled 12 to 15 times and are then recycled ([2]). It is remarkable that this happened although Canada has followed the US in switching to non-reﬁllable containers. One has to take into account, however, that recycling of these one-way containers has been an explicit goal of Ontario’s Waste Diversion Act with a province-wide goal of 60% waste diversion. In this context the Blue Box program has a separate recovery rate of 60%, which was exceeded in 2007 with a rate of 64% (cf. again [2]). The system is guided through fees, refundable deposits and a partial funding of the Blue Box program through companies that introduce packaging into the market (cf. again [2]). Thus, Ontario’s approach is based on special framework conditions to attain the standards it has set regarding recycling. Under these framework conditions, the beer industry in Ontario obviously considers reﬁllable bottles the leastexpensive packaging option, and consumers prefer these bottles thanks to a 10 cent levy on non-reﬁllable containers for alcoholic beverages (cf. [3], p. 21). For all other beverage container programs in Canada cf. [4]. In summary, this brief discussion of the situation regarding reﬁllable drinks containers in various countries demonstrates that without a standard to be attained through appropriate policy measures, the environmental or external effects will continue to reduce the share. This happened, for example, in the US, where no standards for reusable containers were pursued. In Ontario, the situation is interesting as there is, on the one hand, a low quota of reﬁllable soft drink containers, though with a high recycling rate, and on the other hand, there is an almost 100% return of the 72% of the reﬁllable beer containers. This happens because of cost considerations, which induce breweries to stay with the traditional reﬁllable bottles. The situation is similar in Germany with a substantial share of beer bottled in reusable containers, although there is a tendency to a higher share of reusable and ecologically advantageous oneway drinks packaging (cf. Table 9.1 and also Table 9.3). Is this a development which is happening anyway, or is this rather a consequence of framework conditions which fail to provide the right incentives? The last subsection will reconsider this ambiguous role of the framework conditions and will analyze various aspects of the German Packaging Ordinance.

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9.2.2 The Reﬁllables Quota Issue and the German Packaging Ordinance The purpose of the German Packaging Ordinance is to avoid or reduce the environmental impacts of waste arising from packaging. Moreover, in its current version (cf. [9]) the Ordinance aims to increase to at least 80% the share of beverages ﬁlled into reusable drinks packaging and ecologically advantageous one-way drinks packaging. However, the instruments applied to achieve these goals have changed over time. For this reason, parts of this ordinance in its original version and in the current version will now be presented and analyzed regarding the incentives to increase the share of reﬁllable drinks containers (cf. [6] and [9] for the two relevant versions of the Packaging Ordinance). The reﬁllables quota issue turned out to be one of the critical corner stones of the various versions of the Packaging Ordinance in Germany. The goal of 80% of reﬁllable or ecologically advantageous drinks packaging could not be attained up to now, not even approximately (cf. Table 9.1); and there is not really an instrument to substantially increase this share in the near future. Considering the Packaging Ordinance, there is and was an obligation to charge a deposit on drinks packaging which is not reusable (cf. [6], § 8). However, till 2003, there was an exemption from the obligation to charge deposits, as long as, roughly speaking, the combined proportion of drinks packaged in reusable packaging stayed above 72%, the actual share in 1991, when the ﬁrst Packaging Ordinance was enacted (cf. [6], § 9 (2)). Of course, the ultimate goal of these regulations was to divert packaging, to reduce packaging waste. This is clearly a policy of extended producer responsibility (EPR) with a design for environment (DfE) component: producers should be induced or motivated to increase the share of reﬁllable drinks containers (cf. Section 10.1 and [19] for further remarks on EPR policies).

QuotaofReusableDrinksPackaginginGermany(%) Year AllBeverages MineralWater CarbonatedSoftDrinks Beer NonͲCarbonatedBeverages Wine

1991 71.7 93.3 73.7 82.2 34.6 28.6

2002 56.2 68.3 54.0 68.0 29.2 25.3

2009 44.3 43.6 36.5 88.5 11.2 7.2

Table 9.3 Source: GVM Gesellschaft für Verpackungsmarktforschung ([11]). GVM kindly granted permission to use this table.

But the development of the combined proportion of reﬁllable drinks packages in Germany since 1991 shows that something went wrong (cf. Table 9.3). Obviously,

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the incentive structure of this EPR policy associated with the framework conditions determined by these earlier versions of the Packaging Ordinance did not support the goals mentioned above. As a consequence, in 2003 the German government had to charge deposits on one-way drinks containers. And since then, the combined proportion of reﬁllable drinks packages has continued to decline, although at a somewhat slower pace in recent years: from 2008 to 2009 the quota for all beverages decreased by 0.4% ([11]). These regulations were deemed to provide incentives for offering and buying drinks in reusable or, to be more precise, in reﬁllable containers. How could such a disastrous development happen in a country with a presumably high environmental awareness? Interestingly, the requirement of a combined proportion of drinks in reﬁllable containers of no less than 72% is probably mainly responsible for these misguided incentives. Consider – with this combined proportion above 72% – a particular producer with an expected stable demand for drinks in one-way containers, which is, in addition, small in comparison to market demand. Without any urgent need, this producer has little incentive to restructure production towards a larger share of reﬁllable packages. Such a change in packaging would certainly be accompanied by higher costs for new equipment and expenses for logistics, and might even lead to a falling demand because of the consumers’ preferences. Furthermore, if the competitors act accordingly and comply with the intention of the regulation, then everything would be ﬁne, and there would be no need whatsoever to change one’s own strategy. A similar consideration applies all the more if this combined proportion is already below 72%. Why on earth should a “small” brewery or a “small” producer of soft drinks then attempt to increase the share of drinks in reﬁllable containers? It is clear that the Tragedy of the Commons drives this result (cf. Subsection 5.3.3): there is a discrepancy between individual and social rationality. And even the threat of a mandatory deposit fee did not overcome the incentives provided by the Tragedy of the Commons. As the actions of each producer or consumer have only a negligible inﬂuence on the environment, the Tragedy of the Commons “overrides” environmental awareness. A closer look at the regulations in the amended versions of the German Packaging Ordinance does not give the impression that this framework conditions will lead to the desired share of 80% for reﬁllable and ecologically advantageous drinks packages, at least not in the near future. Beyond the advice: “The Federal Government shall conduct the necessary surveys on the respective shares and shall publish the results annually in the Federal Gazette” ([9], Section 1(2)), there are no instruments with which this goal could or should be attained. Thus, the public administration leaves it more or less to chance whether this goal will be achieved or not. Reconsidering the 72% goal of the older versions of the Packaging Ordinance, the credible threat of a mandatory deposit fee did not provide the necessary incentives. Why should these “surveys” help? The section on “Integrated Waste Management” in the next chapter (cf. Section 10.2) will reconsider these incentive-compatibility problems associated with environmental regulations. Before that, however, the following section addresses the

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issue of the economic feasibility or economic reasonableness of a certain commandand-control policy or of certain environmental standards.

9.3 Economic Feasibility of an Environmental Policy Due to the information deﬁcits the economic feasibility of an environmental policy in general or command-and-control policy in particular is a less than straightforward issue. The fact that there is only incomplete information – if any at all – on the details of a Pareto-efﬁcient allocation entails the necessity to come up with some more or less plausible standards, such as the quota of 80% for reﬁllable and ecologically advantageous drinks packaging, or the combined proportion of 72% for reﬁllable containers. In addition to that there should be room for technological innovations for the protection of the environment. Typical examples refer to the promotion of electricity from renewable energy sources, for instance from solar cells. The following subsections provide some ideas about this concept, which plays an important role in the environmental legislation. Even the concepts of “best available techniques” or “best available control technologies” (cf. Subsection 9.1.2) are to some extent related to economic reasonableness.

9.3.1 The Concept of Economic Feasibility As already indicated, there are a number of environmental regulations which refer to the concept of economic feasibility. In Germany, the “Act for Promoting Closed Substance Cycle Waste Management and Ensuring Environmentally Compatible Waste Disposal” (Closed Substance Cycle Act) refers in Article 5 (”Basic obligations of closed substance cycle waste management”) in paragraph 4 to the obligation to recover waste, ”to the extent this is technically possible and economically reasonable, especially when a market exists, or can be created, for an extracted substance or for extracted energy.” Moreover, ”waste recovery is economically reasonable if the costs it entails are not disproportionate in comparison with the costs waste disposal would entail” ([7]). And the Packaging Ordinance also stipulates that “the quantity of packaging actually collected shall be consigned to recovery insofar as this is technically possible and economically reasonable” ([9], Annex I, 1(3)). When, precisely, are “recovery costs not disproportionate in comparison with the costs waste disposal would entail”? One must, ﬁrstly, not expect that each technically feasible substance recycling or energy recovery process is automatically profitable in the economic sense. External effects can imply that an economic loss has to be incurred with these activities. But then again, to what extent is it economically reasonable to accept this loss, to what extent shall the public authorities subsidize these activities? One must not forget that sufﬁciently high subsidies potentially render any economic activity economically proﬁtable.

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These questions can lead to complex considerations, as the example of subsidies for electricity from solar cells in Germany demonstrates (cf. also Section 10.3). These subsidies stimulate not only manufacturers of solar technology in Germany, but also in East Asia, in particular in China. Thus, half of the solar panels installed in Germany in 2010 were produced in Asia. Moreover, the comparatively high subsidy for these technologies increased the number of solar modules installed on German roofs in 2010 by far more than expected. Should Germany therefore restrict the import of these technologies from East Asia in order to protect German manufacturers, or should Germany rather enhance these imports in order to accelerate the process of reductions of global greenhouse gas emissions? These are difﬁcult questions, which for clariﬁcation need some support from economic theory. The model of an economy with environmental effects in the following subsection provides a deeper understanding of this basic issue.

9.3.2 Economic Feasibility: A Formal Analysis The following analysis reconsiders the basic model introduced in Section 5.1 and adds a particular externality, which could be “internalized” with an innovative, but nevertheless costly technology. The question regarding the economic feasibility of this technology arises and has to be answered. The economy allows the production of the two commodities F (“food”) and G (“packaging material”) by means of the scarce factor L (“labor”). Any other factors required for the production of G, such as cellulose content and ﬁbers, are assumed to be available in sufﬁcient quantities without any further costs. The production possibilities will be described by the production functions f : IR+ → IR+ and g : IR+ → IR+ . These functions are assumed to possess all relevant “nice” properties. Thus, they are, in particular, twice continuously differentiable, strictly monotone and concave. Moreover, f (0) = g(0) = 0 is assumed such that the factor L is “essential” for the production of the commodities. The consumers i of this economy are all characterized by the identical, homothetic utility function u(Fi , Gi ; G) for the two consumption commodities Fi and Gi (cf. also Subsection 5.1.1, p. 55, for the concept of a “homothetic” utility function). Utility increases cet. par. with Gi . If, however, the total quantity of G increases, then this exerts a negative external effect on the consumers, a consequence of the increasing pollution of the environment with, for example, discarded packaging material (cf. also [9], Section 1(1)). Within the framework conditions of a market economy there is private property regarding the resources and the means of production, and the market mechanism guides economic decisions and results in a market equilibrium. There is a recycling technology given by the production function gR : IR2 → IR. This technology allows the production of recycled paper with the input of labor and waste paper. It is assumed that the recycled paper is in no way different from the paper produced with the original technology. The following example provides then

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a concrete equilibrium model, with equilibrium and efﬁcient allocation illustrated thereafter by Figure 9.1. Example 9.1. Consider the production functions f (LF ) = 50 · LF and g(LG ) = 2.5 · LG with L¯ = 10 denoting the maximum amount of labor available in a given period of time. u(Fi , Gi ; G) = (Fi · Gi )/(G + 1) is the utility function of the representative consumer i. gR (LR , G) := min(LR , G) characterizes the recycling technology. The equilibrium allocation with external effects and without recycling activities , F , G ) = (5, 5, 250, 12.5) with equilibrium prices p = is given by z = (LF , LG (pL , pF , pG ) = (50, 1, 20). 500

Fˆ

F

300 F 200 100 0

...... ...... ... ...... ... ...... ... ...... ...... .. ...... ... ...... ..... ...... .. ... ...... .. ... ....... ... ........... ... ... ....... ... ... ........ ... ...... ... ... ...... ... ... ...... ... ... ...... .. ...... ... . ...... ........ ... ... ...... ..... ... ...... .... ... ... ...... .... ... ... ...... ..... ... ...... ..... ... .. . ........... ... . ........... ... ... ........... ... ... ......... ... ........ ..... ..... ........ ..... ....... ......... ..... ..... ..... ........... ..... ............. ..... .............. ..... ...... ........ ...... ...... ......... ...... ...... .......... ...... .. ...... ....... ...... .......................... ....... ................ ...... ........ .............. ...... ........ .... ...... ......... ...... .......... ...... ........... ...... ............ ...... .............. ...... ................ ...... ..................... ............................ ........ ......................... ...... ............................ ...... ...... ...... ...... ...... ...... ...... ...... ...... .

u

Ecient Allocation

(pG , pF )

u Equilibrium

Aggregate Supply Set

0

ˆ G

10

G

15

20

25

G Fig. 9.1 Feasible allocations without recycling activities

Figure 9.1 demonstrates the effect of the externality on the equilibrium allocation, which is no longer efﬁcient in this case. Efﬁciency requires a smaller quantity of the polluting commodity G.

Note 9.1. In order to obtain the equilibrium for this model economy determine ﬁrst equilibrium prices through the zero proﬁt condition (cf. Note 5.3 in Subsection 5.1.2). This yields p = (pL , pF , pG ) = (50, 1, 20) with pL normalized to 50. From the ﬁrst-order conditions for utility maximization one obtains: −

uF (F , G ; G ) G dG 1 G |F = = = = . dF 20 uG (F , G ; G ) F 500 − 20G

The equilibrium commodity bundle (F , G ) = (250, 12.5) is located on the transformation curve with MRS equal to MRT. One has, however, to observe that, by assumption, the total quantity of the commodity G, which enters the

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nominator of the utility function and which constitutes the externality, cannot be inﬂuenced by the consumer (cf. Deﬁnition 5.4 in Subsection 5.2.3).

At these equilibrium prices, the recycling technology will not be applied, at least not without any further subsidies. This holds even for a costless collection of the free waste paper, which is required as input in the recycling technology: the production of one unit of recycled paper requires one unit of labor at a cost of pL = 50 units of money, whereas revenue amounts only to pG = 20 units of money. Moreover, the efﬁcient allocation the√application of the recycling tech√ √ without ˆ = (20 26( 26 − 1), 26 − 1) ≈ (418.0, 4.1) with assoˆ G) nology is given by (F, ˆ Gˆ + 1). This commodity bundle results ciated factor quantities. Therefore, Fˆ = 20G( from maximizing utility u(F, G; G) = F(G) · G/(G + 1) with G considered variable. The indifference curve associated with the efﬁcient consumption bundle intersects the transformation curve, which corresponds to the budget line of the representative consumer for this case with identical and homothetic utility functions. Moreover, this indifference curve is also located below the one passing through the equilibrium consumption bundle. This is a consequence of the externality and does not contradict the assumed monotonicity √ of the utility function. Introducing a Pigou Tax tˆG = 20 · ( 26 − 1) on the consumption of commodity G internalizes the external effect and leads, in equilibrium, to the efﬁcient allocation √ with consumer prices pˆ = ( pˆL , pˆF , pˆG ) = (50, 1, 20 26). As the producer price is still given by pˆG − tˆG = 20, there is no incentive to apply the recycling technology,6 even in this case with the externality internalized (cf. Chapter 6 for the concept of internalizing an external effect).

ˆ as an equilibrium, ˆ G) Note 9.2. In order to obtain the efﬁcient allocation (F, the consumer prices ( pˆF , pˆG ) have to fulﬁll the following ﬁrst-order condition: −

ˆ G) ˆ ˆ G; dG pˆF uF (F, Gˆ 1 |Fˆ = = = = . ˆ ˆ ˆ ˆ ˆ dF pˆG uG (F, G; G) F 20(G + 1)

The concrete value of the Pigou Tax then follows immediately from the zero proﬁt condition: √ ˆ pˆF = 1 and pˆG − tˆG = 20, yielding tˆG = 20 · ( 26 − 1) = 20 · G. As usual in these contexts, the revenue from the Pigou Tax has to be redistributed to the consumers in a lump sum way.

6

It is assumed here that any consumption of paper is taxed identically, regardless of the production process.

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A different situation arises, however, if one opens the door for the recycling technology. For the graphical representation in Figure 9.2 it is assumed that LR = 5 units of labor are employed in the recycling technology. Thus, 5 units of recycled paper can be produced out of 5 units of waste paper. This results in a clean environment, no longer polluted by waste paper, and the associated allocation with consumption commodities (F R , GR ) = (250, 5) is Pareto-efﬁcient.7 500 400 300 F

FR 200 100 0

.. ... ... ... ... ... ... ... .. .. ... ... ... ... ... ... .. .......................................................................... ............ . . .... .................... . . .... ........ ........... ...... ..... .... ...... ..... ...... ..... ...... .... ...... ...... ...... ...... .... ...... ...... ....... ... .... ....... ........ ........... .... ......... ...... .......... ...... .... ................. .............. ................... .... ...... .................. .................... ...... .... .................................. ...... ..................................... ...... .... ........... ...... ...... .... ...... ...... .... ...... ...... .... ...... .. ...

u

Ecient Allocation

Aggregate Supply Set

0

GR = 5

10

15

20

25

G Fig. 9.2 Feasible allocations with recycling activities

Note 9.3. The aggregate supply set, given GR = 5, changes as follows: 5 units of labor L remain for the production of the commodities F and G according to the original technologies. This then allows a production of 250 units of F and 12.5 units of G. Adding the 5 units of recycled G, one arrives at a maximum quantity of 17.5 units of G. Taking into account that one needs at least 5 units of waste paper to produce 5 units of the recycled paper leads to the left border of the aggregate supply set at GR = 5, as shown in Figure 9.2. As a consequence, commodity G will, in the efﬁcient allocation, only be produced by applying the recycling technology. The smaller quantity of G in comparison to the market equilibrium is compensated in utility through the cleaner environment. In the case of the efﬁcient allocation above, the waste paper will be completely collected and consigned to recycling. The utility of the representative consumer rises to 1250 from approximately 336 in the efﬁcient allocation without recycling and from approximately 231.5 in the original market equilibrium without recycling. Clearly, the recycling technology is economically feasible or economically reasonable in this context: it allows a Pareto improvement to the previous equilibrium allocation and 7

This result is not straightforward and requires some calculations. One arrives at the solution by determining the maximum achievable utility level uR (LR ) depending on the value of LR ∈ [0, 10].

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even to the previous efﬁcient allocation. And this is happening although the recycling technology is costly in the sense that the same amount of labor employed in the regular and in the recycling technology yields a smaller output of recycled paper. In the case of this example, the authorities could simply prohibit the application of the original polluting technology in order to promote recycling. The efﬁcient allocation with consumption bundle (F R , GR ) = (250, 5) results then as equilibrium with prices (pRL , pRF , pRG ) = (50, 1, 50). Alternatively it is possible to introduce a Pigou Tax on the consumption of paper produced with the original technology. With a tax rate of 30 units of money one obR,L ˆ = (5, 5, 0, 250, 5, 0) with ˆ G , F, ˆ Gˆ R , G) tains the equilibrium allocation zˆR = (Lˆ F , Lˆ G R prices pˆ = ( pˆL , pˆF , pˆG , pˆG ) = (50, 1, 50, 50). A superscript “R” refers to quantities of the recycling technology. Of course, one could also tax the employment of labor in the original technology. A tax rate of 75 units of money would again yield the efﬁcient allocation in equilibrium. There is, however, one important issue to observe: economic feasibility as characterized above is not only a technical or technological property. A simple modiﬁcation of the utility functions, for example, can lead to quite a different situation, although the technologies, including the recycling technologies, remain the same. Example 9.2. The modiﬁed utility ui (Fi , Gi ; G) = Fi Gi /(0.1G + 1) weakens the perception of the external effect – the consumers are scarcely irritated by the pollution through the packaging waste – and results in an efﬁcient allocation, which does not make use of the recycling technology. In other words, the recycling technology is not economically feasible or economically reasonable in this context and should, therefore, not be applied.

Note 9.4. For the case of the slightly modiﬁed utility function ui (Fi , Gi ) = ˜ ≈ ˜ G) Fi Gi /(0.1G + 1) one obtains the efﬁcient consumption bundle (F, (325.83, 8.71). The associated utility level is u˜ ≈ 1516.68. Considering the maximum attainable utility as a function of LR , the amount of labor employed in the recycling technology, demonstrates that any application of the recycling technology leads only to a lower utility level. Of course, the collection of a larger share of the waste paper could lead to higher costs with a convex cost curve, for example. A non-linear relationship between labor input and production would result with different outcomes for the economic feasibility of the recycling technology. What can one learn from these considerations? The following items attempt to highlight the most important conclusions: • The concept of economic feasibility of an environmental policy in general or a recycling technology in particular should be related to the possibility of attaining a Pareto-superior allocation.

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• Economically reasonable (recycling) technologies need not necessarily be profitable from an economic point of view. • Public authorities must, in general, support the introduction of an economically feasible technology through appropriate measures. • Technological feasibility of a certain process of substance recycling does not necessarily entail the economic feasibility of this recycling process. • An innovative technology, which is technically and economically feasible in one country, need not be economically feasible in another country. Especially this last item is important in the context of exporting environmental technologies to developing countries. It should be observed that the economic feasibility of an environmental technology in an industrialized country does not automatically imply the economic feasibility of the same technology in a developing country.8 Another issue refers to the need of supporting the introduction of an economically feasible technology through subsidies or some other instrument. This is, of course, in contrast to the situation of innovative technologies in a market economy, which are not affected by externalities. In this case, the concept of economic feasibility just means economic proﬁtability, as there are no external effects, which have to be taken into account in the evaluation. Therefore, the success on the market alone will decide on the economic feasibility of this technology. However, as soon as there are external effects, as is the case with environmental technologies, economic proﬁtability need not be necessary for economic feasibility.9 Summarizing the results obtained so far, the following deﬁnitions of the “economic feasibility” of an environmental policy, such as the promotion of renewable energies or a standard for recycling activities in waste management, could be considered: Deﬁnition 9.1 (Theoretical Approach). Assume that an environmental policy affects the well-being of the economic agents in a market economy. a)

An environmental policy is economically reasonable or economically feasible in a weak sense, if its implementation allows a Pareto improvement to the current economic situation. b) An environmental policy is economically reasonable or economically feasible in a strong sense, if its implementation allows a Pareto improvement to all Paretoefﬁcient allocations of the current economic situation.

The differentiation regarding a weak or strong economic feasibility results from the fact that there are usually many market equilibria and many Pareto-efﬁcient alloca8

Simple and well-known examples are provided by sophisticated technologies for waste collection and waste treatment, which can destroy jobs for unskilled labor when they are exported to developing countries. Somewhat less straightforward examples refer to the intensive promotion of renewable energy from solar cells in countries with, for this purpose, suboptimal climatic conditions. 9 Of course, environmental technologies can also be proﬁtable. This is usually the case, when a technology helps to save on resources and therefore implies lower factor costs. In this case, cost savings yield a proﬁt, and utility gains through external effects need not be taken into account explicitly.

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tions in a market system. This does not happen in Examples 9.1 and 9.2 because of the assumed identical and homothetic preferences. Therefore, the recycling technology in Example 9.1 is economically feasible in the strong sense. Observe in addition that these deﬁnitions do not address the issue of “proﬁtability” in whatever sense. To be more precise, economic feasibility refers only to enhancing the well-being of the economic agents, which is the purpose of the economic system in general. The next subsection attempts to “transfer” these results to a practical context. How can one make use of these concepts of economic feasibility in real-life applications? The tools of the cost-beneﬁt analysis will thereby prove helpful.

9.3.3 Economic Feasibility in a Practical Context Assume that the economic reasonableness or the economic feasibility of an environmental policy has to be investigated. Thus, according to Deﬁnition 9.1, one has to check, whether this policy allows a Pareto improvement to the current state of the economy. Cost-beneﬁt analysis provides the necessary tools for such an investigation. The main concept of cost-beneﬁt analysis is the “criterion of a potential Pareto improvement”, which is, of course, related to the “Pareto Criterion”. In contrast to the regular Pareto Criterion, this modiﬁed criterion allows a comparison of different feasible allocations.10 Without going too much into the details, this criterion depends on the “willingness to pay” for a change in the economic system resulting from a certain environmental policy. Thus, consumers are asked how much they are willing to pay for a policy with a positive effect on their utility. Alternatively, they are asked for the compensation they need in order to accept the (negative) effects of a certain policy. Summing up these positive and negative amounts leads to a positive or negative “project value”. If this is positive, then the project is, according to the criterion of a potential Pareto improvement, worth carrying out. Then those who gain from the project could compensate those who lose.11 Given Arrow’s impossibility theorem (cf. Subsection 4.2.2 and [13] for more details) it is clear that this “criterion of a potential Pareto improvement” has some ﬂaws, which shall, however, not be discussed here (cf. again [1]). One arrives at the following “practical” deﬁnition of economic feasibility: Deﬁnition 9.2 (Practical Approach). Assume that an environmental policy affects the well-being of the economic agents in a market economy. This policy is economically reasonable or economically feasible from a practical point of view, if its implementation is justiﬁed on the principles of a cost-beneﬁt analysis. 10 Feasible allocations can only be compared by means of the Pareto Criterion, if all consumers are better off in one of the allocations (cf. Section 4.2). 11 This is just a short and rather incomplete introduction to the basic principles of cost-beneﬁt analysis. For a more concise presentation cf., for example, [1].

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The evaluation of the economic feasibility of environmental policies by means of a cost-beneﬁt analysis is the central topic of a study of the OECD in 2005 ([14]). This study familiarizes the reader with the various methods and discusses the challenges that arise with their application to practical problems. These remarks close this chapter. The next chapter considers a variety of applications of the results obtained so far. These applications refer to extended producer responsibility, integrated waste management and renewable energy resources. These policy areas, which count among the integrated approaches, comprise an interesting mixture of command-and-control aspects in general, and framework conditions and standards in particular, supplemented with principles of PFI.

References 1. Boardman A et al (2010) Cost-beneﬁt analysis, 4th edn. Pearson, London 2. Canada (2010) Bottle bill resource guide http://www.bottlebill.org/legislation/canada/ontario.htm. Cited May 2011 3. Canada (2010) The Beer Store: responsible stewardship 2009-2010 http://www.thebeerstore.ca/sites/default/ﬁles/widget/right/Stewardship%20Report%202010_0.pdf. Cited August 2011 4. Canada (2010) Who pays what: an analysis of beverage container recovery and costs in Canada. CM Consulting, Peterborough, Ontario http://www.bcmb.ab.ca/pdf/Who_Pays_What_2010.pdf. Cited August 2011 5. Germany: Federal Environmental Agency (”Umweltbundesamt”) http://www.umweltbundesamt.de/luft-e/index.htm. Cited May 2011 6. Germany (1998) Ordinance on the avoidance and recovery of packaging wastes (Packaging Ordinance – Verpackungsverordnung), amended 1998 7. Germany (2006) Act for Promoting Closed Substance Cycle Waste Management and Ensuring Environmentally Compatible Waste Disposal, amended 2006 http://www.bmu.de/ﬁles/pdfs/allgemein/application/pdf/promoting.pdf. Cited May 2011 8. Germany (2009) Federal Immission Control Act (BImSchG), amended 2009 http://www.bmu.de/ﬁles/english/pdf/application/pdf/bimschg_en_bf.pdf. Cited May 2011 9. Germany (2009) Ordinance on the avoidance and recovery of packaging wastes (Packaging Ordinance – Verpackungsverordnung), amended 2009 http://www.bmu.de/ﬁles/pdfs/allgemein/application/pdf/verpackv_5aenderung_en_bf.pdf. Cited May 2011 10. Germany (2011) Gesellschaft für Verpackungsmarktforschung mbH: GVM Blickpunkt, Juni 2011, http://www.gvmonline.de/pdf/infocus/2011-06_MoevE2009_de.pdf. Cited July 2011 11. Germany (2011) Gesellschaft für Verpackungsmarktforschung mbH: GVM Blickpunkt, June 2011, http://www.gvmonline.de/pdf/infocus/2011-06_EWMW2009_en.pdf. Cited July 2011 12. Hellowell M, Pollock AM (2007) New development: The PFI: Scotland’s plan for expansion and its implications. Public Money & Management 27:351-354 13. Kreps, DM (1990) A course in microeconomic theory. Harvester Wheatsheaf, New York 14. OECD (2005) Analytical framework for evaluating the costs and beneﬁts of extended producer responsibility programmes. OECD, Paris http://www.oecd.org/ofﬁcialdocuments/displaydocument/?doclanguage=en&cote=env/ epoc/wgwpr(2005)6/ﬁnal. Cited May 2011 15. US (2004) Clean Air Act, amended 2004 http://epw.senate.gov/envlaws/cleanair.pdf. Cited May 2011

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16. US (2008) Container Recycling Institute (2008) Wasting and recycling trends: conclusions from CRI’s 2008 beverage market data analysis http://www.container-recycling.org/assets/pdfs/reports/2008-BMDA-conclusions.pdf. Cited May 2011 17. US (2010) Container Recycling Institute http://www.container-recycling.org/facts/glass/decline.htm. Cited May 2011 18. Wiesmeth H (2008) Investment opportunities in waste management through the Private Finance Initiative. Investment Research and Analysis J 3:1-13 19. Wiesmeth H, Häckl D (2011) How to successfully implement extended producer responsibility: considerations from an economic point of view. Waste Management & Research (accepted for publication)

Chapter 10

Integrated Approaches to Environmental Policy

Abstract Integrated approaches to environmental policy are, in principle, derived from economic theory in general and from the theory of environmental economics in particular. In a theoretical context, all economic activities are focused on the efﬁciency of the feasible allocation, resulting, for example, from the market mechanism. In a practical context with all the informational requirements in view of the information deﬁcits, a holistic approach to environmental policy seems to be appropriate. Such an approach implies the adequate integration of signals along the product chain into the environmental policy. This chapter then contains integrated approaches to environmental product design in the context of extended producer responsibility (EPR), to waste management (IWM) and to the promotion of renewable energy sources for the generation of electrical energy.

10.1 Extended Producer Responsibility (EPR) According to guidelines of the OECD, extended producer responsibility (EPR) is deﬁned as “an environmental policy approach in which a producer’s responsibility for a product is extended to the post-consumer stage of a product’s life cycle” ([19], p. 9, or [23], p. 1). Thus, again according to the OECD ([19], p. 9), “an EPR policy is characterized by: 1. the shifting of responsibility (physically and/or economically; fully or partially) upstream toward the producer and away from municipalities; and 2. the provision of incentives to producers to take into account environmental considerations when designing their products. While other policy instruments tend to target a single point in the chain, EPR seeks to integrate signals related to the environmental characteristics of products and production processes throughout the product chain.” In most cases, EPR is meant to provide incentives for producers for a design for environment (DfE), such that, for example, their products can more easily disassembled H. Wiesmeth, Environmental Economics: Theory and Policy in Equilibrium, Springer Texts in Business and Economics, DOI 10.1007/978-3-642-24514-5_10, © Springer-Verlag Berlin Heidelberg 2012

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after the product’s life time. Clearly, when DfE focuses only on the post-consumer stage of a product, inconsistencies may arise with the holistic approach of EPR: heavier components in car manufacturing may be the consequence, if recycled or recyclable materials have inferior mechanical properties ([13], p. 21). So, what is more important in this context: recyclable components or fuel consumption? This and related issues will not be addressed here. The reader is referred to other publications, such as [25] and the literature cited there. Moreover, EPR is often considered an approach to environmental policy in quite diverse areas. For example, EPR plays a role in car manufacturing (cf. again [13]), in waste management in general and in various areas of waste management, such as the consumption of sales packaging (cf. Section 10.2) or waste electrical and electronic equipment (WEEE), in particular. As each area has its own specialities, the following presentation will concentrate on WEEE, on extended producer responsibility regarding so-called “ewaste”. The situation in various countries will be investigated in a comparative way to ﬁnd out similarities and differences, which will then be related to the incentive structure of the framework conditions. Special attention will thereby be paid to the feasibility of the intended holistic approach.

10.1.1 General Aspects of Waste Electrical and Electronic Equipment (WEEE) The rate of e-waste is growing at an alarming rate, especially in the industrialized countries where markets continue to be ﬂooded with an ever increasing number of electronic products. Most innovative technologies introduced into the markets nowadays contain electronic parts, and existing equipment will fast be upgraded with digital technology.1 The resulting large quantities of WEEE and the wide variety of materials they often contain, some of them hazardous to both humans and the environment, has recently focused attention on how WEEE is handled, generated and ways in which it can be prevented. Ongondo et al. ([20]) provide a survey on the global developments and the future perspectives regarding WEEE with all indicators pointing to further increases in practically all parts of the world. Their study shows also that different countries set different priorities to meet the challenges posed by WEEE, in particular the potential effects on health and environment. Unsafe handling of WEEE characterizes the situation in most developing countries in Asia and Africa, aggravated by legal and illegal exports to those countries (cf., for example, [15]). The major concern for the industrialized parts of the world lies in the potential impact of WEEE on the environment due to the comparatively large amounts of WEEE that are still landﬁlled. Of course, the concrete legal framework regarding WEEE has a great inﬂuence on handling e-waste in a certain country, in particular on the collection rate, on re1 Consider, for example, the technological challenges accompanying the increasing generation of electrical energy by means of renewable energy sources. The term smart energy comprises some of these aspects, which are substantially dependent on electronic components.

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cycling processes and recycling quota. Moreover, signiﬁcant differences between countries may induce legal and illegal exports (cf. again [20] for more details). The most interesting question in the context of this section on EPR is, of course, the extent of the integration of the signals along the product chain into the framework conditions to attain and maintain the relevant environmental standards. The examples in the next subsection, partially taken from [20], will show that these framework conditions are not yet functioning properly in most countries. The legal situation for e-waste in the EU is dominated by the European Directive on WEEE, which was enacted in 2003 and which was last amended in 2008 (cf. [2]). Its purpose is, “as a ﬁrst priority, the prevention of waste electrical and electronic equipment (WEEE), and in addition, the reuse, recycling and other forms of recovery of such wastes so as to reduce the disposal of waste. It also seeks to improve the environmental performance of all operators involved in the life cycle of electrical and electronic equipment, e.g. producers, distributors and consumers and in particular those operators directly involved in the treatment of waste electrical and electronic equipment” ([2], Article 1). This therefore deﬁnes the general goal of the directive with the standards given only qualitatively. The relationship to EPR and, in particular, to DfE, is provided by Article 4 of the Directive, which states: “Member States shall encourage the design and production of electrical and electronic equipment which take into account and facilitate dismantling and recovery, in particular the reuse and recycling of WEEE, their components and materials. In this context, Member States shall take appropriate measures so that producers do not prevent, through speciﬁc design features or manufacturing processes, WEEE from being reused, unless such speciﬁc design features or manufacturing processes present overriding advantages, for example, with regard to the protection of the environment and/or safety requirements” ([2], Article 4). The Directive then requires manufacturers and importers of electrical and electronic equipment in the member states of the EU to take back these products from the consumers for appropriate treatment: “Member States shall ensure that producers or third parties acting on their behalf, in accordance with Community legislation, set up systems to provide for the treatment of WEEE using best available treatment, recovery and recycling techniques. . . . For the purposes of environmental protection, Member States may set up minimum quality standards for the treatment of collected WEEE . . . ” ([2], Article 6), with further standards referring to recovery and recycling rates depending on the category of WEEE (cf. [2], Article 7). Provisions for ﬁnancing the collection and treatment of WEEE – through the producers in the ﬁrst place – and the dissemination of relevant information for the users of this equipment regarding separate collection and proper disposal conclude the directive (cf. [2], Articles 8 and 10). Of course, the European Directive had to be implemented in the member states of the EU through individual legal acts. In Germany, for example, the “Act Governing the Sale, Return and Environmentally Sound Disposal of Electrical and Electronic Equipment” (ElektroG) ([6]) implemented the directive into German law in 2005. In the UK, the implementation of the directive came into effect in 2007 with “The Waste Electrical and Electronic Equipment Regulations 2006” ([22]).

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In Japan, the “Home Appliance Recycling Law” was introduced in 2001. Under this law, manufacturers and importers are required to take back their discarded products, to dismantle them and to recover the components and materials that can be reused or recycled with differentiated recovery rate requirements of between 50% and 70% by weight for certain products. Moreover, a surveillance system allows consumers to monitor collection and treatment of their WEEE (cf. [20], p. 720f.). Owners of electrical and electronic equipment in the US seem to stockpile the used products for various reasons, among them, probably, convenience and sufﬁcient storage capacity. Management of WEEE in the US is, in general, established on the level of the states or the municipalities with special and sometimes voluntary WEEE take-back initiatives (cf. again [20], p. 723f.). Until recently, many Australians used to dispose of their WEEE in the domestic garbage collection with WEEE regularly ending up on landﬁlls. With the “National Waste Policy”, enacted in 2009, changes are ahead with a free-of-charge return of WEEE to a collection place and treatment. By 2021, 80% of all televisions and computers are expected to be consigned to recycling ([20], p. 725).

National Waste Policy – Australia, 2009 “Television and Computer Product Stewardship” (excerpt from [1]) The new national television and computer recycling scheme is a key part of Australia’s new National Waste Policy. Council has agreed that the Australian Government will develop and implement requirements under the National Product Stewardship Framework to ensure that manufacturers and importers of televisions and computers establish an efﬁcient and effective national scheme (or schemes) for collecting and recycling their end of life products. The Decision Regulatory Impact Statement on Televisions and Computers sets out a recommended approach to address end of life televisions and computers. Under the proposed scheme(s), manufacturers and importers will be responsible for recycling all products they sell in Australia. The regulatory support will ensure industry non-participants comply with the same standards as voluntary industry participants. Public consultation will be a vital part of ﬁnalising the new product stewardship arrangements and will be held during 2010.

This brief survey on WEEE handling, collection and treatment in a selection of industrialized countries illustrates the range of the practical approaches, both with respect to the legal framework and the relevance of the environmental issue under certain geographical, social and economic conditions. Not surprisingly, those countries, such as the US or Australia, with sufﬁcient possibilities for landﬁlling, tend to have fewer regulations regarding WEEE. Industrialized countries with relative high population densities, such as the member states of the EU or Japan, are much characterized by rather more detailed regulations with comparatively strict enforce-

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ment. This shows once again the importance of the “perception” of an environmental problem, which seems also to depend, at least in the case of WEEE handling, on geographical conditions (cf. Subsection 4.1.1). A look at developing countries such as Nigeria, for example, reveals, in general, a lack of WEEE legislation in combination with ineffective enforcement of existing regulations, if there are any at all ([20], p. 721f.). In these cases, environmental awareness is not yet sufﬁciently developed to produce effective environmental legislation. In addition to that, digital equipment, which is no longer deemed usable in the industrialized world, may be valuable in developing countries. This renders the problem of differentiating between WEEE and reusable equipment difﬁcult, contributing thus to the problem of legal (reusable commodities, in general) and illegal exports (hazardous e-waste components, in general) of WEEE to developing countries. However, WEEE poses an environmental problem not only in developing countries, quite a few of the industrialized countries are also still some distance away from a truly satisfactory solution – despite the detailed and sophisticated regulations in most of these countries. Avoidance strategies and compliance with the regulations remain the critical issues. The following subsections investigate the EPR approaches to handling WEEE both in Germany and in Japan. According to the philosophy of the integrated approach, special attention will be paid to the question of the “integration of all relevant signals along the product chain” into the WEEE regulations.

10.1.2 EPR Approach to WEEE in Germany The brief experience with the German “ElektroG” is nevertheless sufﬁcient to reveal some obvious shortcomings – in relation to the objectives and to the principles of EPR policy. There is, ﬁrst of all, a lack of compliance with some of the regulations. For example, despite the requirement that “owners of WEEE are required to place it in a collection separate from that for unsorted domestic waste” ([6], Article 9), 1% of the municipal waste in Germany consists of discarded small electrical and electronic appliances, which can constitute more than 50% of the total heavy metal load in household waste with possibly severe consequences for the mechanical-biological treatment of waste and the groundwater ([16], p. 116ff.). In addition to that, substantial amounts of WEEE are exported – not always legally, i.e., in compliance with the regulations of the ElektroG (cf. [6], Article 12 (4)), which are in principle based on the “Basel Convention of 22 March 1989 on the Control of Transboundary Movement of Hazardous Wastes and their Disposal”. Thus, for example, according to a study of the German Federal Environmental Agency (UBA), in 2008 “the quantity of exported monitors is of the order of 50,000 t (weighted average; range from 28,000 t to 76,000 t). This corresponds to ca. 2 million appliances. Also for this type of equipment the investigations revealed that they can hardly be new equipment but a relevant portion is assumed to be in

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a very bad state. For comparison: in the year 2006 315,000 t of new equipment of collection group 3 (IT and telecommunication equipment) came onto the market in Germany and 102,000 t were collected separately in the system in accordance with the ElektroG” ([10], p. 7). Clearly, all this is happening because there are other strategies which seem to be more convenient for the producers and the consumers than those recommended or prescribed by the ElektroG. Thus, the ”Tragedy of the Commons” may induce consumers to dispose of small WEEE in the domestic waste, and a lack of information may motivate them to “donate” their WEEE to private “collectors”. Moreover, the export activities regarding WEEE seem to be more proﬁtable – due to higher trading prices in the destination countries – than the costly, but presumably environmentally safe treatment in Germany. The relevant signals of the product chain taken into account by the ElektroG ([6]) are the following: • Product Design: Article 4 of the ElektroG postulates: “Electrical and electronic equipment should, wherever possible, be designed to provide for and facilitate its disassembly, recycling and recovery, and particularly the reuse and recycling of WEEE and its components and substances. . . . ” The problem with this provision is that commodities can be valuable enough to be reused in some developing country, but not in the country of origin. • Separate Collection: According to Article 9, a separate collection of WEEE is required. However, without strict enforcement, consumers will not necessarily comply with this regulation. As explained in Subsection 5.3.3, this kind of behavior need not be in contradiction to a high environmental awareness. It results from individual rationality, which is not in line with collective rationality in this context. • Take-Back System: Paragraph 8 of Article 9 demands that “producers may choose to set up and operate individual or collective take-back systems for WEEE from private households . . . ”. Clearly, producers can proﬁt from a smaller return of WEEE, and will therefore not demonstrate explicitly against exports of WEEE or low returns from the private households. This is in agreement with the observation that these regulations do not sufﬁciently promote individual producer responsibility, considered as a further development of EPR (cf. [21], p. 6). These are probably the most important signals from the ElektroG, covering the product chain from design to take-back requirement and collection including treatment. However, what is missing is a connection between these signals: they scarcely affect each other. For example, the issue of product design, DfE, is not sufﬁciently linked to the collection rates or to the take-back requirement and vice versa. Moreover, the incentives of the owners of WEEE for separate collection are hardly inﬂuenced by the take-back requirement or the product design. It seems as if both producers and consumers were better off with a lack of compliance to return WEEE properly and with exports of WEEE to developing countries.2 So, what should be changed in 2

This follows from the fact that both groups of economic agents would act in accordance with the ElektroG, if it were really in their interest.

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order to arrive at framework conditions which integrate the various signals consistently? Wiesmeth/Häckl (cf. [25]) provide a short outline of an incentive-compatible framework. The basic idea of their approach is to pay owners of WEEE a refund for returning e-waste to an ofﬁcial collection point. Of course, the refund has to depend on the category and on some other basic characteristics such as the degree of difﬁculty to disassemble the equipment and perhaps the market value of the recyclable substances. Then there should be a “compliance scheme”, similar to the compliance schemes for packaging waste in Germany (cf. Section 10.2), which takes back WEEE and consigns it to treatment and recycling. This compliance scheme receives mandatory fees from the manufacturers, which also depend on the characteristics of the products mentioned above. Moreover, this scheme issues the refunds to the consumers. The consequence is a sequence of signals from the product chain, which are bound together: the consumers have a stronger incentive to return WEEE; as the refunds depend on certain characteristics of the WEEE, prices of the new product and the fees to the compliance scheme will be affected as well, and producers have an incentive to change the design of their products, to switch to DfE. Thus, there is a closed loop of signals from product design to take back and recycling, which even helps to reduce illegal exports of WEEE, if the refunds and the fees are set appropriately. In addition to that, this procedure opens, in the sense of PFI, investment opportunities for recycling companies and companies to operate the compliance scheme. The standards regarding collection and recycling rates can be achieved through adjusting the refunds and the fees.3

10.1.3 EPR Approach to WEEE in Japan The “Home Appliance Recycling Law” (HARL) came into effect in Japan in 2001. Before that almost 50% of used consumer electric goods ended up in landﬁlls, with the other half also ending up in landﬁlls after having been crushed by a shredder and having had some precious metal parts removed. The experience with the HARL so far is that again about half of the used home appliances are exported to various developing countries in Asia, mostly as second-hand goods ([20], p. 720). This is certainly not in accordance with the objective of the law, as formulated in Article 1: “This legislation shall have the objective of contributing to the maintenance of the living environment and the healthy development of the national economy, by taking steps to secure the proper disposal of waste and effective utilization of resources through the introduction of measures for proper and smooth collection, transportation, and recycling of speciﬁc household appliance waste by retail traders or manufacturers of speciﬁc household appliances, with the aim of achiev3

The system of fees and refunds has to be balanced in order to reduce incentives for presumably unwanted strategies, excessive imports of WEEE to Germany, for example.

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ing a reduction in the volume of general waste and sufﬁcient utilization of recycled resources” ([17], Article 1). The question is again, why is this happening? What speciﬁc regulations in the HARL motivate consumers and producers to act this way? A closer look at some of the articles reveals the problematic points of HARL, which is a typical commandand-control policy: • Responsibility of Manufacturers: Article 4 of HARL postulates: “Persons who undertake the manufacture of speciﬁc household appliances as a business . . . must also endeavor to minimize the expenditure required for recycling speciﬁc household appliance waste, by enhancing their design of speciﬁc household appliances and their choice of components and materials.” The obvious question is, of course, who can control this “responsibility” and why should manufacturers have much of an incentive to act accordingly? It is true that consumers have to pay a recycling fee which somehow depends on recycling costs. But whether this fee, which is approximately 20 Euro for a washing machine, for example, is really decisive for the purchase of a particular brand, has to be questioned. • Obligation to Collect: Article 17 requires that home appliances be taken back: “Manufacturers must, when requested to collect speciﬁc household appliance waste pertaining to speciﬁc household appliances which they themselves have manufactured . . . , collect the said speciﬁc household appliance waste from the person who has requested collection, in a place designated in advance by the said manufacturer as a place for the collection of speciﬁc household appliance waste . . . , unless they have just cause not to do so.” Again, there is, clearly visible, the command policy at work. Manufacturers will, of course, collect the used equipment, when asked to do so. However, they will, in general, not do more. • Charges for Fees: Finally, Article 19 speciﬁes the regulations for fees: “Manufacturers may, when requested to collect speciﬁc household appliance waste, charge a fee from the person requesting the collection of the said speciﬁc household appliance waste, with respect to acts necessary for recycling the said speciﬁc household appliance waste.” This mandatory recycling fee thus does not particularly stimulate compliance with the regulations, it rather encourages avoidance strategies from both consumers and producers. HARL certainly considers signals from various steps of the product chain. They are, however, not integrated, they are (almost) not linked to one another. If, for example, a used home appliance can be exported as a second-hand commodity then producers are not in charge of recycling it and consumers do not have to pay the recycling fee. Of course, producers will not get the recycling fee either, but due to competition this fee, which has to be announced publicly, will probably not be sufﬁcient to cover the recycling costs. So, the chain of incentives breaks apart. A restructuring of HARL would again start with the consumers at the “top of the chain”. They should be refunded as recommended in the context of the German “ElektroG” (cf. Subsection 10.1.2), and a compliance scheme, ﬁnanced through appropriate and differentiated fees by the manufacturers, should take over the task of collecting and recycling the home appliances. Then consumers have an incentive to

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return used home appliances to collection points and producers have an incentive for DfE, and both consumers and producers will refrain form exporting used appliances. In addition to that the HARL should be extended to include not only the major home appliances such as washing machines, refrigerators, air conditioners, tube television sets and, since 2008, liquid-crystal/plasma television sets and clothes dryers, but all WEEE. A general take-back system with refunds allows the inclusion of further WEEE, especially small WEEE, with potentially hazardous components. In summary, both the German and the Japanese experiences with WEEE demonstrate that consumers and producers act on, or better react rather predictably to the framework conditions provided by a certain EPR policy. For this reason, an integrated approach, which takes into account all signals from the product chain in a holistic approach, is the right way to address the challenges of waste management.

10.2 Integrated Waste Management (IWM) The concept of integrated waste management (IWM) evolved in 1975 from the mission statement of the Solid Waste Authority of Palm Beach County, Florida. According to this statement, the Authority would “develop and implement programs in accordance with its Comprehensive Plan by integrating solid waste transportation, processing, recycling, resource recovery and disposal technologies” ([18], p. 21). Since then the concept has been further developed into a holistic approach to waste management – not unlike the concept of EPR (cf. Subsection 10.1). The following guide to life cycle thinking regarding waste illustrates the key aim of the EU policies on resources and waste:

Life Cycle Thinking and Assessment for Waste Management Waste Management in the EU (excerpt from [3]) Around 3 billion metric tons of waste are generated in the EU each year – over 6 metric tons for every European citizen. This has a huge impact on the environment, causing pollution and greenhouse gas emissions that contribute to climate change. Good waste management can signiﬁcantly reduce these impacts, and Life Cycle Thinking and Assessment can help policy makers choose the best environmental options. A key aim of EU policies on resources and waste is to move to a more resource-efﬁcient and sustainable future. EU policies and legislation on waste highlight the need for good waste management. The Waste Framework Directive establishes the waste hierarchy. This sets an order of priority, starting with the preferred option of waste prevention, followed by preparing waste for re-use, recycling and energy recovery, with disposal (such as landﬁll) as the last resort.

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Following the waste hierarchy will generally lead to the most resourceefﬁcient and environmentally sound choice. However, in some cases reﬁning decisions within the hierarchy or departing from it can lead to better environmental outcomes. The “best” choice is often inﬂuenced by speciﬁc local conditions and care needs to be taken not to simply shift environmental problems from one area to another. Decision-makers need to base their choices on ﬁrm factual evidence. Life Cycle Thinking and Assessment provide a scientiﬁcally sound approach to ensure that the best outcome for the environment can be identiﬁed and put in place.

The following subsections address various aspects of IWM and investigate the German approach to IWM in more detail.

10.2.1 The Concept of IWM in Environmental Economics The above information on life cycle thinking points to some important issues of IWM. Waste management can help to reduce the impacts of waste on the environment, if it is guided by the overarching ideal of life cycle thinking or sustainability. This holistic approach implies that waste management cannot be based on end-ofpipe technologies alone. The waste hierarchy introduced above is the result of such a more integrated approach to waste management. What does all this imply for environmental economics and environmental policy? This subsection addresses ﬁrst the issue of embedding the concept of IWM into environmental economics. Thereafter, instruments to implement IWM will be introduced and investigated, mainly regarding their ecological efﬁciency. In principle, integrated waste management results from a new thinking on waste. More precisely, the economic relevance of waste has become more obvious. On the one hand, there is the environmental pollution associated with all kinds of waste. As an immediate consequence, “waste”, or rather the avoidance of waste, has all the qualities of an environmental commodity. Then there are, on the other hand, the resources, which can be obtained from reusing or recycling certain types of waste. This includes composting of biodegradable waste or generating electrical energy from biogas. Thus, waste turns into a resource containing valuable substances, which can be extracted through recycling. This characterization of “waste” as an environmental and economic commodity has the immediate consequence that waste should be included in the economic allocation problems (cf. Subsection 4.1.2). This implies that answers have to be provided to questions such as: • How much waste do we really “need”? The fact that waste, in general, contributes towards environmental pollution justiﬁes substantial efforts to reduce waste, to prevent waste as proposed in the waste hierarchy of IWM (cf. the remarks on life cycle thinking on p. 167).

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• What to do with waste that cannot be prevented? This question addresses reusable commodities, such as reﬁllable drinks packages (cf. Section 9.2), and recycling activities including energy recovery. The extent of these further options in the waste hierarchy inextricably leads to the question of economic feasibility, as discussed in Section 9.3. The answers to these questions, considered as part of a feasible allocation, will, not surprisingly, depend on the concrete situation in a country, in particular on the current state of the environment, the current state of the economy and the economic growth process, and the innovative potential of the industry. This is relevant for a solution to the allocation problems in general and implies immediately that methods and strategies of (integrated) waste management, which are reasonable in one country need not be meaningful for another one. This result applies in particular to innovative technologies, which allow, for example, a cheap and effective separation of waste after collection in an industrialized country, but may deprive a number of workers in the informal economy of a developing country of their jobs.4 According to the waste hierarchy, the concept of IWM is based on the strategy of the three “R”s: Reduce, Reuse, and Recycle. Material production, cost and energy could be saved by preventing waste, and reusing or recycling more. The problem is then, as discussed above, to identify the “optimal” level of the three “R”s with optimality respecting the situation of a country, and the individual situation of each group of relevant stakeholders. These stakeholders are: • individual households, who as consumers beneﬁt from a clean environment and “green” energy, but also from a sufﬁcient supply of packaging material; • individuals, who proﬁt directly from collecting discarded materials for reuse or recycling purposes; • companies, which proﬁt from recycling activities, but, for example, also from the production or usage of packaging material. Therefore, IWM leaves some room for implementation. This will be investigated in the following subsection, which demonstrates the challenges associated with the practical application of the concept of IWM.

10.2.2 The Implementation of IWM Implementing IWM should assign priority to reduction and reuse strategies, complemented by recycling activities. Assume then that the quota for certain categories of waste to be recovered and recycled are determined according to the requirement 4

Of course, one should nevertheless try to improve the conditions for those working informally on the landﬁlls in many developing countries. For example, a number of NGOs, such as the German “Thüringisch-Kambodschanische Gesellschaft e.V.”, work on this issue on dump sites in Cambodia (cf. [12]).

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of economic feasibility, as discussed in Section 9.3. What does this entail in the context of waste management? The German “Closed Substance Cycle Act” (cf. [4]) addresses this issue in Article 5 (4): “The obligation to recover waste is to be met, to the extent this is technically possible and economically reasonable, especially when a market exists, or can be created, for an extracted substance or for extracted energy . . . Waste recovery is economically reasonable if the costs it entails are not disproportionate in comparison with the costs waste disposal would entail.” Although this last statement is difﬁcult to verify in practical situations, it is nevertheless an integral part of IWM. As recommended in Section 9.3, a cost-beneﬁt analysis on the basis of the available information could help to determine the optimal levels of the various quota. Implementation of IWM then requires appropriate strategies for reduction, reuse and recycling of waste. The possible existence of avoidance strategies is of some importance in this context (cf. also Section 8.1), as well as the integration of the private sector. Waste management, in particular integrated waste management, currently offers a wide range of potentially interesting investment opportunities. They include the simple collection of waste with modern equipment, and segregation of waste at the “source” or with sophisticated machinery at the disposal site. Segregation of waste, on the other hand, is indispensable for recycling activities, which are characteristic for IWM. Of course, recycling itself can be “integrated”, meaning that certain products such as cars, personal computers, and cellular phones are already constructed in a way to enable and simplify disassembling and recycling (cf. Section 10.1 on EPR). Clearly, “integrated recycling” is revolutionizing the production processes with huge potentials of cost savings and ﬁrst-mover advantages for early investors. In addition to that, segregated biodegradable waste can be turned into compost or, alternatively, biogas. The issue of renewable energies (cf. Section 10.4), now recognized all over the world, thus also offers ﬁnancially interesting investment opportunities in waste management. The industry producing biogas plants is ﬂourishing, not only in Germany. However, it does not seem easy and straightforward to reap the beneﬁts of these investment opportunities. What one observes, in particular in the rapidly developing countries, are increasing amounts of waste not accompanied by an appropriate development of the collection and treatment capacities. Often, households face rising collection fees without any fundamental changes in the system of waste management, and households and business companies typically have little incentive to avoid waste, segregate waste at the source and recycle waste. The fact that a substantial part of household waste is biodegradable in these countries aggravates the situation and contributes further towards an unnecessary waste of “natural” and renewable resources. The basic question is therefore: how can one provide reasonable incentives, how can one establish investment opportunities in waste management through appropriate instruments and tools? Obviously, because of the public goods character of the environmental commodities such as clean air, unpolluted soil, clear water, the public sector has to set up appropriate framework conditions. On the other hand, due to the ﬁnancial situation of

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most public administrations it is, however, advisable to bring in private capital. Thus, framework conditions are required which allow a fruitful cooperation between the public and the private sector in the environmentally sensitive area of waste management with potential hazards for public health. The principal idea is that the public sector sets detailed rules to protect the environment and to attract private ﬁnance and private business; the private sector comes in with innovative, fresh ideas and business plans, which ﬁnally support the endeavors of the public sector to protect the environment. In general, the context considered here does not refer to any kind of outsourcing of issues of waste management or contracting in the broader sense with all the ﬁnancial risk and the unsolved environmental problems falling back to the public sector, if the private partner goes bankrupt. Nor does the provision of services at substantially higher cost than originally planned pose a serious problem (cf. [14]). In the sense of a modiﬁed Private Finance Initiative (cf. Subsection 9.1.3) it rather refers to establishing appropriate framework conditions, which allow private companies to set up business and thereby contribute more effectively towards an optimal solution of the allocation problems regarding waste management, towards a solution of the problem of the three “R”s. The next subsections contain some ideas about potential reduction, reuse and recycling strategies.

Implementation of IWM: Reduction Strategies Reduction strategies comprise all approaches a community can use to lower the amount of waste being produced. Typical examples include a variable charge on waste, depending on the weight; a surcharge on excess bags, containers, or household refuse or an incentive program for commercial reduction efforts. But also waste-picking, often observed in developing countries, counts among these reduction strategies. Similarly, segregation of waste at the source can help to reduce waste for depositing or thermal recycling. In this sense, backyard composting reduces the amount of waste disposed in landﬁlls and is a simple waste reduction strategy available to many households. This also refers to small and decentralized biogas plants, which are nowadays not only installed in tropical and subtropical countries to generate electrical energy from renewable sources and to reduce thereby the amount of organic waste. It is important to note that these strategies will in general only work if households or business companies have a personal incentive – which could, but need not be a ﬁnancial remuneration – to get involved in one of these strategies for waste reduction, or if there are no simple strategies to avoid charges or surcharges on waste. Waste-pickers are guided by these incentives, and so are households engaged in backyard composting or biogas generation. A sufﬁciently developed environmental awareness in industrialized countries is certainly of advantage for all these efforts to reduce waste. As prevention of waste requires the commitment and involvement of all citizens, public education is crucial for promoting waste reduction, especially in develop-

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ing countries. In view of the conclusions given above, not all reduction strategies will work equally well in all countries. Charges and surcharges are probably not appropriate for developing countries, as there are obvious strategies to avoid those payments. Composting on a household level will work if these households can use the compost as an alternative to costly chemical fertilizers. Industrial composting requires the existence of markets with adequate prices, otherwise these activities are doomed to fail. Similarly, households will use small biogas plants if they proﬁt directly from the provision of gas which can, for example, be used for cooking or lighting purposes in developing countries. Again, on an industrial level biogas plants will be constructed if there is a sufﬁcient ﬁnancial incentive to provide electrical energy. This is exactly the goal of the German Renewable Energy Sources Act, which supports the generation of electrical energy from renewable sources, in particular from biodegradable waste (cf. Section 10.3).

Implementation of IWM: Reuse Strategies Reuse means using a product more than once, either for the same purpose or for an alternate purpose. Reuse does not require reprocessing and, therefore, has lower energy requirements than recycling. Reuse strategies include, among others, making donations to charity, reusing packaging (including boxes and bags), using empty jars for food storage, and participating, for example, in a paint collection and reuse program. Reuse strategies play some role in the context of waste-picking activities, including selling old tools, machinery and used cars from Germany to households in Central and Eastern Europe for example. However, as discussed in Section 10.1, WEEE is sometimes declared as “reusable” – only to obtain permission for exporting this equipment to developing countries and to thus avoid treatment and recycling costs at home. This demonstrates again the challenges associated with differentiating between waste and reusable commodities. Similar to the case of reduction strategies, also reuse strategies are dependent on appropriate incentives on the level of the individual household or the individual business company. Cost considerations or altruism, as in the case of donations to charity, provide such incentives.

Implementation of IWM: Recycling Strategies The reformation of waste materials into new or similar products by recycling is often viewed as a resource conservation activity. It may, however, offer greater return for many products in terms of energy savings. The interesting issue in this context is the successful creation of markets for products from recycled materials. This is not always an easy and straightforward thing to do. Another means of recapturing value is through the use of the natural biodegradation process as in composting and biogas plants. Finally, there is the possibility

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to incinerate waste and use the heat for energy generation. Although many combustibles are recyclable, there is often a higher total value (due to processing costs) in burning the waste for energy than in material recycling. Often, recyclable materials are contaminated, proposing a cheaper thermal recycling. Also in the case of recycling strategies it is important to have framework conditions which provide the right incentives for individual households and business companies to act accordingly. As already mentioned, these framework conditions have to be dependent on the concrete economical and environmental situation in a country and have to be designed in an incentive-compatible way. There are various examples demonstrating the environmentally damaging and potentially hazardous effects of incentives misguided by false or incomplete framework conditions (cf., for example, the discussion of the framework conditions in the context of the “Reﬁllables Quota Issue” in Section 9.2 or regarding WEEE in Section 10.1). The question is now, how to implement these strategies in a practical context. In particular, how should the framework conditions be conﬁgured in order to stimulate a high level of participation in the reduction, reuse and recycling strategies of an IWM policy? What role could and should the private sector of the economy play in this context? In particular, is there room for PPP or even for PFI? The next subsection contains an analysis of the IWM in Germany. Great attention will be paid to the different tasks for the public and private sectors in IWM (cf. also [24]).

10.2.3 IWM in Germany In Germany, a framework of regulatory measures contributes towards a reduction of municipal solid waste. This set of regulations includes a take-back requirement for packaging waste, the obligation for manufacturers and distributors of sales packaging to take part in a compliance scheme to ensure the collection of sales packaging, and the ban on depositing untreated biodegradable material and municipal solid waste containing organics. As distributors of packaging material can, in general, only partially pass the cost of these measures on to their customers, they have an incentive to reduce sales packaging. In fact, the annual consumption of sales packaging per German citizen has dropped since 1991 in addition to savings in packaging materials due to the reduction in weight, due to the waiver of secondary packaging, and, to a lesser extent, due to reﬁllable packages (cf. Section 9.2 in this context). The integrated approach in Germany rests to a large extent on the “Green Dot” label, which meanwhile is in use in many European countries and abroad. The regulatory framework, in particular the take-back requirement, is provided by the German Packaging Ordinance of 1991, amended in 2009 (cf. [9]). It refers to all kinds of used packaging such as cans, composites, cardboard, and glass containers. The Packaging Ordinance repeats in Section 1(1), the recommendations of the European Directive on Packaging and Packaging Waste: “The purpose of this Ordinance is to avoid or reduce the environmental impacts of waste arising from packaging. Packaging waste shall in the ﬁrst instance be avoided; reuse of packaging, recycling and

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other forms of recovery shall otherwise take priority over the disposal of packaging waste.” Table 10.1 shows that total packaging consumption of households and small business companies in Germany has decreased since 1991. Only the consumption of plastics and paper has since then increased in absolute terms. Taking into account the growth of the German economy would reveal a strongly decreasing packaging intensity (kg of packaging material per unit of GDP). Material Glass recycled% Tinplate recycled% Plastics recycled% Paper recycled% total recycled%

1991 3817.3 53.7 740.8 33.8 976.9 3.1 1834.2 28.0 7646.7 37.3

1994 3504.4 70.1 648 57.5 929.7 49.6 1664.2 57.0 7018.2 61.9

1997 3266.0 83.3 641.5 82.9 937.2 64.1 1722.3 76.3 6845.5 78.2

2000 3318.0 81.7 645.9 79.8 1120.9 58.1 1992.6 77.4 7374.8 76.1

2003 2719.4 85.3 498.4 87.7 1405.9 57.4 2102.7 78.0 7055.3 76.8

2006 2415.8 83.9 450.8 90.6 1751.7 64.7 2037.1 79.0 6962.2 77.1

Table 10.1 Packaging consumption in private households and small ﬁrms in Germany 1991 to 2006 (in kilotonnes). Source: UBA (excerpt from [8]); UBA kindly granted permission to use this table.

The take-back requirement, the obligation to accept returned sales packaging, again follows the prescriptions of the European directive. Section 6(1) of this Ordinance states: “Manufacturers and distributors who put sales packaging ﬁlled with product and typically arising at the private ﬁnal consumer into circulation for the ﬁrst time, shall take part in one or several compliance schemes pursuant to subsection (3) below to ensure the collection of such sales packaging on a full-coverage basis.” Finally, the compliance scheme, which opens interesting and ﬁnancially attractive investment opportunities in this context, is formulated in section 6(3): “A compliance scheme shall ensure adequate regular free-of-charge collection of used and emptied sales packaging from or in the vicinity of the private ﬁnal consumer throughout the catchment area of the obligated distributor on a full-coverage basis . . . A compliance scheme (scheme operator, applicant) pursuant to the ﬁrst sentence above shall consign the packaging entering such a collection system to recovery . . . Several compliance schemes can cooperate in the setting up and operation of their compliance schemes.” Compliance schemes then have to meet certain standards referring to recovery of packaging waste and recycling. Various compliance schemes are currently operating in Germany, among them the Duales System Deutschland GmbH (DSD GmbH), which was established in 1990, and which is still well-known for the “Green Dot”, signaling that a license fee has been paid for collecting and sorting the used packaging material. According to the principles of PFI, the compliance schemes in Germany are owned by private investors. In aggregate, the schemes exceed the standards for recovery and recycling of packaging waste.

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This example from Germany, which can, in variations, also be found in other approaches to IWM, demonstrates that the public and the private sectors can “cooperate” in a way which is beyond the cooperation in traditional public-private partnership projects. In classical PPP projects the public sector typically invites private companies to provide the infrastructure for or manage public utilities such as waste collection, recovery, segregation and recycling of waste. In the case considered here, the public authorities set the framework conditions through directives, acts and ordinances and create an environment, which invites innovators, private capital and private entrepreneurs to set up and operate new companies. In Germany, the crucial point regarding this issue is the take-back requirement for packaging waste in conjunction with the compliance schemes and the recovery and recycling standards as detailed in the Packaging Ordinance. These regulations help to overcome market failure associated with environmental commodities and open the doors for private information to ﬂow in and enrich waste management and thereby environmental protection with manifold new and innovative business ideas. The last section of this chapter considers a particular recycling strategy, the “recycling” of biodegradable waste into electrical energy. Of course, this recycling process belongs to the larger context of renewable energy sources.

10.3 Renewable Energy Sources Intensiﬁed efforts to use renewable energy sources to generate electrical energy are accepted worldwide as a means to reduce greenhouse gas emissions, to cope with global warming. Although this is an international environmental issue it nevertheless has to be addressed on a national, if not regional level.5 This is a consequence of the fact that each consumer, each producer contributes towards the emission of greenhouse gases. In order to promote renewable energy sources on a large scale, the PFI approach seems to be most promising, as in general it does not depend on public funding. The task of the public sector consists again in establishing framework conditions which attract private companies and investors. The approach presented and analyzed below is relevant for Germany and for many other countries. It is substantially based on guaranteed prices for electrical energy from renewable sources. With biodegradable waste as a renewable energy source, there is a close and interesting relationship to IWM, already discussed in the last section. For this reason, the following subsection will refer mainly to biodegradable waste as a renewable energy source, although the results hold also for the other renewable energy sources.

5

It remains true, of course, that only a worldwide consensus on reductions of greenhouse emissions will help to control climate change.

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10.3.1 The German Renewable Energy Sources Act (EEG) The reformation of biodegradable waste or combustible residual waste is considered to be an energy saving activity. As organic waste typically constitutes a signiﬁcant share of municipal solid waste – even in industrialized countries often around 30% – activities to reduce waste by segregating biodegradable components on the one hand and saving energy by turning them into biogas on the other have the potential for offering excellent investment opportunities. As already mentioned, the deposition of untreated biodegradable material and municipal solid waste containing organics is no longer permissible in Germany. The reason is that dumping untreated waste in inadequately lined landﬁlls leads to soil, surface water and groundwater contamination and to emissions of landﬁll gas, another contributor to global warming. Despite all technological progress and innovations, experience seems to show that conventional landﬁlling cannot be made environmentally safe in the long term. This means that biologically degradable waste must be treated before landﬁlling the residual waste. Besides waste incineration, mechanical-biological treatment is a process that can be used to dispose of municipal solid waste in an environmentally sound manner. The variants of the mechanical or mechanical-biological waste treatment process differ in terms of their treatment stages and the material streams which they generate ([7], p. 12f.). In order to prevent biodegradation processes and their associated emissions, pretreatment seeks to biodegrade the organic constituents. In the mechanical stages of the process, high caloriﬁc value fractions such as plastics are removed for energy recovery, and metals are separated for materials recycling. The biological treatment stages use aerobic (rotting), anaerobic (fermentation) or combined processes. Anaerobic processes produce biogas which can be used for energy production – from renewable sources (cf. again [7], p. 12f.). What are, in this context, appropriate framework conditions for private investments? How can the public sector create an environment which attracts private capital while at the same time reducing environmental pollution by treating biodegradable waste and using it for generating energy from renewable sources? In Germany, the Renewable Energy Sources Act (EEG) of 2004, last amended 2010, addresses this issue and helps to attract private ﬁnance to the large-scale generation of energy from renewable sources ([5]). Section 1(1) deﬁnes the goal: “The purpose of this act is to facilitate a sustainable development of energy supply, particularly for the sake of protecting our climate and the environment, to reduce the costs of energy supply to the national economy, also by incorporating external long-term effects, to conserve fossil fuels and to promote the further development of technologies for the generation of electricity from renewable energy sources.” And the Act regulates priority connections to the grid systems for general electricity supply of plants generating electricity from renewable energy sources and the priority purchase and transmission of, and payment for, such electricity by the grid system operators ([5], Section 8). Paragraph 1 deﬁnes a critical part of a market for electrical energy from renewable sources: “. . . grid system operators shall

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immediately and as a priority purchase, transmit and distribute the entire available quantity of electricity from renewable energy sources and from mine gas.” With this regulation the government establishes “demand” for electrical energy from renewable sources: the grid system operators have to buy electrical energy from those providers. In addition to that Section 16 regulates the obligation to pay predetermined fees, to pay a “market price” for electrical energy supplied by renewable sources: “Grid system operators shall pay installation operators tariffs . . . for electricity generated in installations exclusively utilizing renewable energy sources or mine gas. . . . ” ([5], Section 16 (1)). According to the Act the fees paid for electricity produced from landﬁll gas, sewage treatment plant gas and from biomass are ﬁxed: for installations commissioned in 2009, electricity from landﬁll gas and sewage treatment plant gas is 9.0 resp. 7.11 Euro cents per kWh up to and including a capacity of 500 kilowatts ([5], Section 24); and the fees paid for electricity produced in plants exclusively using biomass is 11.67 Euro cents per kWh up to and including a capacity of 150 kilowatts ([5], Section 27). For electricity from solar radiation (small installations attached to or on top of buildings) the feed-in tariff was reduced to 28.74 Euro cents per kWh in 2011 from 43.01 Euro cents per kWh in 2009. The critical components of this “Renewable Energy Sources Act” are therefore the obligation for priority purchases at guaranteed prices. These regulations “motivate” private households and business companies to install solar technology or set up biogas plants, and the thereby perceived “demand” for such equipment initiates research regarding the further development of these technologies. The annual decrease in the guaranteed prices for electricity from new installations contributes toward the development of more effective equipment. The economical and ecological consequences of this attempt to accelerate the application of renewable energy sources will be investigated in the following subsection.

10.3.2 The EEG in Practice Due to the regulations of this Act the construction of biogas plants has meanwhile developed into big business: at the end of 2009 almost 5,000 biogas plants were installed in Germany with a total capacity of 1,900 megawatt, and 16,000 jobs were dependent on the development, construction and operation of these plants, which are delivered to all parts of the world. The export share was 10% in 2009 and is expected to increase to 23% in 2011 – according to the “German Biogas Association”. The framework conditions in Germany for the production of biogas plants and of biogas seem to be optimal. In a more general context, energy from biomass and organic municipal solid waste can make a signiﬁcant contribution to the protection of the environment by reducing the landﬁlling of waste, and to oil-independence and climate protection

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with clean power, heat, and vehicle fuels. And, perhaps even more important, the technology provides access to earning potentials in new markets, both domestic and international, for the waste management and power generation industry. In particular the agricultural sector is gaining increasing importance with all these efforts to raise the share of renewable energy sources. This is of special relevance for developing countries: the World Bank is assisting various countries to prepare projects related to the intensiﬁed application of biomass technology. By installing demonstration plants, the use of biomass-fueled energy systems from agricultural waste is offered as an alternative to gas, oil and coal, and as a sustainable means of addressing the energy supply problems facing rural communities and agro-enterprises in developing countries. The projects will also address the issue of ﬁnancing the gap between the capital cost of biomass and conventional energy systems. This corresponds exactly to the problem of establishing a market for electrical energy from renewable sources by appropriate framework conditions such as guaranteed prices according to the German Renewable Energy Sources Act. There are serious concerns that the increasing number of biogas plants with their increasing demand for energy crops is “crowding out” agricultural land for regular crops, fueling price increases on food markets. Biofuels, which also depend on energy crops, are blamed for the surge in food prices leading to the Mexican “Tortilla Crisis” in 2006. The diversion of corn from ﬂour to fuel raised the price for tortillas. Recent efforts ”to keep the corn on the table rather than in gas tanks” have certainly eased the competition with the food chain. However, this is only the beginning of a more intensive, global cultivation of energy crops as renewable energy sources. Thus, surprises should not be ruled out! As is the case for biogas plants, the development and production of photovoltaic modules has attracted quite a few national and international business companies. In most cases governments have therefore succeeded in providing investment opportunities for private business by tailoring the framework conditions for an increasing use of renewable energies. However, there are some issues to be addressed. First of all, the subsidies for electricity from photovoltaic cells not only stimulated manufacturers of solar technology in Germany, but also in East Asia, in particular in China. Half of the solar panels installed in Germany in 2010 were produced in Asia and obviously proved to be of good quality. Moreover, the comparatively high subsidy for these technologies increased the number of solar modules installed on German roofs in 2010 by far more than expected. This “miscalculation” with respect to the environmental standard leads to the question whether Germany should restrict the import of these technologies from East Asia, as France did last year? Obviously, the publicly communicated goal of promoting renewable energy sources, and the implicit goal of supporting local companies can only partially be achieved jointly with this environmental policy based on guaranteed feed-in prices for electricity from renewable sources.

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10.4 Integrated Approaches: A Summary The sections on extended producer responsibility, integrated waste management and renewable energy sources illustrate the idea of an “integrated approach to environmental policy” in the context of a command-and-control policy: standards such as recovery and recycling quota for packaging materials or WEEE, or shares for renewable energy sources in the generation of electrical energy and gasoline should be attained through policies which respect and integrate signals from the whole product chain. From a more economic point of view, this requires the integration of the environmental issue into the allocation problems. The immediate consequence is that “waste” is no longer considered and treated as waste. A reduction of waste, accompanied by reusing and recycling discarded commodities, helps to save resources and to reduce environmental pollution. However, providing an adequate practical solution to the allocation problems with waste or the reduction of waste as a commodity, is anything but straightforward. The lack of information on the reaction of the economic agents to particular framework conditions or on avoidance strategies creating loopholes can lead to obviously suboptimal results. Moreover, households and business companies can be “misguided” by an inappropriate incentive structure which sometimes leads to surprising outcomes. In addition to that there is no “standard” solution to such a problem, which applies to each part of the world. As is the case for solutions to the allocation problems in general, the optimal solutions depend on the special circumstances in a region. Therefore, another complication arises from the fact that some countries try to “recommend” their solution to their partners in international negotiations on crossborder environmental problems. The insistence on one’s own concept may at least unnecessarily prolongate such negotiations. An integrated policy for a particular environmental problem should therefore provide the right incentives at each stage of the production or consumption process – the incentive structure should be linked without loopholes. On an international level, there has to be an understanding that different circumstances require different solutions. The public administration should therefore be granted some time to “experiment” with the framework conditions. But this is, in general, difﬁcult to accomplish as this requires the time-consuming adaptation and modiﬁcation of laws, acts and ordinances. The “dilemma” of command-and-control policy in general, and of integrated environmental policy in particular becomes thus visible: it is comparatively easy to set certain standards and defend them against attacks from whichever side. To ﬁnd the instruments and deﬁne the framework conditions which function adequately and help to achieve the standards right from the beginning poses, however, a challenge, not only for the public administration. Nevertheless, integrated environmental policy comes closest to the idea of solving the allocation problems optimally in the context of environmental or external effects.

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The next chapter introduces and investigates the price-standard approach to environmental policy – an approach, which provides market-oriented tools to attain environmental standards.

References 1. Australia: National Waste Policy 2009, Television and Computer Product Stewardship http://www.ephc.gov.au/taxonomy/term/51. Cited May 2011 2. EU (2002) Directive 2002/96/EC of the European Parliament and of the Council on Waste Electrical and Electronic Equipment (WEEE) http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2003:037:0024:0038:EN:PDF. Cited May 2011 3. EU (2010) Life cycle thinking and assessment for waste management. DG Environment http://ec.europa.eu/environment/waste/publications/pdf/Making_Sust_Consumption.pdf. Cited May 2011 4. Germany (1994) Act for Promoting Closed Substance Cycle Waste Management and Ensuring Environmentally Compatible Waste Disposal, amended 2006. Fed Law Gazette (BGBl) I 1994, 2705 http://www.bmu.de/ﬁles/pdfs/allgemein/application/pdf/promoting.pdf. Cited May 2011 5. Germany (2004) Renewable Energy Source Act, amended 2010. Fed Law Gazette I p. 1170 http://www.bmu.de/ﬁles/english/pdf/application/pdf/eeg_2009_en_bf.pdf. Cited May 2011 6. Germany (2005) Act Governing the Sale, Return and Environmentally Sound Disposal of Electrical and Electronic Equipment (Electrical and Electronic Equipment Act – ElektroG). Fed Law Gazette (BGBl) 2005:762-774 http://www.bmu.de/ﬁles/pdfs/allgemein/application/pdf/elektrog_uk.pdf. Cited May 2011 7. Germany (2006) Municipal Solid Waste Management Report 2006 http://www.bmu.de/wastemanagement. Cited May 2011 8. Germany (2007) Federal Environmental Agency (”Umweltbundesamt”) – Daten zur Umwelt http://www.umweltbundesamt-daten-zur-umwelt.de/umweltdaten/public/document/ downloadPrint.do?ident=15495. Cited July 2011 9. Germany (2009) Ordinance on the avoidance and recovery of packaging wastes (Packaging Ordinance – Verpackungsverordnung), amended 2009 http://www.bmu.de/ﬁles/pdfs/allgemein/application/pdf/verpackv_5aenderung_en_bf.pdf. Cited May 2011 10. Germany (2010) Federal Environmental Agency (”Umweltbundesamt”) Transboundary shipment of waste electrical and electronic equipment / electronic scrap – Optimization of material ﬂows and control (Summary) http://www.umweltdaten.de/publikationen/fpdf-k/k3933.pdf. Cited May 2011 11. Germany (2010) GVM Gesellschaft für Verpackungsmarktforschung mbH: GVM Blickpunkt, Mai 2010, http://www.gvm-wiesbaden.de/index.php?menue=prospekte. Cited May 2011 12. Germany (2011) Thüringisch-Kambodschanische Gesellschaft e.V. http://www.tkgev.org. Cited May 2011 13. Gerrard J, Kandlikar M (2007) Is European end-of-life vehicle legislation living up to its expectations? Assessing the impact of the ELV directive on ‘green’ innovation and vehicle recovery. J Cleaner Production 15:17-27 http://www.elsevier.com/locate/jclepro. Cited May 2011 14. Hellowell M, Pollock AM (2007) New development: The PFI – Scotland’s plan for expansion and its implications. Public Money & Management, 27:351-354 15. Hugo P (2011) Permanent Error. Prestel, Munich

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16. Janz A, Bilitewski B (2009) WEEE in and outside Europe – hazards, challenges and limits. In: Lechner, P (ed) Prosperity waste and waste resources. Proceedings of the 3rd BOKU Waste Conference, BOKU-University of Natural Resources and Applied Life Sciences, Vienna, p. 113-122 17. Japan (2001) Home Appliance Recycling Law (HARL), Ministry of International Trade and Industry, Japan http://www.meti.go.jp/policy/kaden_recycle/en_cha/en_cha.html. Cited May 2011 18. McDougall F, White P, Franke M, Hindle P (2003) Integrated solid waste management: a life cycle inventory, 2nd edn. Blackwell, Oxford 19. OECD (2001) Extended producer responsibility: a guidance manual for governments. OECD, Paris http://www.oecd.org/LongAbstract/0,3425,en_2649_34395_2405199_1_1_1_1,00.html. Cited May 2011 20. Ongondo F, Williams I, Cherett T (2011) How are WEEE doing? A global view of the management of electrical and electronic wastes. Waste Management 31:714-730 21. Rotter V, Schill W, Chancerel P (2009) Implementing individual producer responsibility (IPR) under the European WEEE directive – experiences in Germany. In: 2009 IEEE International Symposium on Sustainable Systems and Technology. ISSST, Tempe, AZ, USA, May 18-20, p. 1-6. 22. UK: The Waste Electrical and Electronic Equipment Regulations 2006, Statutory Instruments 2006 No. 3289 http://www.opsi.gov.uk/si/si2006/uksi_20063289_en.pdf. Cited May 2011 23. Walls M (2006) Extended producer responsibility and product design: economic theory and selected case studies. Discussion Paper, Resources for the Future, Washington DC http://ideas.repec.org/p/rff/dpaper/dp-06-08.html. Cited May 2011 24. Wiesmeth H (2008) Investment opportunities in waste management through the Private Finance Initiative. Investment Research and Analysis J 3:1-13 25. Wiesmeth H, Häckl D (2011) How to successfully implement extended producer responsibility: considerations from an economic point of view. Waste Management & Research (accepted for publication)

Chapter 11

The Price-Standard Approach to Environmental Policy

Abstract Similarly to the command-and-control policy, the price-standard approach focuses on attaining certain environmental standards. In contrast to the command-and-control policy, which refers with its integrated approaches directly to a (partial) solution of the allocation problems, the price-standard approach is more oriented towards internalizing the environmental effects through completing the market system. As is known from Part II, this can be achieved by means of a Pigou Tax, which can be interpreted as the “equilibrium price” on an artiﬁcial market, or by establishing a market for tradeable certiﬁcates. As is the case with the integrated approaches, these instruments prove helpful in making decentralized information available for individual decisions. Besides some theoretical investigations, this chapter analyzes various practical approaches, including ecological tax reforms, the EU Emission Trading System, and the attempt to introducing a cap and trade policy in the US.

11.1 Market-Oriented Environmental Policies In environmental policy, environmental standards assume the role of the generally unknown efﬁcient production and consumption levels for commodities exerting environmental effects (cf. also Section 9.1). In contrast to a “simple” command-andcontrol policy with the public administration setting the standards and enforcing them with appropriate measures, market-oriented policies tend to integrate the information, which is available in a decentralized way, into decision-making. Thus, it is left to the consumers and the producers to what extent they want to continue a polluting activity, thereby paying transfers to other parts of the economy, or whether they prefer to incur economic costs associated with environmentally friendly production technologies.1 1

Such transfer payments are, for example, pollution taxes, higher prices for certain environmental commodities, the supply of which is restricted by an environmental cap, or expenses on markets H. Wiesmeth, Environmental Economics: Theory and Policy in Equilibrium, Springer Texts in Business and Economics, DOI 10.1007/978-3-642-24514-5_11, © Springer-Verlag Berlin Heidelberg 2012

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Market-oriented environmental policies therefore make use of the scarcity of some environmental commodity, generated through an environmental standard or an environmental cap. This standard will then have an effect on various relevant market prices, which will in turn have consequences for the decisions of the individual economic agents, as indicated above. It is then left to the public administration to make sure that the standard is not exceeded, and it can introduce various instruments to provide more structure to the market regulated with a standard or a cap. There are various examples of market-oriented environmental policies. The most prominent ones are the following: Environmental Cap: This policy introduces an environmental standard which is interpreted as a cap: the supply of a certain environmental commodity is limited by a regulatory measure. Economic agents which want to continue to consume or produce this commodity or employ it as a production factor, will likely be faced with higher market prices. Some agents will therefore prefer to look for and switch to alternatives. As the probably rising market prices are the consequence of regulatory measures, they imply transfer payments from those agents demanding the artiﬁcially scarce commodity to those providing it, or providing feasible alternatives. In order to “structure” these transfer payments, the methods of the charges-and-standard approach (cf. [1], Ch. 11) or the price-standard approach can be used. Pollution Tax: A pollution tax raises the prices of a certain commodity and attempts thus to restrict demand. The resulting “regulated” equilibrium should satisfy the requirements of the environmental standard. In this case, the transfer payments, or rather the revenue from the pollution tax, increase the public budget and can be used for any kind of government expenditures with beneﬁcial effects for various parts of the economy. Tradeable Certiﬁcates: With a market for tradeable certiﬁcates, economic agents trade among themselves. Transfer payments ﬂow from those who can avoid polluting the environment more easily to those who need more certiﬁcates, for whatever reason. In contrast to the pollution tax, a market for tradeable certiﬁcates can mean expenses for buying certiﬁcates, but also allows for revenue from selling certiﬁcates. In addition to economic costs for redirecting consumption and production activities, these transfer payments associated with market-oriented environmental policies can reach a substantial, non-negligible magnitude. Thus, an economic impact assessment of a CFC production cap in the US provided in 1981 shows that the economic costs of a regulatory cap, which would restrict total US annual CFC production to the 1980 level, could cost the US economy as much as 342 million US-$ (in 1976 dollars) in the period till 1990. Moreover, the authors of this study estimate that in for tradeable certiﬁcates; economic costs arise when resources of the economy are used to install, for example, ﬁlters to clean the waste water.

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addition to the economic costs, a production cap could – through higher prices for CFCs, for example – transfer wealth to other parts of the economy of up to twelve times the economic costs ([13], Summary). Of course, as indicated above, a pollution tax or a market for tradeable certiﬁcates could imply transfer payments of a similar magnitude. The following sections provide a careful analysis of the instruments of a pollution tax and a market for tradeable certiﬁcates. The case of an ecotax is also brieﬂy investigated.

11.2 Pollution Tax Similar to a Pigou Tax, which is used in theory to internalize an environmental effect and to return to an efﬁcient allocation, a pollution tax is now applied to attain an environmental standard. Economic efﬁciency is thereby replaced by ecological efﬁciency (cf. Subsection 9.1.1).

11.2.1 Relevant Features of the Pollution Tax Taxes and fees related to environmental issues are abundant. They are disguised as “levies” on some polluting activity such as the discharge of waste water, they appear as “fees”, for example for waste collection; they function as “ﬁscal taxes” with the primary goal to raise revenue, as is the case with the gasoline tax, which is, at least in Germany, mostly used for the construction and maintenance of the trafﬁc infrastructure; and they are meant to have some features of a pollution tax such as, for example, the ecological tax in general and the highway toll in particular.2 There is a crucial difference between ﬁscal taxes and environmental taxes. As already indicated, the primary purpose of a ﬁscal tax is to generate revenue for more or less speciﬁc government expenses. The primary purpose of an environmental or pollution tax is, however, to stimulate the economic agents to reduce the polluting activity. As a consequence, a pollution tax works best when revenues from the tax are small, and a ﬁscal tax works best when revenues are large. Therefore, the difference between a ﬁscal and a pollution tax can be associated with the avoidance strategies regarding the tax, which are available to the economic agents. In the case of a pollution tax, economic agents should have possibilities to avoid paying the tax. Of course, these possibilities should favor the protection of the environment. For the theoretical considerations in Part II, the only way to reduce the tax load of the Pigou Tax, imposed to internalize the external effect, was to produce a smaller amount of the commodity exerting the environmental effect (cf. Section 6.2). In a practical context, there are typically many possibilities to reduce 2

The differences between levies, fees, tolls and taxes, which do play a role in public ﬁnance, are of little relevance in the given context and will therefore not be considered here.

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the tax load, and not all of them will be in accordance with the goal of the pollution tax. Thus, if municipalities levy a fee on household waste which is dependent on the weight of the waste, then households can – and experience shows that some will – dispose of their garbage in the forest or – somewhat more acceptable – in the garbage bins of the rest places along the highways. These are avoidance strategies, which are clearly not in line with the goal of this pollution tax, which are, however, “encouraged” through the “Tragedy of the Commons” (cf. Subsection 5.3.3). Observe that avoidance strategies are also relevant in the context of integrated approaches: declaring WEEE as reusable and exporting it to some developing country helps to reduce recycling costs, but does not – as experience shows again – always support the goal of the EPR approach to WEEE (cf. Section 10.1). The introduction of a pollution tax should therefore always be accompanied by a careful analysis of the available avoidance strategies. Those possibilities, which can be used by the economic agents to reduce the tax load, should support the environmental policy. If there are no or almost no avoidance strategies for a particular tax, or if market conditions are such that the avoidance strategies are not used,3 then this is the case of a ﬁscal tax. Typical ﬁscal taxes are income taxes, or value added taxes. Of particular interest in this case are energy taxes. Although they are considered to be environmental taxes, because the generation and consumption of energy4 is associated with a variety of environmental problems and issues, the tax base “energy” is so broad that avoidance strategies remain limited. Saving energy is, however, among them, as is the installation of energy-saving devices. The extent to which these will be used, depends, for example, on the effectiveness of the “Tragedy of the Commons”, which itself depends on the cost of energy. The introduction of a pollution tax should, however, also be oriented towards a concrete goal. If the goal of a pollution tax is, for example, the reduction of the emission of nitrous oxides (NOx ) from private transport activities, then a direct tax on the composition of the exhaust gas – given this is technically feasible – is certainly better than a simple gasoline tax. If the goal is the general reduction of CO2 emissions from private transport, then the gasoline tax with a sufﬁciently high tax rate may be the better and easier to control alternative.5 Observe ﬁnally that such an environmental or pollution tax allows a decentralization of the decisions regarding a reduction of the polluting activities. An economic agent affected by this tax will make use of the individually available information. There is thus no need for the public administration to try to gather all the required information. It might, however, be necessary to adjust the tax rate in order to achieve the environmental standard. 3 This refers to the situation of a gasoline tax, which is imposed on a largely price-inelastic demand. Consumers will (almost) not react to the price increases resulting from the tax. 4 It would be better to speak of the transformation of energy. However, the term “generation of energy” is now widely used. 5 Typically, CO constitutes a large part of the combustion gas from transport activities, whereas 2 only a comparatively small part consists of NOx , resulting from excessive combustion temperatures.

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This sufﬁces as an overview of the general features of a pollution tax, which create difﬁculties for an environmental policy beyond the deﬁnition of the standards. The following subsections investigate the cost efﬁciency of the pollution tax in comparison to a non-integrated approach of a command-and-control policy (cf. Chapters 9 and 10).

11.2.2 Cost Efﬁciency of the Pollution Tax With environmental standards replacing economic efﬁciency as the primary goal of environmental policy, the question arises, whether a command-and-control policy or the price-standard approach entails lower economic costs. The following example will help to explain these issues and these concepts in a rather simple and straightforward context. Example 11.1. Assume that two business companies of the G industry considered in Part II normally emit A1 = 100 and A2 = 50 units respectively of a certain pollutant in a given period of time. The environmental standard requires now the reduction of total emissions by 50%. Assume moreover that minimal costs to reduce the level of the emissions from Ai to a lower level Ai are given by the cost functions C1 (A1 | A1 ) = 0.1(A1 − A1 ) and C2 (A2 | A2 ) = 0.2(A2 − A2 ) respectively. This information is private to the companies. There are now two different policies to achieve this goal: the ﬁrst one is a simple command-and-control policy with the strict requirement for each company to reduce emissions individually by 50%; the second one is a uniform pollution tax with tax rate chosen appropriately to achieve the goal. Command-and-Control Policy: Economic costs associated with this policy are given by C1 (50 | 100) = 5 and C2 (25 | 50) = 5, adding up to 100 units of money. This policy thus helps to achieve the standard; there are no incentives for a further reduction of the emissions. Uniform Pollution Tax: Let the tax rate be given by 0.12 units of money for each unit of the pollutant. As marginal costs to reduce emissions are constant, company 1 will stop pollution altogether. Marginal costs are 0.1 units of money and are, thus lower than the tax rate with 0.12 units of money. Company 2 with marginal costs of 0.2 units of money exceeding the tax rate will continue production as usual. Economic costs are then given by C1 (0 | A1 ) = 10. Company 2 has to pay the pollution tax of 6 units of money, which – as a transfer payment – does not count as economic cost, although it may clearly create ﬁnancial difﬁculties for the company. Both policies lead to total economic costs of 10 units of money, but the uniform pollution tax allows a higher reduction of emissions. This demonstrates cost efﬁciency of the pollution tax under the conditions of this example. More important, however,

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is the reason for this effect: the tax stimulates the companies to make use of their (private) information on their cost structure. This information is typically not available to the public administration, which is therefore restricted to the “command” of a uniform emission reduction in the context of a simple command-and-control policy. A somewhat more formal approach is based on a modiﬁcation of the model introduced in Part II with production functions F = f (LF , G) and G = g(LG ). It is now assumed that there are different G companies, which produce commodity G and some polluting commodity A (“waste water”). The quantity of Ai will, however, i , Ai ). Under usual substitutability be considered as factor of production: Gi = gi (LG assumptions this implies that a smaller quantity of Ai can be compensated through a higher quantity of Li (“labor”). This approach thus reveals the costs, which are associated with lower environmental pollution. The problem is now to ﬁnd the solution which minimizes economic costs for individual production levels Gi of the companies and which satisﬁes the environmental standard ∑i Ai ≤ A (cf. also [1], Ch. 11.4). First, the centralized solution of a social planner is analyzed. At prices p = (pL , pF , pG ), the following constrained minimization problem has to be solved: min

i ,Ai ) (LG

∑ pL · LGi i

i such that gi (LG , Ai ) ≥ Gi for all i and

∑ Ai ≤ A . i

For an assumed interior solution, the Lagrange method leads to the following ﬁrstorder conditions with Lagrange multipliers λ and μ. The second-order conditions are satisﬁed with the assumed strict concavity of the production functions gi (cf., for example, [3], Ch. 12): p L − λi ·

i i ∂ gi (LG ∂ gi (LG , Ai ) , Ai ) = 0 and λi · + μ = 0 for all i. ∂L ∂A

Next, a decentralized solution is investigated. The emission of the pollutant A will be taxed with the uniform rate t. The decision on the volume of the reduction of the emissions will then be left to the companies. The selection of a cost-minimizing factor combination (Li , Ai ) in company i requires a solution of the following constrained minimization problem: i i min (pL · LG + t · Ai ) such that gi (LG , Ai ) ≥ Gi .

i ,Ai ) (LG

Again with the assumption of an interior solution for company i the Lagrange method requires the solution of the ﬁrst-order conditions with the Lagrange multiplier λi : p L − λi ·

i , Ai ) i , Ai ) ∂ gi (LG ∂ gi (LG = 0 and λi · + t = 0. ∂L ∂A

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These conditions are obtained for each company i, and a straightforward comparison reveals then that the solutions of the two approaches are identical with tax rate t chosen to be equal to the value of the multiplier μ. This result shows that the decentralized approach based on the pollution tax allows the cheapest – in terms of economic costs – production of the required quantities of the consumption commodity under the constraints of the environmental standard. A regular command-and-control policy can therefore only be more expensive – again in terms of economic costs. Once more, one must not forget that the business companies have to pay the pollution tax, which means a ﬁnancial burden and which reduces their proﬁts, although it does not qualify as economic cost. “Market forces” induce the companies to make use of their information in this market-oriented approach.

11.2.3 Cost Efﬁciency with Spatial Differentiation Besides emissions of certain pollutants such as noise or waste water, which have to be controlled at the source, the immission of these pollutants, i.e., the effect of these emissions on the environment including economic agents, has to be considered. This becomes clear, when one investigates noise emissions from an airport or a highway, for example, which affect nearby villages depending on the location, the wind, and other parameters. Similarly, a certain pollutant emitted into a river some distance from a city may imply, due to natural attenuation (cf. [11]), a lower immission level for the city than the same pollutant discharged into the river in the immediate vicinity of the inhabited area. Consequently, a spatially differentiated approach might be appropriate for attaining an immission standard. Consider the following simple example for such an approach (cf. also [1], Ch. 11.5 for further variations in the tax rate): Example 11.2. Each of two G companies discharges 100 cubic meters of waste water per day into a river upstream of a city. The costs for cleaning the waste water are 10 units of money per cubic meter for company 1 and 15 units of money per cubic meter for company 2. Due to the more distant location of company 1 the immission level of its waste water is, however, only 50% of its emissions. For company 2, which is close to the city, immissions correspond to emissions. Two different policies to achieve the standard of reducing emissions to at least 50% of their former level are now considered: the ﬁrst one is a pollution tax with a uniform tax rate; the second one applies a spatially differentiated tax rate, i.e., a different tax rate for the two companies. The results will then be compared with a command-and-control policy requiring each company to reduce emissions by 50%.6 Uniform Pollution Tax: A uniform pollution tax of 12 units of money per cubic meter of waste water discharged into the river is imposed on the companies. 6

In general, it is not always easy to identify the origin of certain immissions. Therefore, as in this example, companies are often required to reduce their emissions.

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Obviously, company 1 will reduce emissions to 0, whereas company 2 will be better off with paying the tax. Consequently, total emissions will be reduced by 50%, immissions will, however, only decrease by one third, as company 1 contributes only one third to total immissions in the city. Before the tax, 150 cubic meters of waste water reached the city per day in terms of the immission level, after the tax this quantity is reduced to 100 cubic meters. This implies economic costs of 20 units of money per cubic meter of waste water avoided in terms of immissions. Differentiated Pollution Tax: Company 2, which is located closer to the city, will now be taxed with a rate of 16 units of money per cubic meter of waste water discharged into the river, whereas the tax rate for company 1 is set to 0. Consequently, company 2 will stop polluting the river altogether. Again, with this policy emissions can be reduced by 50%, but immissions decrease by two thirds in this case. There are economic costs of 15 units of money per cubic meter of waste water avoided, again in terms of immissions. Command-and-Control Policy: If both companies are obliged to reduce emissions by 50%, then immissions will go down to 75 cubic meters per day from 150 cubic meters. Economic costs per cubic meter of waste water avoided are given by 16.67 units of money in terms of immissions. In conclusion, the differentiated pollution tax yields the cost-efﬁcient solution in this case. Observe that the command-and-control policy is, in terms of economic costs, still better than the approach with the uniform pollution tax. This is a consequence of the fact that the company with the lower immission levels is also the one with lower costs to reduce emissions. Clearly, a uniform tax will always affect this company ﬁrst. In the case of two companies and one control point for immissions, the problem can be addressed formally in the following way: assume that Ci (Ai | Ai ), i = 1, 2, are the economic costs for company i to reduce emissions from level Ai to Ai . Source i contributes according to the fraction di1 , 0 < di1 < 1, to the immissions at control point 1. The standard Q1 is relevant for this control point and total immissions should not exceed this standard. The resulting constrained minimization problem from the point of view of a social planner reads: min (C1 (A1 | A1 ) +C2 (A2 | A2 )) such that d11 A1 + d21 A2 ≤ Q1 .

A1 ,A2

An interior solution requires that the following ﬁrst-order conditions are satisﬁed with Lagrange multiplier λ : dC2 (A2 | A2 ) dC1 (A1 | A1 ) + λ · d11 = 0 and + λ · d21 = 0. dA1 dA2 A decentralized approach with ﬁrm-speciﬁc tax rates t1 and t2 would yield the same solution, if ti is chosen to be equal to λ · di1 for i = 1, 2. Thus, also in this case the

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191

cost-efﬁcient solution can be obtained in a decentralized way, which requires less information than the command-and-control solution. If there are more emission sources with immission levels controlled at various points, then the attempt to achieve a cost-minimizing solution with a differentiated pollution tax can become cumbersome. Moreover, due to the lack of information, it is difﬁcult for the authorities to ﬁnd the suitable value for the tax rate right from the beginning. For this reason, more or less frequent adjustments of the tax rate will be necessary, which have to be approved through sometimes time-consuming legal processes. If, for example, a gasoline tax were levied on consumers as a pollution tax, the ecological efﬁciency would very much depend on the ratio between the tax rate and the price of crude oil. Therefore, frequent adjustments – in both directions – of this particular pollution tax would be necessary to ensure a continuous ecological efﬁciency. Additional upward adjustments of the tax rate result from periods of monetary inﬂation. And, according to Section 11.1, one must not forget that the required tax payments imply a potentially signiﬁcant ﬁnancial burden for the companies, even if these costs do not constitute economic costs. These considerations render the pollution tax less attractive as an instrument of a market-oriented approach to environmental policy . And this might be one of the reasons why this instrument does not play a signiﬁcant role in environmental policy of most countries. This sufﬁces as a formal discussion of the pollution tax. As a tax which is typically imposed on the consumption of energy, the ecotax is a special pollution tax gaining increasing importance.

11.3 Ecotaxes In many countries ecotaxes, or green taxes, are part of the restructuring of the tax system, the so-called ecological tax reform. One of the long-term goals of this tax reform is the replacement of existing taxes on incomes with taxes on energy use. This is expected to yield a double dividend in the form of a better economic performance accompanied by sustainable development without increasing the tax burden for the economy as a whole.7 .

11.3.1 Aspects of an Ecotax It is certainly true that in many cases degradation of the environment is a consequence of or related to the generation and consumption of energy. A tax imposed on the consumption of energy therefore initially seems to be a good idea. The question, 7

With the additional goal of greater justice within and between nations, a threefold dividend of an ecotax was even cited at the time when the discussions on ecotaxes started (cf. [14]).

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however, remains, to what extent a “pollution tax” as a tax on the consumption of “energy” can yield this “double dividend”? As was already explained in Subsection 11.2.1, the ecological performance of a pollution tax depends substantially on the availability of “avoidance strategies”. Economic agents must have an environmentally friendly alternative to paying the tax. Without such a possibility, such a tax turns into a ﬁscal tax, generating income for the government without reducing environmental pollution. Now the critical aspect of such an ecotax becomes apparent: in order to promote a sustainable development, the revenue from a tax supporting this goal should be expected to remain small; in order to allow a substantial reduction of income taxes or the contributions to the social security system, the revenue from a tax supporting this goal needs to be large. It will therefore be difﬁcult to satisfy both goals simultaneously at an appropriate level. In addition to that “energy”, in whatever form, is required for all economic activities. The consumption of energy will (and can) therefore react only very hesitantly to the introduction of an ecotax. In the short-run ecological effects will be negligible. For example, the short run responsiveness of US households to changes in gasoline prices is mirrored in a range from -0.034 to -0.077 for the estimated short-run price elasticity for the period from 2001 to 2006 ([9], p. 4). With short-run income elasticities ranging from 0.21 to 0.75, the effects of a price increase will be more than compensated by a small increase in income (cf. again [9], p. 4). Long-run estimates for the OECD countries reveal a price elasticity of about -0.24 and an income elasticity of about 0.59 for energy demand ([6], p. 15). Thus, in the short-run, a 1% price increase for gasoline is estimated to decrease consumption of gasoline in the US between 0.034 and 0.077%. And in the long run, a 1% price increase will decrease energy consumption in the OECD countries by approximately 0.24%, whereas a 1% increase in income is likely to increase energy demand by 0.59%. These numbers, which point to a largely inelastic demand for energy, demonstrate that avoidance strategies for energy demand are scarce and can easily be dominated by increases in income. As an immediate consequence, ecotaxes serve more as ﬁscal taxes and help to generate revenue for the public budgets. The declaration as ecological taxes provides support for the public administration to introduce and justify these taxes. Subsection 11.3.3 will discuss the ecotax in Germany in more detail. The following remarks refer to some theoretical aspects of such a tax, including the double dividend hypothesis.

11.3.2 Theoretical Considerations Regarding an Ecotax If in the basic model with external effects of Part II (cf. Subsection 5.2.3) the factor “labor” is considered as “energy”, then an energy tax of 10%, for example, with a lump sum redistribution of the tax revenue to the consumers will increase all consumption prices by 10% – without changing the equilibrium allocation. This is a

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consequence of non-existing strategies to avoid this tax: the externality cannot be internalized with such a tax. As is the case for this straightforward theoretical result, an implemented ecotax should lead to an increase in the general price level. Such an induced inﬂation could be observed in various countries after the introduction of an ecotax, for example in Germany. Beyond that a Pigou Tax can be – under certain circumstances – used to correct the distorting effect of a consumption or production tax in addition to internalizing an environmental effect. In order to investigate this double dividend more carefully, consider the model introduced in Section 6.3 with taxes (or subsidies) on the consumption of clean water for production of the commodities F and G. If then a production tax tF on commodity F is given, then a Pigou Tax tG on the production of commodity G can be introduced such that the resulting equilibrium allocation is efﬁcient, despite the distorting effect of tF and the environmental effects through the G production. The following example helps to illustrate these relationships: Example 11.3. As in the basic model with external effects, the production functions for the two consumption commodities F and G of the economy are given by (cf. Example 5.3 (A)): f (LF , G) =

50 · LF and g(LG ) = 2.5 · LG G+1

with factor inputs LF and LG . Total factor supply in a given period of time is L¯ = 10 units. The representative consumer is again characterized by the utility function u(F, G) = F · G. Assume now that the tax tF on the production of commodity F is given. Then the ˆ analysis of Section 6.3 demonstrates that the relation 20· G+20·t F = tG between the tax rates tF and tG leads to the efﬁcient allocation in√equilibrium. Gˆ again denotes the efﬁcient quantity of commodity G, given by Gˆ = 26 − 1. Thus, the appropriately deﬁned Pigou Tax tG provides some kind of a double dividend. However, this does not correspond to the original intention of an ecotax. Given these theoretical considerations, the following subsection discusses experiences with the ecological tax reform in Germany.

11.3.3 The Ecological Tax Reform in Germany The ecological tax reform was, after long discussions in the early 1990s, introduced in Germany in 1999 with additional taxes on mineral oil and on electricity.8 The tax rates on gasoline and diesel, for example, were increased in ﬁve steps by a total of 15.37 Euro cents per liter in 2003.

8

Part of the information in this subsection on the ecological tax reform in Germany is taken from [10], a research report commissioned by the German Federal Environmental Agency (UBA).

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Also starting in 1999, an energy tax9 of 1.02 Euro cent per kWh was introduced with yearly increases leading to a tax rate of 2.05 Euro cents per kWh in 2003. In 2006, the “mineral oil tax” was integrated into the “energy tax”. In 2011 the following tax rates on energy consumption are imposed in Germany: 1,000 l leaded gasoline 721.00 Euro 1,000 l unleaded gasoline 654.50 Euro 1,000 l diesel 470.40 Euro 1,000 l light heating oil 76.35 Euro 1,000 kg heavy heating oil 25.00 Euro 1,000 kg liquid gas 180.32 Euro 1 MWh natural gas 13.90 Euro Hard coal and lignite were exempted from the energy tax till the end of 2010, and industry, in particular the energy-intensive industry such as steel and paper production, and agriculture continue to enjoy reduced tax rates. There are, however, plans to increase the tax rates for the manufacturing sector. Interestingly, the revenue from the energy tax in Germany decreased between 2003 and 2007 with yearly rates from 0,5% to 4,0% ([8], Tabelle 33). However, tax revenue in 2009 exceeded that of 2008 by 1.5% and the ﬁnancial outlook for Germany expects steady income ﬂows from both the energy and the electricity tax in the years to come.10 What does all this mean for the impact of the ecological tax reform on the environment, employment and innovations? First of all, it is clear that the energy tax including the electricity tax generates a substantial revenue of approximately 45 billion Euro per year, of which approximately 39 billion Euro accrue to the federal budget. As total federal tax revenue is estimated at 222 billion Euro in 2011, the federal government needs the revenue from the energy tax. Moreover, tax revenue from the energy tax is forecast to remain at a stable absolute level throughout the next years, although the relative share is expected to fall. A decreasing share of energy consumption from non-renewable sources will induce this long-term environmental effect. Whether this is the consequence of the energy tax, or whether this is a consequence of other effects, such as the promotion of renewable energies, is still being debated. In a research project commissioned by the German Federal Environmental Agency (UBA), the reduction of CO2 emissions by 2.4% in Germany in 2003 is attributed to the ecotax ([10], p. 14). In a study of the German Institute for Economic 9

The German ecotax includes both the tax on mineral oil and natural gas as well as the energy tax. Often, the term “energy tax” is used synonymously for the ecotax in Germany. 10 Cf. the relevant information provided on the web sites of the German Ministry of Finance (http://www.bundesﬁnanzministerium.de), in particular regarding the “Finanzplan des Bundes 2010-2014”; the latest changes in the German energy policy are, however, not yet taken into account (cf. the remarks on p. 95).

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Research (DIW), the author shows that CO2 emissions increased by 0.4% in Germany in this period due to weather conditions. Adjusting the data for the weather conditions yields a slight decrease of the emissions by 0.6% ([17]). Another study conducted by the German Federal Environmental Agency (UBA) refers to short-run and long-run price elasticities of the demand for fuel (gasoline and diesel) of -0.15 and -0.3. Therefore, the additional tax of 15.37 Euro cents per liter gasoline can be expected to have reduced fuel consumption ([7], p. 3). And, according to yet another study of the DIW, this implies a per-capita reduction of CO2 emissions by 120 kg or 5% per household and year ([15], p. 7). In summary, the environmental effects of the German ecotax seem to be difﬁcult to measure. However, as a substantial part of the tax revenue is used to support the social security system in Germany, and as this tax is supposed to have inspired innovations regarding energy-saving technologies with relevance for the global market, labor market effects may be non-negligible. In the above-mentioned research project, the authors thus arrive at a number of 250,000 jobs which were created by 2003 ([10], p. 14). Again, of course, the question remains, whether this result is mainly due to the ecotax. In summary, the German ecotax seems to qualify more for a ﬁscal tax with some effects on environmental pollution. This is, however, not surprising, given the theoretical considerations of the previous subsection. After this discussion of the pollution tax and the ecotax, supplemented by an analysis of the German experience with the ecotax, the next section contains the basic principles of a market for tradeable certiﬁcates.

11.4 Tradeable Emission Certiﬁcates This approach to a market-oriented environmental policy is grounded in the internalization of environmental effects through a market for certiﬁcates, which are linked to the emissions of certain pollutants (cf. Section 6.4). The limited number of certiﬁcates, which are issued in a given period of time, represents the environmental standard, and creates demand for these artiﬁcial commodities. Individual demand for certiﬁcates depends on the production possibilities of the polluter, and the situation on the relevant markets. Again, information, which is only available in a decentralized way, is used for decision-making.

11.4.1 Relevant Features of Markets for Tradeable Certiﬁcates One important aspect of a market for tradeable certiﬁcates is the limitation of the number of the certiﬁcates through the environmental standards. In contrast to a pollution tax, for which the appropriate value for the tax rate has to be found in a trial and error process, it is therefore possible to put an effective cap on pollution. Trad-

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ing activities will then yield a market price for the certiﬁcates. For this reason, this policy is well-known as a cap and trade policy. There is ﬁrst of all the question, which polluters should be included in the market activities? Moreover, should there be “equal treatment” in the sense that all participants in the trading scheme face the same rules, or should there be, as in the case of the German ecotax, socially or economically motivated exemptions for certain industries?11 . A particularly critical issue in the context of markets for tradeable certiﬁcates is the initial allocation of the certiﬁcates to the relevant economic agents. The possibility of auctioning off the certiﬁcates is – until now – rarely used, as it puts an additional ﬁnancial burden on the companies. Grandfathering constitutes the most common allocation mechanism for the initial endowments: the reference value for the endowment with certiﬁcates is a recent or an historical value of the polluting emissions, or a combination thereof. However, in order not to provide incentives for increasing polluting activities before the introduction of a market for tradeable certiﬁcates, it is usually preferable to base the initial endowment on an average of historical emission values. There remains, however, the problem of a “perceived” advantage for those agents who contributed more to the pollution of the environment. Should these polluters be “rewarded” by receiving a higher share of the certiﬁcates? Would it not be better to “punish” those polluters? The “polluter pays principle” is derived from these considerations. It is strongly determined by public opinion on environmental degradation, although the question, who is the polluter, cannot always be answered straightforwardly. Moreover, the question of how to integrate new companies into the trading scheme has to be addressed. Typically, a certain fraction of the certiﬁcates is retained for new entrants. Details of the trading scheme can be adjusted to respect geographical situations in combination with ecological necessities. This refers to immission-oriented trading schemes, which are, however, more difﬁcult to design and monitor. The following subsection provides some hints regarding possible structural details of trading schemes and investigates the potential of these decentralized approaches to minimize economic cost while maintaining a certain environmental standard.

11.4.2 Emission-Oriented and Immission-Oriented Trading Schemes Consider a geographical area with a certain number m of emission sources, affecting the environmental quality at a number n of control stations. The relevant environmental standards at the control points may differ and are therefore given by a vector Q = (Q1 , . . . , Qn ), with standard Q j at control station j, j = 1, . . . , n, setting 11

In the EU ETS, for example, small sources of greenhouse gases are not required to participate in the trading scheme, and certain energy-intense production activities, such as the steel production, obtain special conditions (cf. Subsection 11.5.1).

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the maximum concentration of a certain pollutant for example. The m × n-matrix D = ((di j ))i, j provides the distribution of the emissions: di j indicates the immission level at control point j of one unit of emissions of source i. If Ci (Ai | Ai ) denotes economic costs to reduce non-regulated emissions Ai to the levels Ai , i = 1, . . . , m, then one obtains the following problem to minimize economic costs (from the point of view of a social planner) while keeping the environmental standards: m

min

∑ Ci (Ai | Ai )

(Ai )i i=1

m

such that

∑ d i j Ai ≤ Q j

für j = 1, . . . , n.

i=1

For an assumed interior solution the following ﬁrst-order conditions with Lagrange multipliers λ j , j = 1, . . . , n, have to be satisﬁed: n

Ci (Ai | Ai ) + ∑ λ j di j = 0 for i = 1, . . . , m. j=1

There are two basic structural designs for a market for tradeable certiﬁcates in this context, supplemented by mixed designs (cf. also [1], Ch. 12.2 and 12.3). In general, the public administration has to have complete information on the coefﬁcient matrix D, whereas “public” knowledge on the individual costs of the polluting companies to reduce their emissions is, in this market-oriented approach, not required. This is certainly one of the advantages of such an approach. Ambient Permit System (APS): Each control station j is endowed with Q j certiﬁcates, which are in one way or the other allocated to the emission sources. Thereafter, certiﬁcates can be traded with one limitation: with intended emissions of Ai , source i has to have Ai di j certiﬁcates at control station j, j = 1, . . . , n. Therefore, the APS is immission-oriented with respect to maximum immission levels at the control points. For this reason, the certiﬁcates issued at different control stations will not be exchangeable against one another. Rather, markets for certiﬁcates will emerge at each control station, and each emission source will have to acquire certiﬁcates at each control station. This feature certainly implies comparatively high transaction costs and renders ambient permit systems difﬁcult to implement and to handle in practice. Nevertheless, such a system can principally lead to the cost-minimizing solution of the above problem in a decentralized way, if the required parameters are chosen appropriately. Consider the problem from the point of view of emission source i, i = 1, . . . , m: n

min Ci (Ai | Ai ) + ∑ p j di j Ai Ai

j=1

with price p j for a certiﬁcate at control station j. Again, the ﬁrst-order conditions for an interior solution postulate:

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11 The Price-Standard Approach to Environmental Policy n

Ci (Ai | Ai ) + ∑ p j di j = 0. j=1

Thus, with p j := λ j at each control point j = 1, . . . , n, one obtains the costminimizing solution of the social planner in a decentralized way. Emissions Permit System (EPS): For this approach, the geographical area is divided up into zones with each zone obtaining a certain quantity of certiﬁcates, which can again be bought and sold by the emission sources. Within each zone, the system is therefore orientated to emissions. There is, in contrast to the APS, only one market for certiﬁcates. However, the costminimizing solution of the allocation problem with immission standards indicated above can, in general, no longer be attained. The reason is that within each zone the certiﬁcates are not directly related to the immissions. More precisely, emission source i in a certain zone will attempt to solve the problem with price p for a certiﬁcate given: min Ci (Ai | Ai ) + pAi . Ai

An immediate comparison with the approach outlined above shows that the missing speciﬁcation with respect to the immission levels will, in general, not lead to the cost-minimizing solution of the social planner. It is, therefore, left to the skills of the public administration to deﬁne the zones such that deviations from the optimal solution remain small. Offset System: Other approaches, such as the offset system, constitute a mixture of the APS and the EPS. Basically, the certiﬁcates are, as in the EPS, related to emissions, whereas the exchange of certiﬁcates has to respect immission levels, as in the APS. Figure 11.1 provides a simple example: A2 6

Control Point 2:

..... ..... ..... ..... ..... ..... ..... ..... ..... ..... 12 1 22 2 2 ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ......... ..... ......... ..... ......... ..... . ..... . . . . ...................... ..... ... ................ ..... ......... ..... ... ......... ..... ......... ..... ... ......... ..... ........ 2 .. ..... .... .............................................................................................. ......... .......... . ......... ..... ......... ..... . ............. ......... . 1 ................. . ..... ......... ..... ......... 11 1 21 2 . ..... ......... ..... ......... . ..... ......... ......... ..... . ......... ..... ......... ..... . ......... ..... ......... ..... . ......... ..... ......... ..... . ......... ..... ...... .... .

ˆ +d A ˆ
ˆ2 A

u

Δ

Δ

u

Control Point 1:

ˆ +d A ˆ = Q1 d A

ˆ1 A Fig. 11.1 Offset system with two control points and two emission sources

-

A1

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If there is, for example, a binding restriction regarding immission levels at control point 1 with emission levels Aˆ 1 and Aˆ 2 of the two emission sources, then source 1 is allowed to acquire certiﬁcates from source 2 only in the ratio of the coefﬁcients d21 and d11 . If source 2 is willing to sell Δ2 certiﬁcates, then source 1 can buy an additional quantity Δ1 = (d21 /d11 ) · Δ2 of certiﬁcates, because of Δ2 /Δ 1 = d11 /d21 (cf. Figure 11.1). The total change regarding immission levels at control station 1 is then −d21 Δ2 + d11 Δ 1 = 0. The standard at control station 2 can be kept if the quantity of certiﬁcates exchanged starting from (Aˆ 1 , Aˆ 2 ) is not too large. In an “equilibrium” with a binding restriction for the immission levels the exchange values piA , i = 1, 2, for the certiﬁcates of the emission sources are determined by the coefﬁcients di j . More precisely, these prices will have to satisfy the condition p2A /p1A = d21 /d11 , if there is a binding constraint at control station 1. The advantages of an offset system in comparison to an EPS are given by smaller informational requirements for the public administration, and emission sources need not trade certiﬁcates on a multitude of different markets, in comparison to an APS. Therefore, it becomes easier to add or to omit control stations without having to profoundly change the markets for certiﬁcates. The next sections investigate plans and implementations of markets for tradeable certiﬁcates. The presentation includes the EU Emission Trading System (EU ETS), and the US cap and trade system, which was promoted by the Obama administration – albeit without success.

11.5 Experiences with Markets for Tradeable Certiﬁcates This section investigates the EU Emission Trading System, which started in 2005 and which pioneered this market-oriented environmental policy. Although the success of the EU system depends on being supplemented by similar systems, the US will probably not join this initiative in the immediate future, at least not before new elections in 2012. The US cap and trade bill was promoted by the Obama administration and passed by the House of Representatives, but died in the Senate in 2010.

11.5.1 The EU Emission Trading System (EU ETS) The further development and implementation of the EU ETS is now the task of the new EU “Directorate-General for Climate Action”, which was established in February 2010. It also monitors the implementation of the emission reduction targets of the member states outside the EU ETS.12 12

A great deal of the information required for this section has been taken from the homepage of this Directorate-General (cf. [5]).

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The EU ETS is the ﬁrst and still the biggest international scheme for trading certiﬁcates, or allowances, covering some 11,000 power stations and industrial plants in 30 countries (27 EU member states, Iceland, Liechtenstein and Norway). It was launched in 2005 and works on the “cap and trade principle” (cf. also Section 11.1). The ETS refers to CO2 emissions from installations such as power stations, combustion plants, oil reﬁneries and iron and steel works, as well as factories making cement, glass, lime, bricks, ceramics, pulp, paper and board. Nitrous oxide emissions from certain processes are also included. The installations currently in the scheme account for almost 50% of the EU’s CO2 emissions and 40% of its total greenhouse gas emissions. Airlines will have to join the scheme in 2012 and more industries (petrochemicals, ammonia and aluminum) will be included with additional greenhouse gases at the start of the third trading period in 2013. Moreover, the number of allowances will be reduced over time. For this reason, emissions covered by the EU ETS will be 21% lower in 2020 in comparison to 2005. The following list provides a brief survey on relevant features of the EU ETS (cf. again [5]): Scope: In the ﬁrst (2005-2007) and second (2008-2012) trading periods the ETS covers mostly CO2 emissions from major sources, as already mentioned above. Additional greenhouse gases and additional industries will be covered from the third trading period starting in 2013. National Allocation Plans: With the national allocation plans the member states grant quantities of greenhouse gas emission allowances to their companies in the ﬁrst and the second trading periods. Before the start of these trading periods, each member state had to decide how many allowances to allocate in total for a trading period and how many each installation covered by the ETS would receive. The allocation plans were assessed by the European Commission based on certain criteria and could have been rejected. For the third trading period, which begins in 2013, the allocation will be determined directly at EU level, without a national allocation plan. Table 11.1, taken from [4], p. 6f., allows a comparison between the allowances approved for the period 2005-2007 (”2005 cap”) with the emissions veriﬁed for 2005 (”2005 emissions”), the allowances for the period 2008-2012 as proposed by the member states (”2008 proposed cap”) and the allowances for this period approved by the European Commission. Cap: The cap for the year 2013 has been determined at approximately 2.04 billion allowances. This quantity is based on national allocation plans of the member states and takes into account the extended scope of the EU ETS from 2013. The cap will decrease each year by 1.74% of the average annual total quantity of allowances issued by the member states in the period 2008-2012. This annual reduction will continue beyond 2020 but may be subject to revision no later than 2025.

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Auctioning: In the ﬁrst and the second trading periods, allowances were mostly allocated for free. From the start of the third trading period in 2013, however, about half of the allowances shall be auctioned off, because “auctioning is the most transparent allocation method that allows market participants to acquire the allowances concerned at the market price”, according to the DirectorateGeneral (cf. [5]). In particular, power generators will no longer receive free allowances, at least not after a transitional period. By 2020, this transitional period with free allowances for the power sector will end. MemberState Germany Greece Ireland Latvia Lithuania Luxembourg Malta Slovakia Sweden UK

2005cap 499 74.4 22.3 4.6 12.3 3.4 2.9 30.5 22.9 245.3

2005emissions 474 71.3 22.4 2.9 6.6 2.6 1.98 25.2 19.3 242.4

2008proposedcap 482 75.5 22.6 7.7 16.6 3.95 2.96 41.3 25.2 246.2

2008cap 453.1 69.1 21.15 3.3 8.8 2.7 2.1 30.9 22.8 246.2

Table 11.1 Carbon allowances (million tons) for the ﬁrst and second trading periods of the EU ETS for various member states of the EU (Source: [4], p. 6f.)

Benchmarks: For industry and heating sectors, allowances will continue to be allocated for free based on ambitious (greenhouse gas performance-based) benchmarks. Installations that meet the benchmarks (and thus are among the most efﬁcient installations in the EU) will in principle receive all the allowances they need. Installations that do not meet the benchmark have the option to either lower their emissions or to purchase additional allowances to cover their excess emissions. These benchmarks are meant to provide a strong signal for what is possible in terms of low-carbon production. They do not represent emission limits or even emission reduction targets, but merely thresholds for the levels of free allocation of allowances to individual installations. Aviation: As greenhouse emissions from aviation are increasing fast, the EU has decided to impose a cap on CO2 emissions from all international ﬂights that arrive or depart from an airport in the EU from 2012. Like industrial installations, airlines will receive tradeable allowances covering a certain level of CO2 emissions from their ﬂights per year. Carbon Leakage: Carbon leakage is the increase in CO2 emissions outside the states taking part in EU ETS, as a consequence of the ETS. Thus, an increase

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in prices resulting from the ETS may lead to a reallocation of production to regions with less stringent rules, leading to higher emissions in those regions and therefore to carbon leakage. According to the regulations of the ETS, production from sectors deemed to be exposed to a signiﬁcant risk of carbon leakage will receive relatively more free allowances than other sectors. This sufﬁces as an overview of the most important features of the EU ETS, the principal intention of which is, according to the Directorate-General, to serve as a model for other countries considering similar national or regional schemes, and to link these to the EU scheme over time. Therefore, the EU ETS is meant to form the basis for wider, global action, to attract other nations to join this initiative. This is, however, one of the problems that the EU ETS faces, at least so far.

11.5.2 A Critical Assessment of the EU ETS There are a number of concerns with the EU ETS, which will be brieﬂy addressed in this subsection. Carbon Prices and Volatility of the Carbon Prices. Table 11.1 demonstrates that the national caps for the period from 2005 to 2007 did not place any additional restriction on greenhouse gas emissions at all. This “over-allocation” drove certiﬁcate prices down to zero at the end of the ﬁrst trading period in 2007. Although the situation changed somewhat in the second trading period from 2008 to 2012, again for many countries the cap is still quite comfortable. For most of 2008, carbon traded at around 20 Euro to 25 Euro a ton. Thereafter the price decreased to 8 Euro, climbing slowly to 14 Euro in mid 2009. The carbon prices jumped almost 10% to their highest levels in two years following the Japanese earthquake in March 2011. Futures contracts for December 2011 delivery rose from 15.73 Euro on the day of the earthquake to 17.22 Euro a week later. The perceived volatility of the carbon prices is the reason for postulating price ﬂoors and price ceilings for spot and futures prices. Windfall Proﬁts: In the ﬁrst and second trading periods the initial allocation of the allowances was, in general, free of charge. Nevertheless, this “grandfathering” allocation affects, among others, the wholesale price of electricity. Power companies will now offer electricity only at a price which covers marginal cost of production plus the market price of the allowances. Otherwise they will prefer to sell the allowances. Thus, windfall proﬁts may arise from price increases on the electricity market due to the allocation of the allowances, even if this is free of charge. Missing Integration with other National Climate Policies: Although the EU ETS should serve as the basis for a global initiative, other climate policies interfere with the ETS such that their effects are neutralized. The German attempts, for

11.5 Experiences with Markets for Tradeable Certiﬁcates

203

example, to raise the share of renewable sources for the generation of electrical energy through the EEG (cf. Section 10.3) reduces demand for allowances, reduces the market price, and attracts other polluters. Thus, the German efforts to reduce greenhouse gas emissions are counteracted by the EU ETS. In short: the EU ETS and the EEG together lead to the same total greenhouse gas emissions as the EU ETS alone. Insufﬁcient Integration with other International Climate Policies: With the ETS, the EU aims to initiate the development of an international carbon market: the market is expected to emerge from compatible domestic cap and trade systems. An OECD-wide carbon market is expected by 2015, which would be extended to include economically more advanced developing countries by 2020 (cf. again [5]). Currently, domestic cap and trade systems are being implemented or discussed in the US, Japan, Australia, South Korea, New Zealand and Switzerland, amongst others. However, countries with a substantial quantity of greenhouse gas emissions, such as the US or the emerging economies China and India, are still missing. This implies that the efforts of the EU to reduce greenhouse gas emissions, will only have a minor effect on climate change. Of the 30.6 billion tons of CO2 emissions in 2010 from burning fossil fuels (an estimate of the IEA), the EU ETS covered less than 2 billion tons. Of course, these critical aspects do not imply that the efforts of the EU to reduce greenhouse gas emissions are meaningless. Sooner or later other nations will join, or will have to join, and, besides the ecological beneﬁts, business companies in the EU, which develop and produce environmental technologies, will enjoy an even stronger ﬁrst-mover advantage. Currently, for example, German companies are profiting from the EEG and other environmental regulations (cf. Sections 10.2 and 10.3). It does, however, entail that the governments of the member states of the EU have to continuously justify this policy, which, after all, means a ﬁnancial burden for the private sector. Therefore, if the US, for example, would join the climate initiative of the EU, the situation would improve, both economically and ecologically for all participating economies.

11.5.3 The US Cap and Trade Policy Although the Obama administration did not – at least so far – succeed in implementing a nation-wide cap and trade system for greenhouse gas emissions, there are a number of examples of successful cap and trade programs in the US, including the nation-wide “Acid Rain Program” and the “Regional NOx Budget Trading Program” in the Northeast. Additionally, the Environmental Protection Agency (EPA) issued the “Clean Air Interstate Rule” (CAIR) in 2005, to build on the success of these programs and achieve signiﬁcant additional emission reductions. The EPA’s web

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11 The Price-Standard Approach to Environmental Policy

site http://www.epa.gov/capandtrade/programs.html provides more information on these and other programs. The goal of the US cap and trade system was to reduce CO2 emissions by 17% by 2020, and by 80% by 2050 compared with the 2005 level. There was an alternative proposal on a cap and divide system with a “fair” redistribution of the revenue from auctioning the certiﬁcates. And there was the proposal – backed mainly by the oil industry with the goal to limit price ﬂuctuations on the “carbon markets” – of a “linked fee” with the fee based on the total number of gallons of gasoline sold and linked to the average price of CO2 certiﬁcates over the previous three months. The fee then appeared like an increase in the tax on gasoline and that is probably what stopped its implementation. The US “Climate Bill” was passed in the House of Representatives, but there was no decision on the Senate. The following article from the Wall Street Journal indicates the heated debates on the Climate Bill: Who Pays for Cap and Trade? The Wall Street Journal, March 9, 2009 (excerpt from the article published online in [16]; permission to use this article granted) Cap and trade is the tax that dare not speak its name, and Democrats are hoping in particular that no one notices who would pay for their climate ambitions. With President Obama depending on vast new carbon revenues in his budget and Congress promising a bill by May, perhaps Americans would like to know the deeply unequal ways that climate costs would be distributed across regions and income groups. Politicians love cap and trade because they can claim to be taxing “polluters,” not workers. Hardly. Once the government creates a scarce new commodity – in this case the right to emit carbon – and then mandates that businesses buy it, the costs would inevitably be passed on to all consumers in the form of higher prices. Stating the obvious, Peter Orszag – now Mr. Obama’s budget director – told Congress last year that “Those price increases are es-

sential to the success of a cap and trade program”. Hit hardest would be the “95% of working families” Mr. Obama keeps mentioning, usually omitting that his no-new-taxes pledge comes with the caveat “unless you use energy.” Putting a price on carbon is regressive by deﬁnition because poor and middle-income households spend more of their paychecks on things like gas to drive to work, groceries or home heating. The Congressional Budget Ofﬁce – Mr. Orszag’s former roost – estimates that the price hikes from a 15% cut in emissions would cost the average household in the bottomincome quintile about 3.3% of its after-tax income every year. That’s about $680, not including the costs of reduced employment and output. The three middle quintiles would see their paychecks cut between $880 and $1,500, or 2.9% to 2.7% of in-

11.5 Experiences with Markets for Tradeable Certiﬁcates

come. The rich would pay 1.7%. Cap and trade is the ideal policy for every Beltway analyst who thinks the tax code is too progressive (all ﬁve of them). . . . Cap and trade, in other words, is a scheme to redistribute income and wealth – but in a very curious way. It takes from the working class and

205

gives to the afﬂuent; takes from Miami, Ohio, and gives to Miami, Florida; and takes from an industrial America that is already struggling and gives to rich Silicon Valley and Wall Street “green tech” investors who know how to leverage the political class.

There were, of course, other voices, supporters of the “Climate Bill – pointing to numerous opportunities, in particular for private industry. One of them, published online in “businessweek”, is by Richard L. Revesz, the then Dean of New York University School of Law, and Michael A. Livermore, executive director of the Institute for Policy Integrity (cf. [2]):

Obama’s Carbon Cap-and-Trade Plan Can Boost Growth by Richard L. Revesz and Michael A. Livermore Businessweek Viewpoint, March 10, 2009 (excerpt from the article published online in [2]; permission to use this article granted) President Barack Obama hits three nails on the head with his plan to cap carbon emissions: weaning us off fossil fuels, spurring a wave of investment and job creation, and putting cash in the pockets of Americans who most need it. In his budget, Obama included a “cap-and-refund” proposal that puts a strict limit on pollution that causes global warming and uses a permit auction to make large companies pay for the right to pollute. The cap on emissions will increase the price of fossil-fuel-based energy to encourage efﬁciency and new technologies. To protect consumers from rising prices, Obama’s plan refunds the revenue from the auctions directly to the American people through a tax credit.

The point of a carbon cap is to make energy efﬁciency and renewable energy sources more competitive by removing hidden subsidies for dirty energy such as coal. Pollution from fossil-fuel-based energy is known to impose important external costs, from health impacts today to climate change risks tomorrow. By raising the price of carbon emissions, a cap will create incentives for clean energy, efﬁciency, and conservation. Sparing Consumer Electricity Costs: Leveling the playing ﬁeld by forcing fossil-fuel prices to reﬂect their true cost will spur a wave of clean-energy investment: research and development in new technologies, new factories to produce solar panels and wind turbines, and energy-efﬁciency

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retroﬁts of commercial and residential real estate. That means jobs, and lots of them. While some businesses that rely on dirty energy will be hurt, many others will thrive in the cleanenergy economy. Most carbon cap plans are set up to fail because they reward energy companies with permit giveaways and fail to compensate consumers for increased electricity bills. One such proposal hit the Senate ﬂoor last year, only to collapse under the weight of too much spending and not enough protection for the middle class. Obama’s cap-and-refund plan avoids these mistakes. As stated clearly by Peter Orszag, President Obama’s budget director, giving away the permits would be nothing more than “the largest corporate welfare program that has ever been enacted in the history of the United States.” A cap is going to increase the relative cost of dirty energy whether permits are given away or auctioned because companies will have to use permits they could otherwise have sold in the market. Either way, in deregulated markets,

energy companies will pass those costs to consumers. Giving away permits doesn’t help consumers; it just transfers wealth to utility companies. The exception is in regulated energy markets, where consumers would have to count on utility regulators to protect their interests. . . . A Cleaner, Healthier Economy: These are important issues, but they deal with how to implement what is a genuinely transformative policy for this country. Right away, the President’s proposal will create new investment incentives and get cash into the pockets of working Americans. In the future, as we adjust to a new green economy, the cap will be lowered, generating even greater revenue that will be distributed to the U.S. public. The results of America’s fossil-fuel addiction are clear: We send billions overseas for foreign oil, muck up the environment with coal pollution, and stunt economic development. Breaking that addiction will cause withdrawal symptoms for some, but it is necessary to build a cleaner, healthier economy for all.

These articles speak for themselves – in particular they reveal to what extent the issue of climate change has split the country. The climate legislation of the US has therefore failed for a variety of reasons. One of them was – surprisingly – the Deepwater Horizon catastrophe which spilled thousands of barrels of oil a day into the Gulf of Mexico by the end of April 2010. According to a report in The New Yorker ([12], p. 83), this environmental disaster could have helped to save the climate legislation. However, the sponsors of the climate bill were suddenly left with a signiﬁcant expansion of offshore drilling in exchange for a cap on CO2 emissions, when the newspapers were ﬁlled with photographs from the catastrophe. Thus, this bargain “backﬁred” and the bill lost its credibility completely. Back in January 2010, the Pew Research Center asked Americans to rank the importance of certain relevant issues – climate change ranked last. Al Gore, when asked why he thought climate legislation had failed, cited the Re-

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publican partisanship, the Great Recession, and then he added: “The forces wedded to the old patterns still have enough inﬂuence that they were able to use the fear of the economic downturn as a way of slowing the progress toward this big transition that we have to make” ([12], p. 83).

11.5.4 Cap and Trade Policies in Other Parts of the World As already mentioned, amongst others, Australia, Japan, New Zealand, South Korea and Switzerland plan to establish “carbon trading schemes” or have already done so. A brief glance at the situation in the various countries will help to understand the challenges mankind is facing. In terms of economic theory the current state of the climate debates and the political issues regarding the implementation of effective policies shows very clearly how difﬁcult the allocation of a global public commodity can be. Australia: After an initial defeat in the Australian parliament, the start of the Carbon Pollution Reduction Scheme (CPRS) was delayed until July 2011. The bottom-level goal regarding a reduction of greenhouse gas emissions was 5% from 2000 levels by 2020 with an increase to 25% in the event of an ambitious global deal in the international climate negotiations. Japan: In Japan, the government rejected a cap and trade proposal at the end of 2010. The goal was to cut emissions of greenhouse gases by 25% from 1990 levels by 2020. Rather then having a nation-wide cap, the idea of the scheme was to set emission ceilings for individual companies with the option to trade certiﬁcates. New Zealand: With its climate change bill passed in 2008, New Zealand established the ﬁrst cap and trade system outside of Europe. Beginning with forestry in 2008, transport in 2009, and stationary power plants in 2010, this system will eventually cover all segments of the economy. The ambitious goal with this carbon trading scheme is to put New Zealand on course for a goal of carbonneutrality in the energy sector by 2040. South Korea: The initial plan to start a cap and trade system in South Korea in 2013, will probably be delayed by up to two years. As is the case in Australia and Japan, undue costs to business and a threat to the export-oriented industry, also in view of the failed cap and trade legislation in the US, seem to be reasons for this delay. The goal of the scheme was to cut emissions by 30% below business as usual by 2020, which is equivalent to an absolute reduction of 4% from 2005 levels. Switzerland: The Swiss emission trading system is a voluntary scheme for companies to avoid paying a “carbon tax”. Participating companies receive emission

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certiﬁcates according to their bargained reduction goal free of charge. These certiﬁcates can then be traded on a market. Switzerland is attempting to meet the reduction goals set out in the Kyoto Protocol with this instrument. This short review of the most important climate change initiatives shows that there is not much hope for even a weak global cap and trade system to be established in the near future. Chances are that the 30 billion tons of human-made greenhouse emissions attained in 2010 according to a report of the IEA, will soon give room to another record quantity. The following chapter addresses the allocation of global environmental commodities with international agreements and international negotiations as allocation mechanisms.

References 1. Baumol W, Oates W (1988) The theory of environmental policy. Cambridge University Press, Cambridge 2. Bloomberg Busineesweek http://www.businessweek.com/bwdaily/dnﬂash/content/mar2009/db20090310_825431.htm. Cited June 2011 3. Chiang AC (1987) Fundamental methods of mathematical economics, 3rd edn. McGraw-Hill, New York 4. EU (2007) Emissions trading: Commission decides on ﬁrst set of national allocation plans for the 2008-2012 trading period. IP-06-1650.pdf, Brussels http://europa.eu/rapid. Cited June 2011 5. EU (2010) Directorate-General for Climate Action http://ec.europa.eu/dgs/clima/mission/index_en.htm. Cited June 2011 6. Gately D, Huntington HG (2001) The asymmetric effect of changes in price and income on energy demand and oil demand. Economic Research Report 2001-01, C.V. Starr Center for Applied Economics, New York University, New York http://www.carbontax.org/wp-content/uploads/2007/11/inelastic-energy-gately-huntington2001-paper-from-b-tokar.pdf. Cited June 2011 7. Germany (2005) Federal Environmental Agency (UBA), Was bringt die Ökosteuer – weniger Kraftstoffverbrauch oder mehr Tanktourismus? http://www.umweltdaten.de/verkehr/downloads/oekosteuer.pdf. Cited June 2011 8. Germany (2007) Council of Economic Experts, Annual Report 2007/2008, Statistisches Bundesamt, Wiesbaden http://www.sachverstaendigenrat-wirtschaft.de/86.html. Cited June 2011 9. Hughes JE, Knittel CR, Sperling D (2006) Evidence of a shift in the short-run price elasticity of gasoline demand. NBER Working Paper 12530, Cambridge, MA http://www.nber.org/papers/w12530. Cited June 2011 10. Knigge M, Görlach B (2005) Effects of Germany’s ecological tax reforms on the environment, employment and technological innovation (Summary). Research Project commissioned by the German Federal Environmental Agency (UBA) http://www.umweltbundesamt.de/uba-info-presse-e/hintergrund/oekosteuer.pdf. Cited June 2011 11. Lingner S (2003) Legitimacy of tolerating limited environmental pollution? The case for natural attenuation. Poiesis Prax 2:73–78 http://dx.doi.org/10.1007/s10202-003-0038-1. Cited Dec 2010

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12. Lizza R (2010) As the world burns: how the Senate and the White House missed their best chance to deal with climate change. The New Yorker, October 11, 2010, 70-83 13. Palmer AR, Quinn TH (1981) Economic impact assessment of a chloroﬂuorocarbon production cap. Environmental Protection Agency, Support Document EPA-560/4-81-003, Washington DC http://nepis.epa.gov/Exe/ZyPURL.cgi?Dockey=910039ZU.txt. Cited June 2011 14. Robertson J (1996) Eco-taxes. New Internationalist Magazine, Issue 278, Oxford, UK http://www.newint.org/features/1996/04/05/taxes. Cited June 2011 15. Steiner V, Cludius J (2010) Ökosteuer hat zu geringerer Umweltbelastung des Verkehrs beigetragen. Wochenbericht des DIW Berlin, 13/14 / 2010:2-7 http://www.diw.de/sixcms/detail.php?id=diw_01.c.354588.de, Cited June 2011 16. The Wall Street Journal, March 9, 2009, p. A 18 http://online.wsj.com/article/SB123655590609066021.html. Cited June 2011 17. Ziesing H-J (2004) CO2 -Emissionen in Deutschland im Jahre 2003: Witterungsbedingt leichte Steigerung. Wochenbericht des DIW Berlin, 10 / 2004:121-128 http://www.diw.de/sixcms/detail.php?id=diw_02.c.229134.de. Cited June 2011

Chapter 12

The Allocation of International Environmental Commodities

Abstract The increasing relevance of cross-border environmental issues is mirrored in the quest for effective allocation mechanisms for international environmental commodities. Cost sharing agreements such as the commitments of the Kyoto Protocol are predominant “mechanisms”. For strategic goals the negotiations, which precede these international agreements, are gaining increasing importance. For example, a country might want to help or motivate others to participate effectively in activities to reduce cross-border environmental pollution. In contrast to the classical principal-agent approach not so much the unobservable effort of the agent is the main obstacle to an efﬁcient outcome, as the question of appropriate instruments to achieve the goal. This chapter will therefore investigate tools in this context and analyze their practical relevance. After a brief survey on the role of international environmental agreements as allocation mechanism, the principal-agent approach will be used to investigate stable and efﬁcient allocations resulting from international negotiations. Mitigation strategies and adaptation strategies regarding climate change will be addressed in particular.

12.1 International Environmental Agreements Depending on the details of the regulations, international environmental agreements, such as the United Nations Convention on Biological Diversity (cf. Subsection 3.2.1), set the framework conditions for the allocation of global environmental commodities, or prescribe concrete allocations, similarly to the Kyoto Protocol (cf. Subsection 3.2.3). With the exception of the EU Emission Trading System (cf. Subsection 11.5.1) these agreements dominate the allocation of international environmental commodities. Therefore, strategies are gaining importance to achieve a certain allocative goal in the negotiations, such as a greater reduction of greenhouse gas emissions for example. Given this context, a large variety of literature on international environmental agreements can be expected. Part of the literature focuses directly on important asH. Wiesmeth, Environmental Economics: Theory and Policy in Equilibrium, Springer Texts in Business and Economics, DOI 10.1007/978-3-642-24514-5_12, © Springer-Verlag Berlin Heidelberg 2012

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pects of such agreements (cf., for example, [1]), the development of international environmental law (cf. [15] or the establishment of an international order for the environment, similar to the WTO regulations for multilateral trade (cf. [12], Ch. 13). Although there is some success regarding the development of international environmental law – the “Electronic Information System for International Law” (EISIL) provides an excellent survey on the agreements concluded (cf. http://www.eisil.org) – there seems to be a problem with the effective enforcement of these regulations.1 Moreover, the fact that international trade has been successfully enhanced since 1948 with the establishment of the GATT, does not necessarily entail the founding of a similar institution for international environmental issues. Part IV of the book will analyze this area in more detail. Other approaches to international environmental agreements or negotiations rely in fact upon multilateral trade or, to be more precise, on the effects of international trade on the state of the environment in the countries of the trading partners. The issue of a “race towards the bottom” regarding environmental standards through competitive forces represents just one of the topics of great concern. Ineke de Boer provides a survey on the area of international trade and the environment (cf. [4]); Baumol/Oates integrate environmental and trade issues (cf. [2], Ch. 16) and so do Weber/Wiesmeth (cf. [17]); their approach will be considered in Part IV of this book. The stability of international environmental agreements is the topic of various papers edited by Carraro (cf. [6]). The obvious difﬁculties to achieve self-enforcing agreements with a large number of signatories are thereby related to the economic and environmental asymmetries across the world, and to the intrinsic instability of environmental agreements due to public goods characteristics, favoring the Prisoners’ Dilemma (cf. [6], p. 2). Interesting approaches taken in these papers to overcome this problematic aspects refer to – among other attempts – transfers and, more generally, issue linkage. The basic idea is to design a negotiation mechanism with countries negotiating not only on environmental issues but also on additional political or economic issues (cf. [6], p. 3). Thus, Botteon/Carraro demonstrate that transfers in a system of asymmetric countries can increase the effectiveness of transfers and can thus be used to broaden an originally stable coalition (cf. [5]). Moreover, Carraro/Siniscalco link an environmental agreement to an agreement on R&D cooperation (cf. [7]). In this case, the countries involved can reap the environmental beneﬁts and the beneﬁts from R&D cooperation.2 In general, this literature on international environmental agreements is somewhat detached from the idea of negotiation strategies in general and of a principal-agent approach to international environmental policy in particular. The following discussion will therefore explore this principal-agent approach in more detail. In particular, 1

Take the Kyoto Protocol, which is a legally binding agreement for the signatories. Nevertheless, a majority of the parties to the Kyoto Protocol did not comply with the regulations agreed upon, if one considers the numbers of the IEA report (cf. Subsection 3.2.3). 2 For some further details consider Weber/Wiesmeth, who introduced and investigated efﬁcient allocations in the context of issue linkage in the EU (cf. [16]).

12.2 The Principal-Agent Problem in Environmental Policy

213

the concept of the core of a public goods economy will be reconsidered and applied to this context (cf. Chapter 7).

12.2 The Principal-Agent Problem in Environmental Policy Normally, principal-agent problems refer to the question how one individual, the principal, can design a compensation scheme or a contract, which motivates another individual, the agent, to act in the principal’s interests (cf. [13], p. 241). Problems arise, when the principal can only incompletely monitor the efforts and the activities of the agent, i.e., when there is incomplete information. Then the careful design of appropriate contracts gains increasing importance. Granting a bonus for an outstanding performance could be considered as a compensation scheme in the context of the principal-agent approach. The crisis on the ﬁnancial markets in 2008 and 2009 demonstrates, however, that it can be difﬁcult to stimulate the agents in an “optimal” way. In the context of cross-border environmental problems, such as global warming or climate change, the situation is somewhat different. Again, there are “principals”, countries with well-deﬁned interests regarding a worldwide reduction of greenhouse gas emissions. Due to their comparatively high environmental awareness and the availability of sufﬁcient ﬁnancial means the principals demand challenging goals in international climate negotiations. The “agents”, on the other hand, are represented by those countries with a lower environmental awareness and typically less ﬁnancial means.3 However, some of the “agents”, such as China or India, are already emitting huge amounts of carbon dioxide and will emit signiﬁcantly more in near future in a business as usual scenario. So, the question arises, how to motivate and “convince” these countries to increase their efforts to reduce greenhouse gas emissions, to join the international climate debates in a constructive way (cf. the report on the Copenhagen summit on p. 118). Whereas in the classical case appropriate contracts “guide” the agents to optimally pursue the interests of the principal, the question for a set of appropriate “tools” or “instruments” becomes more important in the context considered here. Again, as in the original principal-agent approach, incomplete information on the actual economic situation or the actions of an “agent” country will render a thorough analysis difﬁcult, in particular for practical purposes. The “old” case of the protection of the tropical rain forest, which can be considered as a principal-agent problem where the international community is the principal and the rain forest country the 3

The association of the “principals” in this context with the rich “industrialized” countries results from the fact that environmental awareness tends to increase with per-capita income (cf. Subsection 4.1.1 and [9]). The fact that some industrialized countries such as the US did not ratify the Kyoto Protocol, has other reasons and could be the consequence of a lacking public support: in a Gallup poll taken in March 2010, 48% (up from 35% just two years previously) of the respondents said they believe the threat of global warming to be “generally exaggerated” (The New Yorker, April 12, 2010, p. 21). Whether this lacking support is a a failure of environmental policy or a consequence of the inherent dependency of the country on fossil fuels, remains to be seen.

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agent, demonstrates clearly the challenges of such an approach to international environmental problems (cf. [11]). The following subsections will refrain from these aspects of incomplete information and focus primarily on the selection of potentially effective instruments, in particular mitigation and adaptation strategies to ﬁght climate change.

12.2.1 Stability and Efﬁcient Mitigation Strategies This subsection and the next will revisit the concept of the core of a public goods economy as a means to characterize stable and efﬁcient outcomes of negotiations, in particular in a global context without a supranational government guiding the discussions and enforcing the results. The conferences in the context of the UNFCCC, which led to the Kyoto Protocol in 1997, and the climate talks regarding a second commitment period for the years from 2013, provide illustrative examples for negotiation processes on mitigation strategies (cf. Section 3.2). The course of the debates reveals the attempts to arrive at a mutually acceptable, “stable” result. Whether this result will then be implemented depends, however, on the strength of the Prisoners’ Dilemma and the attempts to control it through appropriate measures.4 However, core allocations are, in general, not unique (cf. Section 7.3 for an example). The immediate consequence is that the ﬁnal outcome of the debates may depend on the “positioning” of certain countries in the beginning and the course of the negotiations. The Copenhagen summit provides an example of the positioning of the developing countries (cf. the report on p. 118). But also the commitment of the German government to reduce CO2 emissions by 40% by 2020 in comparison to the emissions in 1990 and the calls of the European Parliament for the EU to adopt reduction targets of 30% by 2020, again compared to 1990 levels, should be interpreted as an “invitation” to other countries to follow suit. The following article taken characterizes this “Carbon Gamble” before the Copenhagen summit in December 2009. For further details of the “EU Greenhouse Gas Emission Trading System” (EU ETS) refer to Subsection 11.5.1. The Carbon Gamble: Is Europe Leading or Losing on CO2 Emissions? by Mark Scott Businessweek, August 4, 2008 (excerpt from [3], published online; permission to use this article granted) The continent’s bureaucrats hope their counterparts in China, India, and the US will embrace carbon regulation next year in Copenhagen. 4

The bureaucrats that run the European Union’s day-to-day business aren’t known for taking risks. Yet back in 2005, when they devised the

The attempts to install the principles of measuring, reporting and verifying (MRV) into the current climate talks, seem to address the Prisoners’ Dilemma.

12.2 The Principal-Agent Problem in Environmental Policy

EU Greenhouse Gas Emission Trading Scheme (EU ETS), these pencil pushers gambled that a cap and trade scheme would help cut the EU’s carbon dioxide emissions. Now, three years on, the environmental beneﬁts from the EU ETS remain unclear: The continent’s CO2 output actually rose 1.1 percent last year. Moreover, its impact on the European economy is far from clear. Optimists think Europe’s early adoption of a cap and trade CO2 market will give local companies a competitive advantage when other regions of the world ﬁnally start trading carbon. Under the EU ETS, companies are given a set number of carbon allowances (the “cap” in cap and trade), which then can be bought and sold on the open market. In theory, this provides a ﬁnancial incentive for ﬁrms to become more en-

215

ergy efﬁcient, giving European businesses a head start in cutting overhead just as fuel costs begin to hit company proﬁts. This goal will be put to the test ahead of next year’s U.N.-backed meeting in Copenhagen to negotiate a global agreement on climate change. For Europeans, the summit holds particular importance. The continent has banked its ﬁnancial future – and moral authority – on creating a lowcarbon economy. This gamble’s efﬁcacy now depends on the likes of China, India, and the U.S. deciding whether to embrace carbon trading. “Copenhagen will play a big part in showing that Europe’s creation of a cap and trade carbon market will pay off,” says Mark Spelman, global head of strategy at consultancy Accenture (ACN).

The following analysis on mitigation is based on Example 7.4 introduced and discussed in Section 7.3. This example will thereby be slightly extended to allow an investigation along the lines of the principal-agent approach introduced above. Example 12.1 (Mitigation Strategies). The two countries i = 1, 2 are characterized by the homothetic utility functions u1 (x1 , y) = x1 · y and u2 (x2 , y) = x2 · yα , 0 < α < 1, respectively, and by initial endowments ω1 = 1 and ω2 = 2 respectively. One unit of the private commodity can be turned into one unit of the public commodity in country 1 and in β > 1 units in country 2. As in Example 7.4, country 1 is considered to be a “rich” industrialized country5 , whereas country 2 is a developing country with a lower marginal rate of substitution of the private commodity for the public commodity (cf. Subsection 4.1.1). As before, the modiﬁed Samuelson Condition and the feasibility constraint for an efﬁcient allocation z = (x1 , x2 , y) are given by: MRS1 (x1 , y) + β · MRS2 (x2 , y) = 1 and (1 − x1 ) + β · (2 − x2 ) = y. From these conditions for feasibility and efﬁciency the set of core allocations results with appropriate upper and lower bounds for the public commodity y (cf. Section 7.3 5 The term “rich” refers to per-capita income which is assumed to be higher in country 1 in comparison to country 2. The higher initial endowment of country 2 is, by assumption, compensated through a higher population.

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and, in particular, Note 7.6):

1 + 2β − 2y y(1 + α) − α(1 + 2β ) (x1 , x2 , y) : x1 = ; x2 = ; ymin ≤ y ≤ ymax . 1−α β (1 − α) As before, the minimum value ymin for y can be calculated from u1 (x1 (y), y) ≥ 0.25 with 0.25 the utility level that country 1 can guarantee itself without “support” from country 2. The result, depending on the values for α and β , is: ymin =

1 · α(1 + 2β ) + 1 + 4α 2 β + 4α 2 β 2 . 2(1 + α)

So far the details of this slightly extended version of Example 7.4 from which conclusions with respect to mitigation strategies will now be derived by means of the following remarks. The ﬁrst remark refers again to the above mentioned issue of “positioning” oneself as a country with a high environmental awareness and an equally high willingness to contribute a comparatively large amount of the private commodity towards the production of the public commodity, i.e., towards the reduction of greenhouse gas emissions: Remark 12.1 (Positioning). From the modiﬁed Samuelson Condition x1 + αβ x2 = y and the feasibility constraint x1 + β x2 = 1 + 2β − y above one obtains for the total variations in x1 , x2 and y: dx1 + αβ dx2 = dy and dx1 + β dx2 = −dy, adding up to 2dx1 + β (1 + α)dx2 = 0. This implies dx2 = [−2/β (1 + α)]dx1 < 0 and dy = dx1 + αβ dx2 = dx1 [(1 − α)/(1 + α)] > 0 for dx1 > 0. Therefore, dx1 > 0 if and only if dy > 0. Thus, if the industrialized country 1 plans to position itself as a party with a high environmental awareness it has to lower consumption of the private commodity (dx1 < 0) with the consequence of a smaller contribution (dx2 > 0) of the developing country 2 towards the provision of the public commodity, and a reduced level of the public commodity y altogether, i.e. a low level of agreed emissions reductions. In this sense, this way of “positioning” oneself as an environmentally concerned country will not sufﬁciently motivate the developing country to share the burden adequately. Observe that this mirrors to some extent the climate debates in Copenhagen (cf. again the report on p. 118).6 The following remark refers to the possibility of gradually raising environmental awareness in country 2 through various measures, such as further education in environmental issues, or ﬁnancial support for the latest environmental technologies. A successful policy results in a higher value of the parameter α: 6

Of course, this is nothing but a simple example with rather speciﬁc assumptions, and one should hesitate to derive any general statements from it. But, on the other hand, this example (and the negotiations in Copenhagen in 2009) demonstrate that these conclusions are far from being “out of the world”.

12.2 The Principal-Agent Problem in Environmental Policy

217

Remark 12.2 (Raising Environmental Awareness). Consider ymin as a function of α, the parameter indicating the attitude towards the environment, thus indicating the “degree” of environmental awareness. From Example 12.1: ymin =

1 · α(1 + 2β ) + 1 + 4α 2 β + 4α 2 β 2 . 2(1 + α)

The positive root y(α) ¯ of the quadratic equation u1 (x1 (y, α), y) = x1 (y, α) · y = 0 is calculated to y(α) ¯ = [α(1 + 2β )]/(1 + α) and increases with α (cf. Example 12.1). Moreover, all functions y → u1 (x1 (y, α), y) intersect at y = (1 + 2β )/2 for 0 < α < 1 (cf. Note 12.1). One obtains u1 (x1 (y , α), y ) = (1 + 2β )2 /4 > 1 > umax and 1 ymin (α) increases with α. This situation is depicted in Figure 12.1 with β = 2. This result indicates that climate talks might be more successful if they are carried out under “equals”: the “positioning” of an industrialized country might be more effective in a coalition with partners characterized by comparable environmental awareness. 12

10

8

6

4

u1

2

-2

-4

-6

. .. .... ... ... ... ... ... ... .. ... .... . ... ....... ... ...... ......... ......... . ... ....... ..... ....... ..... .. .. ... . . . . . . . ... ... . .. ... .. ... u1 (y, α) for α1 = 0.5, ...u .. .. .. . . . . . . . . . α2 = 0.6, and α3 = 0.7 ...... .... ...... ....... .......... .......... . . .. ........ ... ... ... .. ... ... .. .... .... .. ... ..... .... . . .... .... .. .... ... .. .... ... ... .... .... .. ... ...... .... umax ymin (α) . . . 1 . . ...... ...... .... .. .. .... u ............................................. . ............... .............. ..u .......................... ....u ..... .. ..... ....... . . . . . . . .. . . . . ....... ... .. ..... .... .. ........... ... ....... .. .... ... .................... 0.5 1 1.5 2 2.5 3 ....... ... .... ...... ........... .......... ...... .... ......... .... ........ ............. ...... ... .......... . . . . . . . ................. . . . . . . .... ....... . . . . . . . . y........ ............................... .. .... ........ . . . . . .. .... ........ ... ....... ........ .... ... ........ ......... .... .... ......... ............. .... ............................................. .... .... ... . . .... . .. .... .... ...... ..... ...... ...... ....... ...... ....... ...... . . . ........ . . . . .... ........... ..................................

-8

Fig. 12.1 Raising environmental awareness

Note 12.1. In order to investigate y > 0, the point of intersection of u1 (y, α 1 ) and u1 (y, α 2 ) for different values α 1 and α 2 of the parameter α, consider the equation u1 (y, α 1 ) = u1 (y, α 2 ), i.e., (y )2 (1 + α 1 ) − α 1 y (1 + 2β ) (y )2 (1 + α 2 ) − α 2 y (1 + 2β ) = . 1 − α1 1 − α2

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12 The Allocation of International Environmental Commodities

This expression simpliﬁes to y (1 + α 1 )(1 − α 2 ) − α 1 (1 − α 2 )(1 + 2β ) = y (1 + α 2 )(1 − α 1 ) − α 2 (1 − α 1 )(1 + 2β ), which leads to 2y (α 1 − α 2 ) − (1 + 2β )(α 1 − α 2 ) = 0 with the ﬁnal result y = (1 + 2β )/2. Thus, y is independent of α.

The issue of raising environmental awareness is related to the policy of international organizations. The IMF, for example, in close cooperation with the World Bank, provides policy advice and ﬁnancing to members in economic difﬁculties and also works with developing nations to help them achieve macroeconomic stability and reduce poverty. The World Bank, on the other hand, is concerned mainly with longer-term development. Its loans ﬁnance infrastructure projects, the reform of particular sectors of the economy, and broader structural reforms. Cf. the homepage of the IMF ([10]) for more details. In the context of a slightly different principleagent approach in development economics, Svensson investigates incentive effects of “tied” aid (cf. [14]). In the context of the Kyoto-Protocol, the Clean Development Mechanism encourages CDM projects between Annex I countries and non-Annex I countries (cf. Subsection 3.2.3). Companies in an Annex I country can thereby complement their obligation to reduce greenhouse gas emissions by acquiring “Certiﬁed Emission Reductions” (CER). Assume that there is agreement at the beginning of climate debates that industrialized countries may approach developing countries to carry out such CDM projects. How does such an opportunity affect the positioning of the countries? Do CDM projects constitute a tool to stimulate further efforts for the reduction of greenhouse gas emissions in developing countries? A formal investigation in the context of the above example is provided in the following remark, which highlights again the role international development organizations, such as the International Monetary Fund (IMF) or the World Bank, can play in this context: Remark 12.3 (CDM Projects). In order to integrate a CDM project into the above example, it is assumed that such a project involves a transfer of resources from the industrialized country to the developing country. Of course, a CDM project can also imply a transfer of knowledge to the developing country, or both a transfer of resources and of knowledge.7 As transfers of technology are considered in the next remark, the following presentation focuses on a transfer of resources from the industrialized country 1 to the developing country 2. 7 For example, if a company from country 1 is – in the context of a CDM project – invited to bring innovative environmental technology to country 2, then this is probably more a transfer of technology. If such a company invests in sanitizing a landﬁll in country 2 and recovers part of the cost through selling the acquired CER, then the project includes some transfer of resources from country 1 to country 2.

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It is therefore assumed that the possibility of carrying out CDM projects will lead to a potential increase of the initial endowment of country 2 from ω2 = 2 to, say, 2.1, accompanied by a compensating decrease of ω1 = 1 to 0.9. How does this “option” structurally affect the set of core allocations? Consider again the, in the context of the above example, quadratic equation u1 (x1 (y), y) = x1 (y) · y = 0 with ﬁxed values for the parameters α and β and with ω1 and ω2 adjusted as above. In this case, one obtains for u1 (x1 (y), y) = x1 (y) · y: x1 (y) · y =

α(0.9 + 2.1β ) y2 (1 + α) − yα(0.9 + 2.1β ) = 0 with root y(α) ¯ = > 0. 1−α 1+α

This change in the initial endowments thus increases y(α) ¯ because β > 1 by assumption; moreover, the slope of the graph y → u1 (x1 (y, α), y) decreases with this change, with the consequence that the solution of u1 (x1 (y), y) = 0.25, yielding the value of ymin , increases too. In this sense, the transfer of resources in the context of CDM projects can help to increase the minimum level of the provision of the public commodity in the course of the negotiations. The last remark in this context refers to the transfer of technology, of knowledge, from the industrialized country to the developing country. It is assumed that such a transfer leads to an increase of the parameter β . Remark 12.4 (Transfer of Technology). Consider x1 (y, β ) now as a function of β , and observe that the positive root y(β ¯ ) of the quadratic equation u1 (x1 (y, β ), y) = 0 increases with β . Again, the slope of the graph y → u1 (x1 (y, β ), y) decreases with an increasing value of β . As a result, ymin , the positive solution of the quadratic equation u1 (x1 (y, β ), y) = umax = 0.25, increases with β . Therefore, this “policy” 1 tends also to increase the motivation of the developing country to contribute towards the production of the public commodity. The following section offers a brief analysis of adaptation strategies, supplementing or complementing the mitigation strategies considered above. The analysis will again be based on the principal-agent approach introduced in this section.

12.2.2 The Role of Adaptation Strategies In addition to the mitigation strategies, which usually include lowering the concentration of greenhouse gases either by reducing their emissions or by increasing their sinks, adaptation strategies involve appropriate actions to protect a particular country or particular regions against the likely effects of global warming. Climate policy is therefore typically based on two pillars: avoidance of greenhouse gases and adaptation to those consequences of climate change which are already unavoidable – given the continuing growth of global greenhouse gas emissions.

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The German Adaptation Strategy (excerpt from [8]) On 17 December 2008 the Federal Cabinet adopted the “German Strategy for Adaptation to Climate Change”. This creates a framework for adapting to the impacts of climate change in Germany. It primarily describes the contribution of the Federation, thus acting as a guide for other actors. The strategy lays the foundation for a medium-term, step-by-step process undertaken in cooperation with the federal Länder and other civil groups and aimed at assessing the risks of climate change, identifying the possible need for action, deﬁning appropriate goals and developing and implementing options for adaptation measures. Besides outlining the current status of knowledge on the anticipated climate changes (globally and in Germany) and the impacts these could entail, the strategy also highlights possible climate impacts and options for action for 15 spheres of activity and selected regions. In addition, the Strategy describes the international context and the German contribution to adaptation in other parts of the world, and explains the next steps for further developing the German Adaptation Strategy. The aim of the Strategy is to create a national framework for action in order to avert dangers to the public, natural habitats and the national economy. This framework is intended to make it easier for the various levels of the Federation, Länder, local authorities and for individual citizens to identify impacts and adaptation needs, and to plan and implement measures. For instance, early incorporation of adaptation aspects into planning can save climate costs in the future. The German Strategy for Adaptation to the Impacts of Climate Change was developed in close cooperation with the Länder by a working group comprised of representatives from most of the federal ministries and under the lead responsibility of the Federal Environment Ministry. Support was provided by the competence centre for climate impacts and adaptation (Klimafolgen und Anpassung (KomPass)), which was set up at the end of 2006 at the Federal Environment Agency. Several sources were used in the elaboration of the German Adaptation Strategy, including the results of a review with a particular focus on the Federation and Länder and the conference “German strategy for adaptation to climate change – expectations, goals and options for action” organised by the Federal Environment Ministry on 15 and 16 April 2008 in Berlin. In addition, the Federal Environment Ministry and the Federal Ministry for Education and Research jointly organised a research symposium on adaptation at the Centre for Environmental Research in Leipzig on 27 and 28 September 2008. In order to investigate the potential effect of the availability of adaptation strategies on the positioning in international environmental negotiations, Example 12.1 will be

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reconsidered and adjusted to allow for adaptation strategies. It is thereby assumed that adaptation strategies diminish the urgency for a particular country to reduce greenhouse gas emissions. In technical terms, the “environmental awareness” for the issue of climate change decreases for this country because the potential effects can be controlled, at least in principle and to some extent.8 More precisely, there is a continuously differentiable function α1 : [0, ω1 ] → [0, 1] with α1 (0) = 1 and α1 (t) < 0 for all t ∈ [0, ω1 ]. Again, α1 (t) determines the marginal rate of substitution of the private commodity for the environmental commodity in country 1 in the sense that ut1 (x1 , y) := x1 · yα1 (t) and MRSt1 (x1 , y) = α1 (t) · (x1 /y) (cf. also Example 12.1). The function α1 represents the adaptation strategy available to country 1. Investing the amount t of the private commodity in adaptation activities relieves country 1 somewhat from the pressure to reduce greenhouse gas emissions, and the MRS between the public and the private commodity decreases. Thus, ut1 (x1 , y) = x1 · yα1 (t) and u2 (x2 , y) = x2 · yα2 with α2 ∈ [0, 1] constitute the utility functions for the representative agents in country 1 and country 2 respectively, with a given value of the parameter t indicating the level of the adaptation activities in country 1. As before, the initial endowments in the two countries are given by ω1 = 1 and ω2 = 2. Beyond the regular contribution towards the production of the public commodity, i.e., towards the reduction of greenhouse gas emissions, country 1 has to choose an additional strategic variable: the value of t, the value of the investments in adaptation strategies. Starting from t = 0, it will be investigated whether a small increase in the value of t can motivate country 2 to increase its contributions. Thus, it will be analyzed whether the availability of adaptation strategies in country 1 imposes a “threat” on country 2. Assume now that for the ﬁrst situation to be analyzed the value of t ∈ [0, 1] is given and ﬁxed. Denote by C (t) the set of the resulting core allocations. Obviously, these allocations are determined by the ﬁrst-order conditions for efﬁcient allocations (the modiﬁed Samuelson Condition and the feasibility constraint): α1 (t)x1 + β α2 x2 = y and (1 − x1 − t) + β (2 − x2 ) = y. From these two equations one obtains (with assuming α1 (t) > α2 for all relevant values of t): (1 + α2 )y − (1 + 2β − t)α2 x1 (y) = . α1 (t) − α2 Again, the focus is on the minimum value ymin (t) of the total amount of the public commodity that can be achieved under the given circumstances. In order to calculate the value of ymin (t), one has ﬁrst to consider the reservation level umax 1 (t) of the utility of country 1, which it can guarantee for itself without support from the other country (cf. also the calculations in Example 12.1). 8

Possible long-term effects, such as migration from severely affected countries to the “protected” industrialized countries, are not taken into account.

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If country 1 has to take care of the provision of the public commodity alone, then feasibility requires x1 + y1 = 1 − t. Utility maximization leads to maxx1 ,y1 u1 (x1 , y1 ) α (t) under the feasibility constraint. This implies maxy1 (1 − t − y1 )y1 1 with the immediate solutions: 1+α1 (t) 1−t α1 (t)(1 − t) max 1−t max α1 (t) , x , u = = = α (t) · ymax 1 1 1 1 + α1 (t) 1 + α1 (t) 1 1 + α1 (t) for x1max , ymax and umax 1 1 , depending, of course, on the given value of the parameter t. To obtain the required result for ymin (t), one thus has to solve for the positive root of the equation ut1 (x1 (y), y) = umax 1 (t) or

(1 + α2 )y1+α1 (t) − (1 + 2β − t)α2 yα1 (t) = umax 1 (t). α1 (t) − α2

Observe that this equation has exactly one positive root. This follows, ﬁrst of all, from the fact that the equation ut1 (x1 (y), y) = 0 has root 0, and exactly one positive root: y(t) ¯ = (1 + 2β − t)α2 /(1 + α2 ). Moreover, consider the slope of the function y → ut1 (x1 (y), y). The derivative is given by: yα1 (t)−1 d t u1 (x1 (y), y) = · [(1 + α1 (t))(1 + α2 )y − (1 + 2β − t)α1 (t)α2 ]. dy (α1 (t) − α2 ) This slope is negative for small values of y, and positive for y ≥ [(1 + 2β − t)α1 (t)α2 ]/[(1 + α1 (t))(1 + α2 )], which is equal to [α1 (t)/(1 + α1 (t))] · y(t), ¯ the location of the unique (relative and absolute) minimum of this function. Observe that both y(t) ¯ and the location of this minimum decrease with an increasing value of t. As only levels of y such that y ≥ y(t) ¯ are relevant candidates for ymin (t), because umax 1 (t) > 0, the conclusion for the uniqueness of ymin (t) follows. In order to investigate further relevant properties of ymin (t) it is ﬁrst necessary to study the behavior of umax 1 (t) for t in a neighborhood of 0. Differentiating this expression with respect to t at t = 0 yields (cf. also Note 12.2): dumax 1 1 (t) |t=0 = − · (2 + α1 (0) ln 2). dt 4 Obviously, this derivative is negative, if −α1 (0) ln 2 < 2. Remember that α1 (0) < 0 by assumption. Thus, this condition is satisﬁed if α1 (t) does not decrease too strongly in a neighborhood of t = 0. Note 12.2. In order to differentiate umax 1 (t) with respect to t, observe that this function can be rewritten as follows (with the exponential function exp and the natural logarithm ln): umax 1 (t) = exp[α1 (t) ln(α1 (t)) + (1 + α1 (t))(ln(1 − t) − ln(1 + α1 (t))].

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Differentiating this expression with respect to t and evaluating the derivative at t = 0 yields with umax 1 (0) = 0.25 and α1 (0) = 1 the above result. A careful analysis of the function y → ut1 (x1 (y), y) depending on t reveals further structural properties, as indicated in Figure 12.2. In particular, this function ¯ Both the lois strictly convex with a unique minimum at [α1 (t)/(1 + α1 (t))] · y(t). cation of the minimum and the minimal value decrease with an increasing value of t. Therefore, two utility functions ut1 (x1 (y), y) associated with two different levels t 0 < t 1 of the parameter t intersect at a value of y with ut1 (x1 (y ), y ) < 0. The solution of ut1 (x1 (ymin (t)), ymin (t)) = umax 1 (t) > 0 implies a value of ymin (t) which clearly exceeds y(t) ¯ (cf. Figure 12.2). 50

40

30

20

10

u1 -10

-20

-30

-40

-50

. ... ... .. . ... ... ... .. .. . ... ... ... .. ... . . . ... ... t0 = 0.0, α10 = 1.00, α2 = 0.9 .... ... .... ... 1 1 ... . . . . . . t = 0.1, α1 = 0.95, α2 = 0.9 . ... .... ... ... ... ... .... ... .. . . . ... ... ... ... ...... .. .. .. ...... . . . . ... ..... ... ..... ... .... .... ......... ....... . ....... ..... ... ..... ..... 0.5 1 1.5 2 2.5 3 ...... ... ..... ...... ... ..... ........ . . ... ...... . y ... ... . ...... . ... . . . ...... .... ... ....... ...... ... ... ....... ...... .... ... ....... ...... . ....... 0 0 ....... ... ... ........ ....... u (α , t ) . ... . . 1 . . 1 ... . ........ . ... .. ......... ........ ... ........ .. ......... . . . . . . . . . . . ... . ........... . .............. ........... ... .... ..................................................................... .... ... .... ... .... .... ... .... . . .... ... .... ... .... .... .... .... .... .... . . .... . . .... .... u1 (α11 , t1 ) .... .... ...... ..... ....... ....... ....... ....... . . . ........ . . . ..... ......... ......... ............ ...........................................

Fig. 12.2 Utility of agent 1 depending on y and various levels of α1 and t

The following remark summarizes these exemplary results for using adaptation strategies in the context of international environmental negotiations under the framework conditions of Example 12.1: Remark 12.5 (Adaptation Strategies). Assume that the utility functions for the private commodity x and the public commodity y of the two countries are given by ut1 (x1 , y) = x1 · yα1 (t) and u2 (x2 , y) = x2 · yα2 respectively with adaptation strategy α1 (t) available to country 1. Let ω1 = 1 and ω2 = 2; moreover one unit of the private commodity can be turned into one unit of the public commodity in country 1 and in two units of the public commodity in country 2.

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Then, if −α1 (0) ln 2 − 2 < 0, the minimum level of the public commodity ymin (t) attainable in core negotiations is below ymin (0) for small values of t. This result is an immediate consequence of the conclusions obtained above: 1 ut1 (x1 (y), y) with t 1 > 0 is above ut1 (x1 (y), y) with t 0 = 0 for y > y , and umax 1 (t ) < max 0 t 1 max 1 u1 (t ). Therefore, u1 (x1 (y), y) with t = t assumes the value u1 (t ) at ymin (t 1 ), which has to be smaller than ymin (t 0 ), representing the corresponding situation for 0 ut1 (x1 (y), y) with t = t 0 and the value umax 1 (t ). This situation, which is illustrated in Figure 12.2 and, in more detail, in Figure 12.3, will be discussed in the following example. 8

6

4

2

u1

-2

-4

-6

-8

-10

-12

.. ... ... ... .... ... .. ... ... .. . .... ... u (α0 , t0 ) .. 1 1 ... ... ... ... .. . .... .. ... . .. ... ... ... ... ... .. max 0 .... . (t ) .. u1 . umax (t1 ) ..... ..... 1 ... ... . .. ..u ......................................................................u .......................................... .. .. ... ... 2.25 .... .... 2.5 2.75 .. .. ... ... y .... .... .. .. ... ... ... ... y ........ ..... .....u .. .. .... ...... ...... . t0 = 0.0, α10 = 1.00, α2 ..... ... ... ... ... t1 = 0.1, α11 = 0.95, α2 .. ... . ... ... ... ... ... ... .. ... . ... ... ... .... u1 (α11 , t1 ) .. .. .. . . ... ... .... .. ... ... ...

3

= 0.9 = 0.9

Fig. 12.3 Details of Figure 12.2

Example 12.2. Choose the values of the parameters β = 2 and α2 = 0.9, and assume that initially there are no adaptation strategies in country 1, i.e., t 0 = 0 and α1 (t 0 ) = 1. Take t 1 := 0.1 and α1 (t 1 ) := 0.95. In the context of this example, there is no need for a further detailed speciﬁcation of the function α1 , representing the adaptation strategies and their effect on the MRS in country 1. The details of the utility functions ut1 (x1 (y), y) associated with t 0 resp. t 1 are given in Figure 12.3. In particular, ut1 (x1 (y), y) with t = t 0 assumes the value 0 0 max 1 umax 1 (t ) = 0.25 at ymin (t ) ≈ 2.374. As u1 (t ) ≈ 0.21 is slightly smaller than max 0 t u1 (t ), and as the slope of the graph of u1 (x1 (y), y) with t = t 1 is steeper according to the above considerations, ymin (t 1 ) ≈ 2.323 must be smaller than ymin (t 0 ). The 0 max 1 small difference between umax 1 (t ) and u1 (t ) can, however, only be indicated in Figure 12.3.

References

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The important conclusion of this subsection is therefore that the opportunity to invest in adaptation strategies does not necessarily “stimulate” the negotiations regarding the provision of the public (environmental) commodity, i.e., negotiations regarding the reduction of greenhouse gas emissions, at least not in the context of the framework conditions of this model economic system. Of course, this result does not preclude the necessity of an adaptation to those consequences of the climate change which are already deemed unavoidable, as outlined in the introduction to this subsection. Part IV of the monograph continues the analysis of international environmental issues. The focus is thereby more on the integration of trade and the environment.

References 1. Barrett S (1997) Heterogeneous international environmental agreements. In: Carraro C (ed) International environmental negotiations. Edward Elgar, Cheltenham 2. Baumol W, Oates W (1988) The theory of environmental policy. Cambridge University Press, Cambridge 3. Bloomberg Busineesweek http://www.businessweek.com/globalbiz/content/aug2008/gb2008084_780404.htm. Cited June 2011 4. Boer de I (1994) Trade and environment: a brief survey of current theoretical issues. In: Ierland van EC (ed) International environmental economics. Elsevier, Amsterdam 5. Botteon M, Carraro C (1997) Burden sharing and coalitional stability in environmental negotiations with asymmetric countries. In: Carraro C (ed) International environmental negotiations. Edward Elgar, Cheltenham 6. Carraro C (ed) (1997) International environmental negotiations. Edward Elgar, Cheltenham 7. Carraro C, Siniscalco D (1997) R&D cooperation and the stability of international environmental agreements. In: Carraro C (ed) International environmental negotiations. Edward Elgar, Cheltenham 8. Germany (2010) Federal Ministry for the Environment, Nature Conservation and Nuclear Safety: The German Adaptation Strategy cf. http://www.bmu.de/english/climate/adaptation_to_climate_change/doc/42825.php. Cited Nov 2010 9. Grossman GM, Krueger AB (1995) Economic growth and the environment. Quart J Eco 110:353–377 10. International Monetary Fund (IMF) cf. http://www.imf.org/external/about.htm. Cited Nov 2010 11. Siebert H (1991) Transfrontier pollution and global environmental media, Kiel Working Paper No. 499. The Kiel Institute of World Economics 12. Siebert H (2008) Economics of the environment, 7th edn. Springer, Berlin 13. Stiglitz J (1990) Principal and agent. In: Eatwell J et al (eds) The New Palgrave: Allocation, information and markets. Macmillan, London 14. Svensson J (2000) When is foreign aid policy credible? Aid dependence and conditionality. J Dev Eco 61:61–84 15. Swanson TM, Johnston S (1999) Global environmental problems and international environmental agreements. Edward Elgar, Cheltenham 16. Weber S, Wiesmeth H (1991) Issue linkage in the European Community, J Common Market Studies XXIX:255–267 17. Weber S, Wiesmeth H (2003) From autarky to free trade: the impact on environment and welfare, Jahrbuch für Regionalwissenschaft 23:91–115

Part IV

The Environment in the Globalized World

This last part of the book gives insight into the intricate relationship between international policy, in particular international trade, and the environment, in particular environmental policy. The chapters in this part thus focus on existing networks of international relations and their relevance for environmental issues. International trade certainly constitutes one of these networks which gained increasing importance with the effects of globalization becoming more and more visible in the last decades. However, globalization not only furthered international trade. It certainly helped to reveal and to address international and global environmental problems such as overﬁshing or climate change and to raise public awareness, but it also contributed, among other things, towards increasing trafﬁc with sometimes severe consequences for the environment. Thus, a combined consideration and careful analysis of the ﬁelds trade and the environment promises new insight into how international trade and environmental policy are intertwined, how they affect each other with respect to transnational economical and ecological issues. However, local or regional environmental pollution can also be “transferred” across borders through international trade. This becomes very clear, for example, in the issue occasionally raised in the western world, whether “rich” industrialized countries should engage in trade with developing countries, when they continue to produce under conditions neglecting and polluting the local environment, thereby gaining a cost advantage. In this context, Part IV therefore provides ﬁrst a characterization of a further international dimension of environmental economics with a brief review of relevant international organizations and agreements which govern international trade, in particular in its relationship to environmental policy. Thereafter follows an investigation of economic mechanisms which lead to overﬁshing. This investigation is supplemented by a discussion of various ﬁsheries policies introduced to curb overﬁshing in the globalized world. Finally, an analysis of effects on the environment, which are in general associated with international trade, concludes this part.

Chapter 13

Trade and the Environment: The Legal Context

Abstract This chapter provides a brief characterization of the international dimension of environmental economics in its relation to international trade. A survey on “Selected Ecological Trends” demonstrates the increasing importance of crossborder environmental problems. However, the international competitiveness of private companies may also be harmed by high environmental standards, even if they refer to local pollution only. Should environmental standards therefore be harmonized to establish a “level playing ﬁeld” for international trade? Although an answer to this question will only be attempted in a later chapter, it shows clearly that also regional environmental problems gain, through international trade, an intrinsic international dimension. As a consequence, one should ﬁrst study the framework conditions for international trade and their consequences for national and international environmental policy.

13.1 The Framework Conditions for International Trade The rapid development of international trade in the past decades accompanied global population growth, stimulated technological innovations, and was in turn affected by the availability of technological innovations, which helped to reduce trade barriers worldwide.

WTO: Trade and Environment (excerpt from [20], p. 1) The world economy has changed profoundly over the last 50 years. The sheer size of economic activity has increased tremendously as a result of population and per capita income growth. World population has more than doubled from 2.5 billion in 1950 to 6 billion today, at the same time as average income has risen by a factor of two-and-a-half. The cumulative effect is a six-fold rise in global GDP over just half a century. During this period, the H. Wiesmeth, Environmental Economics: Theory and Policy in Equilibrium, Springer Texts in Business and Economics, DOI 10.1007/978-3-642-24514-5_13, © Springer-Verlag Berlin Heidelberg 2012

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world economy has become more integrated as a result of three factors: advances in communication and information technologies, reduced trade barriers, and reduced barriers to foreign investment. These factors have reduced the transactions costs of international commerce substantially, in turn stimulating trade directly, by allowing countries to specialize in different sectors, and indirectly, by allowing production processes to be subdivided geographically among specialized production units around the world. The net result is a 14-fold increase in trade since 1950. At the same time, industries have become more mobile, as reﬂected by an even more rapid growth in foreign direct investment. However, this growth in population, trade and the world economy has been accompanied by environmental degradation in all its facets. The “Trade and Environment Study” of the WTO therefore concludes “. . . that the current trends are not sustainable unless tough measures are taken to temper resource consumption and polluting emissions” ([20], p. 1). This becomes apparent with a look at the following “key environmental trends in emerging Asia” ([12], p. 8): • Deforestation: The region’s forests are disappearing at an alarming rate. • Water Scarcity: The high demand for water, coupled with water pollution, means that water reserves are being used faster than they can be replenished. • Climate Change: Rapidly increasing global emissions of greenhouse gases are leading to ﬂoods, droughts, and extreme weather events, as well as to international pressure to reduce emissions and shift to low-carbon technologies. • Food Security: The recent steep rise in rice and wheat prices is threatening to undo advancements made in poverty reduction and workforce health. • Energy Security: This region’s economic growth has led to the world’s highest increases in the demand for energy, along with rising global energy prices. • Air Pollution: As the countries in this region have become more industrialized and motorized, the air quality of their cities has deteriorated. • Urbanization: The percentage of the population living in cities in emerging Asian countries has risen dramatically. • Population Growth: This region contains a quarter of the world’s population as of 2008, leading to signiﬁcant stress on local resources. The international dimension of environmental issues is, however, not only the result of cross-border environmental pollution or worldwide recognizable environmental trends such as climate change. Local and regional environmental degradation gains increasing importance in view of the continuously developing network of international trade. The question of raising or lowering environmental standards in one country is therefore not independent from the possible reaction of the most important trading partners. Is there are danger of a loss in international competitiveness through higher standards, or will other countries adapt their standards as well? Or should one rather strive for harmonized standards with the risk of restricted trade activities? These are

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just some of the questions, which are a consequence of this international dimension of regional environmental effects. A simple answer to these questions is, however, not available. In various contributions, Porter (cf., for example, [11]) points out that strict environmental regulation can stimulate technological innovations, which will increase productivity, will help to save on resources, or will open new areas for proﬁtable business activities.1 In addition to that, national business companies producing environmental technologies may gain a competitive edge with this ﬁrst-mover advantage. Thus, a consequent national environmental policy may even stimulate international trade in environmental technologies, which can help to promote environmental goals on a global level (cf. also Section 12.2). The international dimensions of environmental economy and environmental policy further the integration of economical and ecological issues both on a national and an international level. The new challenges require equally well integrated solutions, again both on a national and an international level. If one takes into account that a national policy should optimally respect the actions or reactions of other relevant countries, and that there is not really a supranational government or institution, which is in charge and which has the power to implement and supervise an international environmental policy, this complicated situation will generate quite a few additional important questions, for which answers are urgently required. One obvious approach is to integrate economic and environmental issues into already existing international agreements. As there is – beyond the Kyoto Protocol – no international environmental agreement, which is, with respect to its importance and its worldwide acceptance, comparable to trade agreements, the following sections focus on an investigation of trade organizations, their goals and their development regarding the integration and the treatment of environmental issues.2 The World Trade Organization (WTO), which emerged from the General Agreement on Tariffs and Trade (GATT) in 1995, will be considered ﬁrst. Thereafter, an analysis of the relevant environmental regulations of the EU and of the North American Free Trade Agreement (NAFTA) will follow. The focus will always be on the degree of the integration of trade and environmental concerns.

13.2 Environmental Aspects of the GATT and the WTO When GATT was established in 1947 after World War II, the main goal was to reconstruct and revive the world trade system. Ecological consequences of a gradu1

For example, the German Renewable Energy Sources Act (EEG) with guaranteed prices for electrical energy from biomass stimulated the development of an industry for the production of biogas plants. Today, Germany is one of the world market leaders for biogas plants. 2 Of course, there are numerous multilateral environmental agreements. For a list of those, to which the EU is a party, see http://ec.europa.eu/environment/international_issues/agreements_en.htm (cited Dec 2010). However, many of these agreements are hardly known outside the relevant institutions immediately concerned with these topics.

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ally integrating world economy did not play a signiﬁcant role in that period of time. From today’s point of view only three out of the more than twenty general principles or articles of the GATT are to some extent related to environmental issues. These articles are still relevant for the WTO, which provides a home to the international agreements GATT (cf. [16]), the GATS (cf. [15]) and the TRIPS (cf. [21]). Article I of the GATT introduces the basic principle of the most-favoured nation. Any condition conceded to one country must be extended to all other members of the GATT. “Like” products, independent from the particular production process, must be treated in the same way. Only the regulations of Article XX allow some exemptions from this rule.

General Most-Favoured-Nation Treatment Excerpt from GATT, Art. I ([16]) (1) With respect to customs duties and charges of any kind imposed on or in connection with importation or exportation or imposed on the international transfer of payments for imports or exports, and with respect to the method of levying such duties and charges, and with respect to all rules and formalities in connection with importation and exportation, and with respect to all matters referred to in paragraphs 2 and 4 of Article III, any advantage, favour, privilege or immunity granted by any contracting party to any product originating in or destined for any other country shall be accorded immediately and unconditionally to the like product originating in or destined for the territories of all other contracting parties.

Article III of the GATT formulates the principle of non-discrimination. The purpose of this article is to avoid protectionism with internal taxes and regulatory measures. Members of the GATT (and now the WTO) are therefore obliged to take care of equal competitive conditions for domestic and imported products. As a consequence, imported goods must not be taxed differently in order to protect the domestic industry against imports produced at lower cost with lower environmental standards. National Treatment on Internal Taxation and Regulation Excerpt from GATT, Art. III ([16]) (1) The contracting parties recognize that internal taxes and other internal charges, and laws, regulations and requirements affecting the internal sale, offering for sale, purchase, transportation, distribution or use of products, and internal quantitative regulations requiring the mixture, processing or use of products in speciﬁed amounts or proportions, should not be applied to imported or domestic products so as to afford protection to domestic production.

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(2) The products of the territory of any contracting party imported into the territory of any other contracting party shall not be subject, directly or indirectly, to internal taxes or other internal charges of any kind in excess of those applied, directly or indirectly, to like domestic products. Moreover, no contracting party shall otherwise apply internal taxes or other internal charges to imported or domestic products in a manner contrary to the principles set forth in paragraph 1. In Article XVI, the GATT regulations rule out subsidies for the domestic industry in order, for example, to provide a compensation for higher costs due to more expensive environmental protection measures. The trading partners have to be informed on a subsidy affecting any aspect of trade. In case of an objection, the matter has to be discussed with the contracting parties. Subsidies Excerpt from GATT, Art. XVI ([16]) (1) If any contracting party grants or maintains any subsidy, including any form of income or price support, which operates directly or indirectly to increase exports of any product from, or to reduce imports of any product into, its territory, it shall notify the contracting parties in writing of the extent and nature of the subsidization, of the estimated effect of the subsidization on the quantity of the affected product or products imported into or exported from its territory and of the circumstances making the subsidization necessary. In any case in which it is determined that serious prejudice to the interests of any other contracting party is caused or threatened by any such subsidization, the contracting party granting the subsidy shall, upon request, discuss with the other contracting party or parties concerned, or with the contracting parties, the possibility of limiting the subsidization. It is not unusual that environmental problems originate in special production processes, for example in harvesting shrimp with methods leading to the incidental killing of turtles. The main principles of the GATT as formulated in the original legal texts of “GATT 1947” made it almost impossible to discriminate against such products. Only Article XX listed a few exemptions which allowed a deviation from the general principles of non-discrimination. General Exceptions Excerpt from GATT, Art. XX ([16]) Subject to the requirement that such measures are not applied in a manner which would constitute a means of arbitrary or unjustiﬁable discrimination

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between countries where the same conditions prevail, or a disguised restriction on international trade, nothing in this Agreement shall be construed to prevent the adoption or enforcement by any contracting party of measures: ... (b) necessary to protect human, animal or plant life or health; . . . (g) relating to the conservation of exhaustible natural resources if such measures are made effective in conjunction with restrictions on domestic production of consumption; . . . In the early 90ties some cases with environmental concern were brought before the Dispute Settlement Body of the GATT. One of the famous cases, which attracts a lot of attention till today, is the tuna-dolphin case. At that time, Mexico did not meet the dolphin protection standards set for the domestic American ﬁshing ﬂeet. As a consequence, the US banned all imports of tuna from Mexico. The panel reporting to the GATT in September 1991 concluded that the US could not embargo imports of tuna products from Mexico simply because Mexican regulations on the way tuna was produced did not satisfy US regulations. The reasoning behind this ruling was that if the US arguments were accepted, then any country could ban imports of a product from another country merely because the exporting country has environmental, health and social policies different from its own (cf. [19] for more details on this case). The key questions addressed in this case were whether one country can prescribe another what its environmental regulations have to be, and whether trade rules permit action to be taken against the method used to produce certain goods. In order to advance dialogue on questions like this and understanding of the integration of trade and environment, the WTO provides support for sustainable development through various specialized institutions. Thus, the Committee on Trade and Environment (CTE) was established towards the end of the Uruquay Round of the GATT in 1994. This committee identiﬁes potential areas of conﬂict on trade and environment and gives recommendations (for more information cf. [14]). In the committee administering the Technical Barriers to Trade Agreement governments, among other things, discuss potential effects of environmental regulations on trade (cf. also [13]). Moreover, the preamble to the Marrakesh Agreement Establishing the World Trade Organization includes direct references to the objective of sustainable development and to the need to protect and preserve the environment. It says WTO members recognize that “their relations in the ﬁeld of trade and economic endeavor should be conducted with a view to raising standards of living, ensuring full employment and a large and steadily growing volume of real income and effective demand, and expanding the production of and trade in goods and services, while allowing for the optimal use of the world’s resources in accordance with the objective of sustainable development, seeking both to protect and preserve the environment and to enhance the means for doing so in a manner consistent with their respective needs and concerns at different levels of economic development” ([17]).

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13.3 Regional Trade Agreements Regional trade agreements (RTAs) have become a very prominent feature of the multilateral trading system. According to the WTO, to which these RTAs have to be notiﬁed, 283 agreements are in force as of 31 July 2010 (cf. [18]). The European Union (EU) and the North American Free Trade Agreement (NAFTA) are certainly among the best known.3 These two agreements will be presented in the following subsections. The handling of environmental issues in these agreements will thereby play an important role.

13.3.1 The Environmental Policy of the EU Concepts such as protection of the environment or environmental policy are not included in the treaties of most of the organizations preparing the ground for the current EU, and environmental protection does therefore not constitute an original area of common interest in the EU. The aim of the treaty establishing the European Coal and Steel Community (ECSC) was to contribute, through the common market for coal and steel, to economic expansion, growth of employment and a rising standard of living. This is understandable as this ﬁrst organization leading to the later EU was created in 1951, in the aftermath of World War II, when reconstructing the economies of the European continent and ensuring a lasting peace appeared necessary and more important than environmental issues (cf. [6] for further details). The treaty establishing the European Economic Community (EEC), signed in Rome in 1957, furthered the integration of the six member states of the ECSC, France, Germany, Italy and the Benelux countries, via trade with a focus on economic growth (cf. [7]). Again, environmental issues were not mentioned explicitly, although an appropriate interpretation of the treaty gave way to an effective environmental policy in the EEC at the beginning of the 70ties, in particular after the Paris Summit of October 1972. There was an economic motivation driving this development: harmonized standards for products and production processes should help to protect the Common Market against cost advantages through different environmental regulations. Only the Single European Act (SEA) of 1987 introduced the goal of environmental protection explicitly into the treaties. The SEA adds three new articles (Articles 130R, 130S and 130T of the later EC Treaty: cf. the excerpts further below) which permit the Community “to preserve, protect and improve the quality of the environment, to contribute towards protecting human health, and to ensure a prudent and rational utilization of natural resources”. It speciﬁes that the Community can only intervene in environmental matters when this action can be attained better at 3

Not to be mistaken, the EU today is much more than just a free trade area, although this section focuses mainly on this aspect.

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Community level than at the level of the individual member states according to the principle of subsidiarity (cf. [8]). The Treaty of Maastricht, creating the European Union (EU) in 1992, and even more so the Treaty of Amsterdam in 1997, upgraded the environment to a Community policy and no longer simply action by the Community. The Treaty of Maastricht established a more efﬁcient decision-making procedure for environmental policy, replacing unanimity in the Council of Ministers by qualiﬁed majority voting as the general rule for decision-making. However, different procedures continued to exist side by side: • the co-decision procedure for general action programs; • the cooperation procedure for the environment policy; • simple consultation, with unanimous adoption by the Council, for measures concerning taxation, town and country planning, land use, or energy supply. The Treaty of Amsterdam simpliﬁed the situation, replacing the cooperation procedure by the codecision procedure, thereby reducing the number of procedures. Moreover, the principle of enhanced cooperation requires a strict orientation on environmental concerns (cf. again [7] and the links provided there to the other treaties, in particular to the Treaty of Amsterdam).

The European Union and the Environment (Excerpts from the Treaty of Amsterdam) Environment: Art. 174 (ex Article 130r) 1. Community policy on the environment shall contribute to pursuit of the following objectives: preserving, protecting and improving the quality of the environment, protecting human health, prudent and rational utilization of natural resources, promoting measures at international level to deal with regional or worldwide environmental problems. 2. Community policy on the environment shall aim at a high level of protection taking into account the diversity of situations in the various regions of the Community. It shall be based on the precautionary principle and on the principles that preventive action should be taken, that environmental damage should as a priority be rectiﬁed at source and that the polluter should pay. In this context, harmonization measures answering environmental protection requirements shall include, where appropriate, a safeguard clause allowing Member States to take provisional measures, for non-economic environmental reasons, subject to a Community inspection procedure. 3. In preparing its policy on the environment, the Community shall take account of: available scientiﬁc and technical data, environmental conditions in the various regions of the Community, the potential beneﬁts and costs of action or lack of action, the economic and social development of the Community as a whole and the balanced development of its regions.

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4. Within their respective spheres of competence, the Community and the Member States shall cooperate with third countries and with the competent international organizations. The arrangements for Community cooperation may be the subject of agreements between the Community and the third parties concerned, which shall be negotiated and concluded in accordance with Article 300. . . . Environment: Art. 176 (ex Article 130t) The protective measures adopted pursuant to Article 175 shall not prevent any Member State from maintaining or introducing more stringent protective measures. Such measures must be compatible with this Treaty. They shall be notiﬁed to the Commission. The Treaty of Lisbon, which was signed in December 2007 and entered into force in December 2009, introduced some amendments to the earlier treaties. The environmental regulations cited above remain, however, effective (cf. [7], Articles 191 and 193). In general it has to be remarked that the main concern of the EU has always been the economic integration of the member states, as indicated by the growth of their economies and the reduction of the inequalities between them. This focus on the realization of the internal market seems to move environmental goals to a second place behind the pure economic goals, although environmental issues certainly do play an important role. Nevertheless, according to some environmentalists, this restricts the development of effective guidelines for the protection of the environment.

13.3.2 The North American Free Trade Agreement (NAFTA) According to the website “http://www.naftaworks.org” (cf. [10]) the North American Free Trade Agreement (NAFTA) is the product of a general trend toward free trade between North American nations, beginning with the GATT. Initiated by President Ronald Reagan, enacted by President George H. W. Bush, and modiﬁed by President Bill Clinton, NAFTA has experienced a number of changes since it was ofﬁcially signed in 1992. Despite these changes, which largely appeared inevitable, there was a wide opposition, primarily in the United States and Canada. Concerns included a weakening of the labor force, environmental issues, and reduced sovereignty. Nonetheless, NAFTA was signed due to the fact that the beneﬁts seemed to outweigh the risks; although, in hindsight, some sectors may have suffered, overall economic growth was all but a certainty, and the establishment of a uniﬁed North American economy was reasonable with globalization rapidly gaining strength. Therefore, NAFTA’s primary goal was and is to establish and implement a free trade area between Canada, Mexico and the United States.

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Objectives of NAFTA (excerpt from [9], Art. 102) 1. The objectives of this Agreement, as elaborated more speciﬁcally through its principles and rules, including national treatment, most-favoured-nation treatment and transparency, are to: a) eliminate barriers to trade in, and facilitate the cross-border movement of goods and services between the territories of the Parties; b) promote conditions of fair competition in the free trade area; c) increase substantially investment opportunities in the territories of the Parties; d) provide adequate and effective protection and enforcement of intellectual property rights in each Party’s territory; e) create effective procedures for the implementation and application of this Agreement, for its joint administration and for the resolution of disputes; and f) establish a framework for further trilateral, regional and multilateral cooperation to expand and enhance the beneﬁts of this Agreement.

As already indicated, environmental issues strongly affected the discussions leading to NAFTA. In fact, the US administration obviously began NAFTA discussions by refusing to acknowledge a link between trade and the environment ([1], p. 193). Environmentalists then successfully promoted the principle of sustainable development, which, not only according to them, provides a “natural” link between trade and the environment. As a result of this struggle, general environmental aspects of NAFTA are now addressed in the preamble besides the political and the economic goals (cf. [9]).

Preamble of NAFTA (excerpt from [9], preamble) The Government of Canada, the Government of the United Mexican States and the Government of the United States of America, resolved to: • CONTRIBUTE to the harmonious development and expansion of world trade and provide a catalyst to broader international cooperation; • CREATE an expanded and secure market for the goods and services produced in their territories; • ESTABLISH clear and mutually advantageous rules governing their trade; • ENHANCE the competitiveness of their ﬁrms in global markets; • UNDERTAKE each of the preceding in a manner consistent with environmental protection and conservation; • PROMOTE sustainable development;

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• STRENGTHEN the development and enforcement of environmental laws and regulations; . . .

Environmental aspects of NAFTA are, moreover, addressed in Article 104 and in Annex 104.1 (cf. [9]), describing the relations to various environmental and conservation agreements, among them • the Convention on International Trade in Endangered Species of Wild Fauna and Flora, • the Montreal Protocol on Substances that Deplete the Ozone Layer, • the Basel Convention on the Control of Transboundary Movements of Hazardous Wastes and Their Disposal, • the Agreement Between the Government of Canada and the Government of the United States of America Concerning the Transboundary Movement of Hazardous Waste, • and the Agreement Between the United States of America and the United Mexican States on Cooperation for the Protection and Improvement of the Environment in the Border Area. Thus, similar to the regulations of the WTO, the focus of NAFTA is on promoting trade with basic environmental concerns addressed in the preamble and speciﬁc issues relegated to existing international or regional agreements. This is what Audley called the “greening of trade agreements” or “green window dressing” at the time of the creation of NAFTA ([2]) in the early 1990s. Today, all trade agreements involving the US contain separate chapters on the environment. Moreover, in 2002 the US administration was granted binding negotiating objectives for the environment by the Congress in the context of the trade promotion authority. In particular, Congress instructs US negotiators to ([3], p. 17): • strengthen the capacity of US trading partners to protect the environment; • promote the sale of green products and services; • reduce or eliminate government practices or policies that unduly threaten sustainable development; • establish consultative mechanisms to strengthen the capacity of US trading partners to develop and implement environment and human health protection standards; • conduct environmental reviews of trade agreements; • respect the Doha Declaration on Trade-related Aspects of Intellectual Property Rights clarifying a developing country’s right to break patents during a public health crisis; • and promote consideration of multilateral environmental agreements (MEAs) in negotiations on the relationship between MEAs and trade rules, especially as they are related to GATT Article XX. In summary, the “environmental revolution” has established and secured its position in trade-related international agreements. Whether or not or to what extent this new

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environmental provisions help to improve the quality of the environment, is still an issue which is of concern, not only among environmentalists (cf. again [3]).

13.4 Consequences for the Integration of Trade and the Environment Today, trade and environment are two policy areas, which are strongly interdependent and which are of utmost importance for welfare in the globalized world. Nevertheless, free trade is an “old issue”, stimulated by and dependent on free market forces, whereas environment is still considered a comparatively “young issue”, based on regulatory interferences with the market system. As an immediate consequence, trade and environment often provide the battleground for two different and, in the opinion of many “free traders” and “environmentalists”, non-compatible views of the social-economic system. The “Battle of Seattle” in 1999 and other demonstrations at the occasion of WTO meetings thereafter point to the still incomplete integration of trade and the environment. What could be achieved by an integration of these two areas? Why is this integration of dire need? How could such an integration be achieved? International environmental problems, such as climate change, are difﬁcult to solve. No supranational institution equipped with the necessary legislative, executive, and judicative powers is available to allocate these international environmental (or public) commodities effectively or even efﬁciently (cf. Chapter 7). If there is an international agreement, such as the Kyoto Protocol, for example, then the Prisoners’ Dilemma tends to distort the implementation of the agreement with inefﬁcient outcomes (cf. Subsection 5.3.2). In such a context the question arises, whether international trade could function as a “surrogate” for the non-existing supranational institutions in the environmental arena? Consider in this context the already well established trade between industrialized countries and the rapidly developing economies in environmental technologies or in environmentally friendly commodities. Moreover, Chapter 12 indicated a few “strategies” to “motivate” these developing economies to adequately contribute towards the global reduction of greenhouse gas emissions. All these approaches depend on international networks, most of them on trade relations. With his well-known hypothesis, Porter opens another door to integrate trade and environment. The market potential of technological innovations resulting from strict environmental standards is dependent on international trade. Due to the EEG, electrical energy generated from biogas can be sold in Germany at a proﬁtable price. This fact stimulated the German industry for biogas plants, which is now one of the leaders in the world market. Similarly, China is currently working on the Carbon Capture and Storage (CCS) Technology to capture CO2 from fossil fuel power plants and to inject it in suitable geological formations. It can well happen that China will offer the services of its CCS technology in the near future to countries like Germany,

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which will likely face opposition with respect to applying this technology at home at large scale. In both cases, international trade is thus involved to address an important environmental issue. Of course, trade can only be an incomplete replacement for a “world government”. But the rapidly developing economies which are most relevant for a global reduction of greenhouse gas emissions, are already sufﬁciently integrated into the international network of trade. Several decades ago trade economists analyzed framework conditions for free trade to lead to an equilibrium allocation which corresponds to a “world equilibrium” with factors such as labor or natural resources completely mobile across borders (cf. [5], for example). Now, in this sense, it seems to be the right time to investigate conditions under which trade can effectively and efﬁciently help to address international environmental issues, an attempt, which requires the full integration of trade and the environment. The public opinion is, however, still inﬂuenced by common fallacies regarding the effects of trade on the current and future quality of the environment. Bhagwati ([4]), in particular, refers to two widespread fallacies, which seem to be conﬁrmed at the ﬁrst glance by, for example, the rapid growth of trafﬁc accompanying economic growth with environmental degradation.

Fallacy 1: Free trade will harm the environment because it is aimed at efﬁciency and economic growth whereas growth leads to environmental degradation. Bhagwati ([4], p. 162f.) argues that “it is incorrect to assume that the growth of per capita income necessarily, or even overwhelmingly, damages the environment, for several reasons: • Increased income per capita, aside from directly reducing poverty by creating jobs, will reduce poverty indirectly as well by enabling the state to raise revenues to pay for “basic needs” programs. Similarly, it would help to pay for pollution control and remedial clean-up. • Again, if the demand for better environment is income-elastic, the growth of per capita income would translate the added resources for potential pollution control and environmental use (that growth makes available) into actual expenditures toward that purpose. . . . • At the same time, even if the rich countries had both greater resources to tackle problems such as environmental pollution and more articulate and effective organizations demanding that these issues be addressed, the reduced levels of pollution may still be higher, in absolute terms and also as a proportion of GNP, than in poor countries simply because the rich countries also produce more pollution in the ﬁrst place. . . . ” In conclusion, there need not be a general and clear correlation between economic growth and the quality of the environment. On the one hand, economic growth in-

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creases demand for environmental commodities and provides the ﬁnancial means to protect the environment; on the other hand, economic growth is accompanied by speciﬁc environmental degradation through, for example, increasing transport activities. In Germany, transport activities with private cars are estimated to increase by 20% by 2020 against 2002; with trucks the increase of transport activities is estimated to approach 34%. Moreover, per-capita emission levels of greenhouse gases are still signiﬁcantly higher in the industrialized countries (cf. Subsections 3.2.3 and 5.3.2).

Fallacy 2: Free trade directly causes more environmental damage than selfsufﬁciency or protection.

Beyond pointing to the possibility of importing pollution-control technologies and pollution-free processes, Bhagwati argues as follows ([4], p. 163f.): • “The 1991 GATT report on Trade and the Environment ( . . . ) shows how agricultural protection shifts agricultural production from efﬁcient producers in low income countries to inefﬁcient producers in high-income countries. In turn, this is likely to cause more environmental damage because of the greater use of chemical fertilizers and pesticides in the richer countries. . . . • Another example comes from automobile protection in the rich countries. It is well-known that the exports of automobiles from Japan have been restrained during the 1980s by the imposition of voluntary export restraints by the United States and the European Community (EC). Research . . . has shown that these restraints shifted the composition of Japanese exports to the United States from small to large cars. The larger cars, in turn, were fuel-inefﬁcient compared to the smaller cars. . . . Free trade in cars may well have been the better environmental policy.” Again, the relationship between trade and environment is not straightforward and requires a more detailed analysis, which should ideally provide hints for a closer integration of these two policy areas. Some aspects of such an integration will be attempted in the remaining chapters of this part of the book. Each chapter addresses a different topic, but international trade will provide the link between these topics.

References 1. Audley JJ (1993) Why environmentalists are angry about the North American Free Trade Agreement. In: Zaelke D, Orbuch P, Housman RF (eds) Trade and the environment: law, economics and policy. Island Press, Washington DC 2. Audley JJ (1993) The “greening” of trade agreements: environmental “window dressing” and NAFTA. In: Fatemi K (ed) North American Free Trade Agreement: opportunities and challenges. Macmillan Press, London

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3. Audley JJ (2004) The Evolution of the United States Trade and Environment Policy. Bridges 8(6):16-18 (cf. also http://www.ictsd.org. Cited Dec 2010) 4. Bhagwati J (1993) Trade and the environment: the false conﬂict? In: Zaelke D, Orbuch P, Housman RF (eds) Trade and the environment: law, economics and policy. Island Press, Washington DC 5. Ethier WJ (1995) Modern international trade, 3rd edn. Norton, New York 6. EU: Treaty establishing the European Coal and Steel Community (ECSC 1951) http://europa.eu/legislation_summaries/institutional_affairs/treaties/treaties_ecsc_en.htm. Cited Dec 2010 7. EU: Treaty establishing the European Economic Community (EEC 1957) http://europa.eu/legislation_summaries/institutional_affairs/treaties/treaties_eec_en.htm. Cited Dec 2010 8. EU: Single European Act (1987) http://europa.eu/legislation_summaries/institutional_affairs/treaties/treaties_singleact_en.htm. Cited Dec 2010 9. NAFTA: The North American Free Trade Agreement (1992) http://www.nafta-sec-alena.org/en/view.aspx?x=206. Cited Dec 2010 10. NAFTA: Understanding NAFTA http://www.naftaworks.org. Cited Dec 2010 11. Porter M (1990) The competitive advantage of nations. The Free Press, New York 12. WRI: World Resources Institute (2009) Emerging risk: impact of key environmental trends in emerging Asia 13. WTO: Agreement on technical barriers to trade (TBT 1994) http://www.wto.org/english/tratop_e/tbt_e/tbt_e.htm. Cited Dec 2010 14. WTO: Committee on trade and environment (CTE 1994) http://www.wto.org/english/tratop_e/envir_e/wrk_committee_e.htm. Cited Dec 2010 15. WTO: General agreement on trade in services (GATS 1994) http://www.wto.org/english/docs_e/legal_e/26-gats_01_e.htm. Cited Dec 2010 16. WTO: General agreement on tariffs and trade (GATT 1994) http://www.wto.org/english/res_e/booksp_e/analytic_index_e/gatt1994_e.htm. Cited Dec 2010 17. WTO: Marrakesh Agreement Establishing the World Trade Organization (1994) http://www.wto.org/english/tratop_e/envir_e/sust_dev_e.htm. Cited Dec 2010 18. WTO: Regional Trade Agreements (2010) http://www.wto.org/english/tratop_e/region_e/region_e.htm. Cited Dec 2010 19. WTO: The “Tuna-Dolphin Case” (1991) http://www.wto.org/english/tratop_e/envir_e/edis04_e.htm. Cited Dec 2010 20. WTO: Trade and environment (1999) Special Studies 4, WTO publications, Geneva 21. WTO: Trade-Related Aspects of Intellectual Property Rights (TRIPS 1994) http://www.wto.org/english/docs_e/legal_e/27-trips_01_e.htm. Cited Dec 2010

Chapter 14

Overﬁshing

Abstract The continuing exploitation of the world’s marine ﬁshery resources has led to many attempts to control the “race for ﬁsh” without, however, any groundbreaking success. In order to understand the “economics of ﬁsheries”, this chapter presents, after some introductory remarks, a formal model, which integrates economy and biology, and reveals the various externalities affecting ﬁshing activities. The equilibrium model allows insight into the economical and biological mechanisms leading to overcapacity and overﬁshing, and the role of globalization and international trade in this context. The conclusions from the formal analysis include aspects of quota management systems and an investigation and evaluation of current ﬁsheries policies of the EU and the US.

14.1 The State of Fishery Resources In 1955, Francis Minot, the director or the Marine and Fisheries Engineering Research Institute, in Woods Hole, Massachusetts, co-wrote a book titled “The Inexhaustible Sea”. He observed that “we do not know the ocean well enough. Much must still be learned. Nevertheless, we are already beginning to understand that what it has to offer extends beyond the limits of our imagination” ([5], p. 72). In 1964, the annual global catch totaled around 50 million tons; a US lnterior Department report from that year predicted that it could be “increased at least tenfold without endangering aquatic stocks”. Three years later, the department revised its estimate; the catch could be increased not by a factor of ten but by a factor of forty, to two billion tons a year. However, in the late 1980s, the total world catch reached its peak at only 85 million tons. For the past two decades, the global catch has been steadily declining at an estimated rate of 500 thousand tons a year (cf. again [5], p. 72). According to a position paper and “technical resource” of the World Wildlife Fund (WWF) from 2004 ([9]), the world’s ﬁsheries are now seriously depleted. Dramatic improvements in ﬁshing technology, matched with rising demand for ﬁsh H. Wiesmeth, Environmental Economics: Theory and Policy in Equilibrium, Springer Texts in Business and Economics, DOI 10.1007/978-3-642-24514-5_14, © Springer-Verlag Berlin Heidelberg 2012

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products and aggressive government efforts to develop ﬁshing industries, has resulted in the largest and most widespread reduction in ﬁsh stocks known to recorded history. According to WWF statistics, seventy-ﬁve percent of the world’s most valuable commercial ﬁsheries are overexploited, fully exploited, signiﬁcantly depleted, or recovering from overexploitation. The Food and Agriculture Organization (FAO) of the United Nations concludes in its 2008 report on the status of ﬁsheries resources ([3], p. 30) that “the global state of exploitation of the world marine ﬁshery resources has tended to vary, with some trends in the observed exploitation categories. While the proportion of underexploited or moderately exploited stocks declined linearly from 40 percent in the mid-1970s to 20 percent in 2007, the proportion of fully exploited stocks remained steady at about 50 percent. The proportion of overexploited, depleted or recovering stocks appears to have stabilized at between 25 and 30 percent since the mid-1990s” (cf. Figure 14.1). Percentage of stocks assessed 60 50 40 30 20 Underexploited + Moderately exploited Fully exploited Overexploited + Depleted + Recovering

10 0 74

76

78

80

82

84

86

88

90

92

94

96

98

00

02

04

06

Fig. 14.1 Global trends in the state of world marine stocks since 1974 (Source: FAO ([3], p. 33); FAO kindly granted permission to use this ﬁgure.

The WWF report ([9], p. 6) ﬁnds “several critical challenges” that “lie at the heart” of the ﬁsheries crisis, and the “sad” condition of the world’s ﬁsheries results from a number of diverse, complex, and interrelated problems, which are the unfortunate consequence of wide and deep failures by governments and intergovernmental bodies to adopt and implement effective policies for managing ﬁsheries resources. The report identiﬁes in particular the following leading elements of the ﬁsheries crisis (cf. [9], p. 6ff. for the complete presentation): • Fishing effort is far above sustainable levels. To many observers, the most fundamental cause of overﬁshing has been the failure of governments to impose effective limits on ﬁshing activity, whether through direct limits on total catch size, limited ﬁshing seasons, individual ﬁshing quotas to establish “property rights”, or otherwise.

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• Fishing capacity is far above sustainable levels. The world’s commercial ﬁshing ﬂeets are suffering serious overcapacity – that is, there are “too many boats chasing too few ﬁsh”. The extent of this overcapacity is not known with precision, although some estimates suggest it may be as high as 250%. • Illegal, unreported, and unregulated (IUU) ﬁshing is widespread. The generalized weakness of national and international ﬁsheries management regimes is painfully evident in the pervasive problem of IUU ﬁshing. • Many traditional tools for sustainable ﬁsheries management are underutilized. The tools of modern ﬁsheries management are widely known, but less widely applied in a fully effective manner. • Some important new tools for sustainable ﬁsheries management are underutilized. Although improved ﬁsheries management remains a top priority, many conservation organizations – and some governments – have recently begun to look beyond traditional management policies for additional ways to promote sustainable ﬁshing. As an – at least to some extent – understandable consequence of this unfortunate development, governments try to support national ﬁsheries through subsidies which are, however, considered to be part of the problem. The subsidies, which are estimated to total globally roughly 20% of the industry’s revenue, allow ﬂeets to operate under otherwise unproﬁtable conditions and contribute to overﬁshing (cf. again [9], p. 10). This development leaves many unanswered questions. What are possible reasons for this “sad” state of the ﬁsheries worldwide? In particular, why is the capacity of the boats far above reasonable and necessary levels? Why is it obviously so difﬁcult to adopt and implement policies for effectively managing ﬁsheries resources? In particular, why do governments continue to pay subsidies to the ﬁsheries? The Common Fisheries Policy (CFP) was implemented in the EU in the 1980s. But, according to Joe Borg, European Commissioner for Maritime Affairs and Fisheries ([2], p. 4f.), “the majority of commercial ﬁsh stocks in EU waters continue to give cause for concern. In 2007, independent ﬁsheries scientists assessed the condition of 33 of Europe’s most important commercial ﬁsh stocks, and concluded that 29 (some 88% of them) were overﬁshed.” This is more than the global average of 25 to 30% of overexploited stocks reported by the FAO. The following model attempts to provide some answers to these questions. The theoretical analysis will reveal a bundle of externalities which, in combination with economic interests, increasing global demand for ﬁsh, regulatory interferences, and subsidies lead eventually to the above observations. The following sections draw from works of Smith/Weber/Wiesmeth (cf. [11] and [12]).

14.2 Short-Run Supply of the Fisheries This section introduces and justiﬁes the basic assumptions of the model. The gametheoretic concept of a Nash equilibrium will then lead to short-run aggregate supply

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14 Overﬁshing

of the ﬁsheries. The analysis is restricted to a ﬁxed number of ﬁrms or boats that are allowed into a ﬁshery. This assumption refers to a regulatory measure that was adopted some time ago and which involves a limited entry licensing scheme whereby the number and capacity of boats is restricted. These limited entry regulations have, however, not met with much success. Output has all but returned to the original free access level while employment has declined and some of the licensed ﬁrms have left the industry. One of the chief causes of this failure lies in the deﬁnition of boat capacity. Regulators, intending to restrict capacity, placed limits on boat size in terms of tonnage. Boat owners quickly demonstrated that the catching power and hence capacity of a boat of given tonnage could be increased, in part, by investing in new and better equipment and a mixture as opposed to only one type of harvesting gear. Indeed, investment in the industry continued to increase albeit at a somewhat lower pace than in the case of free access. This chapter tries to explain why these incentives continue to arise in an industry regulated by limited entry.

14.2.1 Interdependence of Fisheries Total catch of ﬁsh in a certain ﬁshing area and in a given period of time will certainly depend on the size and the equipment of the ﬁshing ﬂeet, but also on the size of the resource stock or, more precisely, on the density and the size of the resource stock. For the sake of simplicity, a constant density of the resource stocks will be assumed for the remainder of this chapter. Thus, resource stocks will only differ with respect to size, i.e., total weight x. The ﬁshing industry to be considered here consists of 2 heterogeneous ﬁrms. The following analysis remains, however, valid for the case of n > 2 ﬁrms. The interdependence of the output of ﬁrm i, qi , and the output of the other ﬁrm q j is captured by the following “production function”: qi = δi (1 − e−Ei )(x − q j ) i = j, where δi ∈]0, 1] is an efﬁciency parameter depending, in part, upon past capital accumulation and the experience and ability of the skipper and crew, Ei is the amount of (an index of) a variable factor (hereafter referred to as effort) that ﬁrm i allocates to harvesting and x is the resource stock with constant density already mentioned.1

Note 14.1. In the production function introduced above, the output of any ﬁrm is interpreted as the amount it expects to produce given that the other ﬁrm will 1

The speciﬁc form of the production function used here has many common features with that of M. Spence (cf. [13]). Moreover, because available stock enters the production function linearly, uncertainty with respect to this available stock will not affect the optimization problem of the ﬁrm that will be introduced shortly.

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249

be harvesting from the same resource pool. Following the traditional mass contact model of production in resource industries, ﬁrm i will extract a proportion (given by δi (1 − e−Ei )) of the resource stock available to it. This available resource stock, however, also depends upon the harvesting activities of the other ﬁrm. The speciﬁcation of qi incorporates the dependence of output upon the level of extraction by the other ﬁrm during the harvesting season. In this setting, the term x − q j is interpreted as the resource stock that ﬁrm i, i = j, expects to face when it harvests. Thus, each harvesting ﬁrm generates a negative externality for the other ﬁrm in the industry. In the short run, the licensed ﬁrms are allowed to choose the levels of their variable factors and it is assumed that each ﬁrm takes output and factor prices (p, w) as ﬁxed when it maximizes proﬁt given the output of the other ﬁrm in the industry: all markets are thus considered to be perfectly competitive. This assumption is not overly restrictive. Given that ﬁrms behave in a competitive fashion with respect to price, the introduction of a downward sloping demand function would serve only to determine the price that ﬁrms take as parametric in equilibrium. The proﬁt function of ﬁrm i with ﬁxed costs Fi is given by: πi = pδi (1 − e−Ei )(x − q j ) − wEi − Fi , i, j = 1, 2, i = j. The optimal choice of effort for ﬁrm i, Ei , is uniquely determined by the ﬁrst order conditions given by: ∂ πi = pδi e−Ei (x − q j ) − w = 0, i, j = 1, 2, i = j. ∂ Ei If Ei is nonnegative, it represents the optimal effort of the ﬁrm i. Otherwise, the marginal proﬁts are negative at Ei = 0 and the ﬁrm will exit the industry or, at least, quit ﬁshing. Ceteris paribus, a ﬁrm is more likely to stay in the industry the more efﬁcient it is (δi higher), the greater the harvestible stock available to it and the lower the real wage (w/p). In summary, one obtains the output of one of the ﬁrms depending on resource stock x, the real wage rate w/p, the efﬁciency parameter δi and the output of the other ﬁrm. The reaction functions of the two ﬁrms are given by: q2 < x − w/(pδ1 ) δ1 (x − q2 ) − w/p if R1 : q1 = 0 otherwise δ2 (x − q1 ) − w/p if q1 < x − w/(pδ2 ) R2 : q2 = 0 otherwise Thus, the reaction curves qi as a function of q j , i, j = 1, 2, i = j, are given by piecewise straight lines. Their slopes, if not zero, are determined by the values of the efﬁciency parameters δi , i = 1, 2.

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14.2.2 Short-Run Supply and Fixed-Stock Equilibrium The reaction curves q1 (q2 ) and q2 (q1 ) with resource stock x, the real wage rate w/p and the efﬁciency parameters δi , i = 1, 2, ﬁxed, allow the deﬁnition of an equilibrium. This ﬁxed-stock equilibrium is given by the point of intersection of the two reaction curves (q1 , q2 ). Total output Q (x) = q1 (x) + q2 (x) is the short-run supply of the ﬁsheries at given market prices p and w and for resource stock x.

q2

2 ... .. ..... .... R1 : q1 = q1 (q2 ) .... .... .... 1.5 .... .... .... .... .... .... Fixed-Stock 1 .... .... Equilibrium .... .... .... .... .. 0.5 ..................................... ........................ ....... ? R2 : q2 = q2 (q1 ) ................................................................................................................................................u ........................ q2 ... ... . . ..... ... ........................ .... ... ........................ .... .... ...................................................... .. .. 0 0 0.5 q1 1 1.5 2.0

q1 Fig. 14.2 Reaction curves of the two ﬁrms in the industry and the ﬁxed-stock equilibrium

This situation is represented in Figure 14.2 with δ1 > δ2 (δ1 = 0.5, δ2 = 0.3), x = 2 and w/p = 0.1. Observe that with different values of the parameters (q1 > 0, q2 = 0) or even (q1 = 0, q2 = 0) can result as equilibrium outputs, if δ1 > δ2 is assumed. Note 14.2. Each ﬁrm, while optimizing its factor input, respects the decision of the other ﬁrm. Thus, a “strategic situation” results, which can be represented in economic theory as a “game”. The solution concepts of game theory include most prominently the concept of a Nash equilibrium (cf. [6], Ch. 12.4, for example). The ﬁxed-stock equilibrium (q1 (x), q2 (x)) represents such a Nash equilibrium. At output qj (x) of ﬁrm j, qi (x) is the proﬁt maximizing output level of ﬁrm i. As a consequence, qi (x) is the short-run supply of ﬁrm i, and Q (x) is short-run supply of the industry at x and w/p. For the production functions considered here, the equilibrium can be directly calculated. With δ1 > δ2 , the equilibrium outputs q1 and q2 are unique and determined by the conditions q1 = q1 (q2 ) and q2 = q2 (q1 ), characterizing the intersection of the two reaction curves R1 and R2 at ﬁxed-resource stock x (cf. also Figure 14.2):

14.2 Short-Run Supply of the Fisheries

251

⎧ 0, ⎪ ⎪ ⎪ ⎪ if x ≤ w/(pδ1 ) ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ δ1 x − (w/p), q1 (x) = if w/(pδ1 ) < x ≤ [w/(pδ2 )] · [(1 − δ2 )/(1 − δ1 )] ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ (δ1 (x + w/p) − δ1 δ2 x − w/p)/(1 − δ1 δ2 ), ⎪ ⎪ ⎩ if x > [w/(pδ2 )] · [(1 − δ2 )/(1 − δ1 )]

q2 (x) =

⎧ 0, ⎪ ⎪ ⎪ ⎪ ⎨

if x ≤ [w/(pδ2 )] · [(1 − δ2 )/(1 − δ1 )]

⎪ ⎪ (δ2 (x + w/p) − δ1 δ2 x − w/p)/(1 − δ1 δ2 ), ⎪ ⎪ ⎩ if x > [w/(pδ2 )] · [(1 − δ2 )/(1 − δ1 )]

This result guarantees that the mass balance restriction satisﬁed by the production functions of the individual ﬁrms holds in the aggregate as well. The mass balance restriction implies that, in equilibrium, aggregate industry output is less than the total available resource, i.e., Q (x) = q1 (x) + q2 (x) < x for any level of x. Note 14.3. The mass balance restriction is obviously true, if q2 (x) = 0 in equilibrium. For the case of strictly positive equilibrium values (q1 (x), q2 (x)) the validity of the restriction can be veriﬁed as follows: (δ1 + δ2 )x − 2δ1 δ2 x + (δ1 + δ2 )(w/p) − 2(w/p) < 1 − δ1 δ2 (δ1 + δ2 )x − 2δ1 δ2 x < , because δ1 + δ2 < 2. 1 − δ1 δ2

q1 (x) + q2 (x) =

Thus, q1 + q2 < x, if (δ1 + δ2 ) − 2δ1 δ2 < (1 − δ1 δ2 ), or if 1 − δ1 − δ2 + δ1 δ2 > 0. This last expression is equal to (1 − δ1 )(1 − δ2 ), which is positive with 0 < δ2 < δ1 < 1. Consequently, the mass balance restriction is veriﬁed for the ﬁxed-stock equilibrium for any level x of the resource stock. Both reaction curves include sections on the axes such that q1 (q2 ) = 0 and q2 (q1 ) = 0 respectively (cf. Figure 14.2). It is therefore possible that in equilibrium one (the ﬁrm with the smaller efﬁciency parameter) or both ﬁrms stop all ﬁshing activities. For example, if x ≤ w/(pδ1 ), then the resource stock is too small to allow proﬁtable ﬁshing, even for the more efﬁcient ﬁrm 1 with δ1 > δ2 . If, on the other hand, market price p for ﬁsh rises sufﬁciently high, then ﬁshing becomes economically proﬁtable, even for a small resource stock. Assume now again δ1 > δ2 . For strictly positive equilibrium outputs q1 (x) and q2 (x) the following result, which can be critical for the observed overcapacity in the ﬁshing industry, holds:

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14 Overﬁshing

q1 (x) δ1 π1 (x) + F1 q1 (x) and > > q2 (x) δ2 π2 (x) + F2 q2 (x) with ﬁxed costs Fi and proﬁts πi (x) of the two ﬁrms in the ﬁxed-stock equilibrium (q1 (x), q2 (x)). The ﬁrst result is an immediate consequence of the above formula for equilibrium output levels q1 (x) > 0 and q2 (x) > 0. For the second result one has to show: pq1 (x) − wE1 pq2 (x) − wE2 E1 E2 > or < . q1 (x) q2 (x) q1 (x) q2 (x) Ei , i = 1, 2, denotes the optimal, i.e., proﬁt-maximizing, factor input in equilibrium. From the ﬁrst-order conditions for deriving Ei one obtains: Ei = ln

δi (x − qj (x)) w/p

for i, j = 1, 2, i = j.

Moreover, the equations for the reaction curves yield δi (x − qj (x)) = qi (x) + (w/p), and the above inequality simpliﬁes to: 1 q1 (x) q2 (x) 1 · ln + 1 < · ln + 1 . q1 (x) w/p q2 (x) w/p 6

.... ............... .............. ............. ............. ............ . . . . . . . . . . . ........... ........... ................ ........... ..... . .......... ......... .... . .......... . . . . . . . . . . . . . . . ........ ..... ..... ......... ..... ........ ..... ... ........ ..... ..... ........ ... ....... ..... . . . . . . . . ... . . .... ...... . . . . . . . . . .... . . . ...... ..... . . . . . . . . . ... . ...... . .... . . . . . . . . ... . ..... . . ..... . . . . . . . ... . . . ...... . ..... . . . . . . .... . . . . .... ..... . . . . . . . ... . .... . . . .... . . . ... . . . ..... ... . . . . . . ... . . .... ... . . . . . . . .... . . ... ...... . . . . . . . . . ... . .... ..... . . . . . . . ... . . .... ... . . . . ... . . . .. ..... . ... . . .... . . . . ....... . .. . . . . ... . ..... . .. . . . . . . . ... .. . ..... .. . . . . . ... . . .... .. . . . . . . . .... . . 2 1 . .......... ... . . . ... . ........... .. . . . . . . . ..... .... .. 2 . .... . ... ... . ....... ... .... ... . ...... . . ... ... . ...... ... . . ... ............. . 1 . ... . ... . . .... ..... . . . . ... . . ... . .

ln(q + 1)

ln(q + 1)

ln(q + 1)

α

α

q2

q1

-

q

Fig. 14.3 Equilibrium output and the efﬁciency parameters

The function G(q) := ln(q + 1) is strictly monotone and strictly concave with G(0) = 0. A simple graphical consideration reveals the the validity of the above inequality (cf. Figure 14.3). Assume now that ﬁxed costs are a function of the efﬁciency parameter: F = F(δ ) for δ ∈ (0, 1], and the technical equipment of the ﬁshing ﬂeet determines efﬁciency.

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253

F will then certainly increase with δ , moreover, F(0) = 0. If F is, in addition, strictly concave then F(δ )/δ decreases with δ increasing (cf. again Figure 14.3). This assumption of a strictly concave function F is not improbable: doubling the efﬁciency or, more generally, the capacity of a boat need not double the ﬁxed costs. The following additional result follows from these considerations and the derivations obtained above: π1 (x) π1 (x) + F(δ1 ) F(δ1 ) π2 (x) + F(δ2 ) F(δ2 ) π2 (x) = − > − = , δ1 δ1 δ1 δ2 δ2 δ2 thus, π1 (x)/π2 (x) > δ1 /δ2 , with πi (x), i = 1, 2, again denoting proﬁt of the two ﬁrms in the Nash equilibrium (q1 (x), q2 (x)) at resource stock x. According to these results, there is an incentive to invest in equipment. The associated increase in efﬁciency provides an immediate “double” advantage: ceteris paribus, there is a higher level of output for the investing ﬁrm; this, however, exerts an even stronger negative externality on the other ﬁrm, decreasing its output and supporting once more the “proactive” ﬁrm.

Note 14.4. The incentive to achieve a competitive advantage by investing in (technical) equipment is gaining importance in a situation, where the increase in efﬁciency is accompanied by additional negative externalities for the competitors. If this applies to various ﬁrms, then such a situation may induce an “investment race” among the ﬁrms, leading to overcapacity in the industry without changing the “ranking” of the ﬁrms regarding efﬁciency. This can be observed for the ﬁsheries, locally and globally. Other oligopolistic markets with a limited market potential, are in a similar situation. Consider, for example, the market for broadband internet services. Each contract closed with one provider leaves – at least for some time – one potential client less for the others. As a consequence, “investments” in marketing to attract some of the comparatively few new clients, or clients whose contracts are expiring, are a “must” for all providers. Such a development can be accelerated through a growing demand, through an increase in international trade in the context of globalization, for example. Moreover, subsidies, which reduce (investment) costs, may also contribute towards an investment race. This issue will be taken up again in Section 14.6 in the context of an investigation and an evaluation of ﬁsheries policies. The ﬁxed-stock equilibrium at a resource stock x will now be combined with the biological development of the resource stock. Fishing activities will, in general, leave a reduced resource stock. Growth processes, depending on the size of the stock xt and the availability of food in period t, will lead to a resource stock xt+1 in the next period of time. These considerations lead to a simple dynamic growth model introduced and analyzed in the following section.

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14 Overﬁshing

14.3 Integration of Economical and Biological Aspects Combining an economic system with a biological system requires ﬁrst of all a model of biological growth. Referring to ﬁsh, growth will mainly depend on the size (and the density) of the stock and on food. Limited availability of food will certainly restrain the growth of a stock. Therefore, reducing a stock through ﬁshing yields a sudden excess supply of food, stimulating growth. The maximum sustainable yield indicates the maximum amount of ﬁsh which can be sustainably, i.e., each period, taken out of a given stock without reducing it – again sustainably. The integration of this dynamic biological process with the economic system developed earlier is the goal of the following subsections.

14.3.1 A Biological Growth Process A formal characterization of a growth process for resource stocks respects the issues mentioned above. Assume therefore that xt is the size of the stock at the end of period t. Spence ([13]) introduced the following growth function: xt+1 − xt 1 xt with growth rate wt = xt+1 = =√ − 1. α xt αxt This formula deﬁnes a qualitatively correct relationship between the size of the stock in succeeding periods with the parameter α > 0 representing a measure for the available food supply. The dependence of the growth rate wt on xt and α is the result of the above considerations. For x = 0 and x = 1/α the system assumes a steady state with xt = xt+1 . If x = 1/α, then food resources are just sufﬁcient to reproduce the same size of the stock next period: the growth rate is therefore 0. However, x = 1/α is stable in the sense that for an initial stock x0 > 0 the sequence {xt }t converges to 1/α. √ Note 14.5. With x0 < 1/α one obtains: x1 − x0 = x0 /α − x0 > x0 · x0 − x0 = 0. Moreover, x1 < 1/α. Thus, by complete induction, {xt }t increases monotonically and converges to the unique “attractor” x = 1/α. One obtains a similar result for an initial value x0 > 1/α. A total catch of QtF in period t modiﬁes the fundamental formula for the growth of the resource stock as follows: xt+1 = (xt − QtF )/α. Considering only total catches QF (x) which do not sustainably reduce a given stock x, i.e., xt+1 = xt = x in the above formula, leads to QF (x) = x − αx2 . QF (x) thus

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255

describes the amount of ﬁsh that can be taken out of the stock x without sustainably diminishing this stock. According to the assumptions, the stock will recover due to biological growth and resume its original size next period. In this context, QFM = 1/(4α) represents the maximum sustainable yield associated with resource stock xM = 1/(2α). For total catches less than QFM one obtains a steady state with two associated resource stocks. Obviously, the smaller one requires more effort to catch the desired quantity of ﬁsh, and represents, in economic terms, an inefﬁcient size of the resource stock, given the quantity of ﬁsh to be caught. 0.5 0.4 0.3

QF 0.2 0.1 0

................................................ ....... ....... . . . . . . ...... QF (x) ........ ..... .... ... . . . .... . . . . .... . . .... ... . . .... . . . . ....... ....... ....... ....... ........u . ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ...........u......... ....... ....... ....... ....... . . ... ... ... ... inecient ... . ecient . ... . . ... . ... .. ... .. resource stock ... ... .... ... ... .. . ... ... .. ? ? . 0 xi ≈ 0.37 xM = 1 xe ≈ 1.63 2 x

Fig. 14.4 Sustainable catch for efﬁcient and inefﬁcient levels of the resource stock

This situation is represented in Figure 14.4, which shows the graph of the function QF (x) for α = 0.5 and the efﬁcient (xe ) and the inefﬁcient (xi ) size of the resource stock for a sustainable catch QF = 0.3. After this introduction to biological growth processes, the following subsection contains the description of a bioeconomic equilibrium. This concept provides an attempt to integrate economical and biological aspects of exhaustible and perishable resource stocks such as ﬁsheries. The results will show that, together with the strong incentives to invest in more efﬁcient equipment, there is a tendency towards overﬁshing in the sense that the resource stock will eventually decrease below xM , the stock associated with the maximum sustainable yield.

14.3.2 The Bioeconomic Equilibrium Consider the ﬁxed-stock equilibrium (q1 (x), q2 (x)) for a given resource stock x. As introduced in Subsection 14.2.2, this deﬁnes the aggregate short-run supply Q (x) = q1 (x) + q2 (x) as a function of x. Market prices p and w are, however, still considered to be ﬁxed and determined exogenously. With the results obtained in

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Subsection 14.2.2, Q (x) is given by: ⎧ 0, ⎪ ⎪ ⎪ ⎪ in 1: x ≤ w/(pδ1 ) ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ δ1 x − w/p, Q (x) = in 2: w/(pδ1 ) < x ≤ [w/(pδ2 )] · [(1 − δ2 )/(1 − δ1 )] ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ((δ1 + δ2 − 2δ1 δ2 )x − (2 − δ1 − δ2 )w/p)/(1 − δ1 δ2 ), ⎪ ⎪ ⎩ in 3: x > [w/(pδ2 )] · [(1 − δ2 )/(1 − δ1 )]. The graph of Q (x) is illustrated in Figure 14.5 with α = 0.5, δ1 = 0.25, δ2 = 0.15 and w/p = 0.1. Observe that Q (x) is a convex function in x with the slopes of the three linear sections of Q (x) increasing with x. The three sections result from various activity levels of the two ﬁrms: there are no ﬁshing activities, if x is in the ﬁrst section, only ﬁrm 1 operates with the size x of the stock in section 2, and both ﬁrms operate, if x belongs to section 3. The reaction of Q (x) to changes in the market prices or the efﬁciency parameters is of relevance for the investigation of the market equilibrium in the following section. Obviously, Q (x) increases with p increasing, and with increasing values of δ1 and δ2 . 0.5 0.4 0.3

Q

0.2 0.1 0

. ......................................... .. ... ....... ...... .. . ........... . . . . . . . . . . . . ...... . .. ..... Q (x ) .......... ...... . . .... .. ........ ... .... .......... .. .. ..... . . Sections . . ? . ....u.... .. ....... ................ . . . . . . . . . .. Q (x)........ .... ..... QF (x)...... .. .... ..... .. .. ...... . . . ... .. ...... .... . . . . .. .. ... ... .. .... .... . . ... . .. . .. .. ... . . . ... . . . . . .. .. .. . . . . ... . . .... .. ......... ... .. . 1 .. 2 . . . . 3 ... .. ..... .. .... . . ... .. . . .. .... ...... . . ... . . .. . . . . . .. . . . . ... . .. .... .. ............. ... .. . .. ... . ............................................... 0

w/pδ1 = 0.4

1

x ≈ 1.54

2

x Fig. 14.5 Bioeconomic equilibrium

The following deﬁnition integrates sustainable catches with aggregate short-run supply for given values of the efﬁciency parameters δ1 and δ2 and market prices p and w to a (short-run) bioeconomic equilibrium. “Short-run” means that the above mentioned parameters as well as the market prices are ﬁxed for the time period under consideration.

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257

Deﬁnition 14.1 (Bioeconomic Equilibrium). A (short-run) bioeconomic equilibrium is determined by output levels qi (x ), i = 1, 2, and a resource stock x , such that: • (q1 (x ), q2 (x )) is a ﬁxed-stock equilibrium at resource stock x . • Short-run aggregate supply Q (x ) corresponds to sustainable catch QF (x ), again at resource stock x . Figure 14.5 shows that a bioeconomic equilibrium with a strictly positive resource stock x > 0 exists and is uniquely determined through convexity of Q (x) and concavity of QF (x). Moreover, of interest is also the following stability property of the bioeconomic equilibrium: under the given assumptions on biological growth and economic behavior, the bioeconomic equilibrium will be attained in the sense that the resource stocks {xt }t converge to the resource stock x associated with the bioeconomic equilibrium, as long as the initial stock x0 is strictly positive. With aggregate short-run supply Q (x), the development of the resource stock is characterized by the growth process (cf. Subsection 14.3.1): xt+1 = (xt − Q (xt ))/α =: F (xt ). Observe that because of Q (xt ) < xt the function F is deﬁned for 0 ≤ xt ≤ 1/α and assumes values in the interval [0, 1/α]. Moreover, F (0) = 0 and x with F (x ) = x satisﬁes the sustainability condition x − α(x )2 = Q (x ) (cf. Figure 14.6). In general, one obtains for the derivative of F at values of x, at which F is differentiable: (1 − (Q ) (x)) dF (x) = . dx 2 α(x − Q (x)) 2

..... ...... ...... ...... ...... . . . . . .............. ... ...... ...... ...... ...... ...... . . . . . . ....... ...... ... ...... .... ...... ...... ..... ...... . . . . . ... .... .... ...... ...... . . . . .... . ..... . . . . .... . ...... . . . . .... . ..... . . . . . .... ....... . . . . .... . ..... ... . . . . . ... ..... . . . . . .... . .. ...... . . . . . . .... . ..... . . . . .... . .. ...... . . . . . . .... . ..... . . . . . .... .. ..... . . . . . . . ... ...... . . . . .... . . ..... ... . . . . . . .... . . . ...... . . . . .... . . . ..... . . . . . . . . .... . . . ...... . . . . .... . . . ..... . . . . . . . . . .... .. .. ..... . . . . . ... ...... . . . . . . . . .... . . . ..... . . . . . . .... . ...... . . . . . . . . ... . . ...... ... ... ..

1

F

. . . . . . . . . . . . . . . . . . .

2

. . . . . . . . . . . . . . .

3

Q (x ) ........... .............. . . . . . . . . . . . u . . F (x) ............. 1.5 ............. ..... . . . . . . . . . . . . .. ............ 6 ........... . . . . . . . . . .. ......... 1 ........ 6 . . . . . . ...... .... . . . ..... ... 6 0.5 . . . .. .... . ... 0 . 0 xt xt+1 xt+2 x ≈ 1.54 2 x

Fig. 14.6 Stability of the bioeconomic equilibrium

For each one of the three sections characterizing Q (x) (cf. Figure 14.5) the derivative of Q (x) satisﬁes (Q ) (x) < 1 and F (x) is an increasing, concave function

258

14 Overﬁshing

on the compact interval [0, 1/α] with values in this interval (cf. Note 14.6 below). Thus, a ﬁxed point x > 0 of F exists, which represents the bioeconomic equilibrium at the speciﬁed values of the parameters. Moreover, {xt }t converges to the bioeconomic equilibrium if the initial resource stock x0 is strictly positive (cf. again Figure 14.6). Note 14.6. The slope of Q (x) is 0 for x contained in the ﬁrst section (cf. Figure 14.5) and (Q ) (x) = 0. For x belonging to the second section, (Q ) (x) = δ1 , which is less than 1 by assumption. For x belonging to the third section consider the following expression: 1 − (Q ) (x) =

(1 − δ1 ) · (1 − δ2 ) > 0 for 0 < δ1 , δ2 < 1. 1 − δ1 δ2

Thus again (Q ) (x) < 1, and the derivative of F (x) is positive but decreasing because (x − Q (x)) [term in the denominator of (F ) (x)] increases with x and (1 − (Q ) (x)) [term in the nominator of (F ) (x)] decreases with x. Consequently, F (x) is a continuous, piecewise differentiable, increasing and concave function.

0.8

... ....

. Q2 (x) ....... .

.... .... . . . . .... Q1 (x) .... ....................................... . . . . . . . . . . . . . ....... . . . . . . . . . . . . . ........ ........ . .......u.. . . . . . . . . . . . . . . . . . . ....... . .... .. . Q (x ) 0.4 ... ............... ...... .... ... 2 2 ...... Q1 (x1 ).............u QF (x) .................. ..... . .. ... .... ... ........ .... ........ .... ... .... .... ....... ........ . . . . . . . . . .... ... ...... ...... .... .... . . . .... . . . . 0.2 . . .... ...... .... .... . .... ....... . . . . . . . .... . . . . . . . . . . . . . . . . .... .... . . . . . . . . . . . . ... ........... .. ..... . . . . . . . . . . . . . . . . ... . . . . . . . . . . . . . . . . . . . .. .......................................... . . . . . . . . . . . . . . . . 0 0 x2 ≈ 0.69 1 x1 ≈ 1.54 2 0.6

Q

x Fig. 14.7 Dependence of the bioeconomic equilibrium on the values of the efﬁciency parameters

Figure 14.7 gives an impression of the dependence of the bioeconomic equilibrium on the values of the efﬁciency parameters. The ﬁrst equilibrium (related to x1 ) corresponds to values δ1 = 0.25 and δ2 = 0.15; the second equilibrium (related to x2 ) results from δ1 = 0.8 and δ2 = 0.4. The remaining parameters are kept ﬁxed at α = 0.5 and w/p = 0.1. Observe that this second equilibrium is characterized by overﬁshing: the associated resource stock x2 is below xM (= 1). Thus, the inherent

14.4 The Market Equilibrium

259

incentive to invest in equipment (cf. Subsection 14.2.2) leads to overcapacity and to overﬁshing in the model considered here. In summary, the bioeconomic equilibrium deﬁned by the concrete values of the various parameters represents market supply at the given price p. If x (p) := x (p, w, δ1 , δ2 , α) is the resource stock associated with the bioeconomic equilibrium, then market supply S(p) at price p satisﬁes: S(p) = Q (x (p)) = QF (x (p)). The following section provides an analysis of this aggregate market supply S(p), also in dependence of the values of the parameters δ1 and δ2 . Supplementing the market with aggregate demand D(p) will allow a more detailed and “in-depth” analysis of overﬁshing.

14.4 The Market Equilibrium Aggregate supply S(p) will be analyzed for given values of δ1 and δ2 . Obviously, S(p) is bounded because QF is bounded. Moreover, S(p) = 0 for small values of p: Q (x) = 0 for x ≤ w/(pδ1 ), and this will hold for any level of the resource stock if p is sufﬁciently small; x will then be contained in the ﬁrst section in Figure 14.5. On the other hand, for p sufﬁciently large, i.e., w/p ≈ 0, almost all values of x will belong to the third section in Figure 14.5. But this implies for large values of p: Q (x) ≈

(δ1 + δ2 − 2δ1 δ2 )x for all x ∈ [0, 1/α]. 1 − δ1 δ2

... ..... ... S(p) with δ1 = 0.25, ... . . δ2 = 0.15, α = 0.5 ... 2 and w = 0.1 ..... ... ... . ... ... . . . ... 1 ................................................................................................................................................................................................................................................u ... . . . . . . .. ...... ......... ... ... S(1) ≈ 0.35 ................................... ..... . . . . . . ... . . . . . . . . . . . . . . . . . . ... . . . . . . . . . . . . . . . . . . . . . . . . . . . ... . . . . . . . . . . . . . ............. ... ... .. 0 0 0.1 0.2 0.3 0.4 3

p

S(p) Fig. 14.8 Aggregate supply S(p) with δ1 = 0.25 and δ2 = 0.15

0.5

260

14 Overﬁshing

The structural properties of S(p) can now be described as follows: S(p) increases monotonically with p, if the resource stock x (p) associated with the bioeconomic equilibrium for arbitrarily large values of p exceeds xM . This happens if the slope [(δ1 + δ2 − 2δ1 δ2 )]/(1 − δ1 δ2 ) of the above function Q (x) is not greater than 1/2, which corresponds to the slope of the straight line from 0 to the point of maximum sustainable yield on QF . With xM = 1/(2α) and QF (xM ) = 1/(4α), the slope is therefore given by [1/(4α)]/[1/(2α)] = 1/2. However, if this slope exceeds 1/2, then the bioeconomic equilibrium will be located in the “inefﬁcient” part of QF (cf. Figure 14.5) and aggregate supply will decrease with a further increasing value of p, a “backwards bending” supply curve results. Figures 14.8 and 14.9 illustrate these two structurally different versions of aggregate supply S(p). For α = 0.5 and w = 0.1 Figure 14.8 shows the graph of S(p) for the values δ1 = 0.25 and δ2 = 0.15 of the efﬁciency parameters. For p = 1 one obtains the bioeconomic equilibrium x of Figure 14.5. Finally, Figure 14.9 shows the backwards bending graph of S(p) for δ1 = 0.9 and δ2 = 0.2, revealing the structural effect of a large value of the efﬁciency parameter δ1 . ... ... ... ... ... ... ... S(p) with δ1 = 0.9, ... 2 δ2 = 0.2, α = 0.5 ... ... and w = 0.1 ... ... ... .... .... .... ...... 1 ...... ...... ....... ........ ...... . ........ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ........................................... . . . . . . . . 0 0 0.1 0.2 0.3 0.4 0.5 3

p

S(p) Fig. 14.9 Aggregate supply S(p) with δ1 = 0.9 and δ2 = 0.2

The next step combines market supply S(p) with market demand D(p) or p(Q) (inverse demand function) to arrive at a market equilibrium (p , Q ). In order to analyze the development of the market equilibrium, various scenarios will be investigated. These scenarios consider increases in demand as well as increases of the efﬁciency parameters δ1 and δ2 . Scenario 1: The ﬁrst case assumes ﬁxed values for the efﬁciency parameters δ1 and δ2 of the ﬁshing ﬂeet. However, market demand for ﬁsh increases continuously. The consequences for the market equilibrium are illustrated in Figure 14.10 for δ1 = 0.9 and δ2 = 0.2.

14.4 The Market Equilibrium

261

The following observations are relevant for Scenario 1 and Figure 14.10: initially, market demand is given by pa (Q) := 5−20Q. An increase of demand to pb (Q) = 5 − 15Q increases the equilibrium quantity, which can be sold at a slightly higher equilibrium price. Further increases of demand to pc (Q) = 5 − 10Q and pd (Q) = 5 − 20Q eventually yield a reduced equilibrium quantity accompanied by a much higher equilibrium price. Thus, a continuously increasing demand leads in this case to a resource stock below xM characterized by inefﬁciency and overﬁshing. The values of the efﬁciency parameters δ1 and δ2 have in fact been chosen such that the slope of Q (x) with x in the third section is above 1/2. A less efﬁcient ﬁshing ﬂeet would therefore not produce this result in the context considered here (cf. the situation illustrated in Figure 14.8) – there would be neither overcapacity nor overﬁshing. 5 4 3

p 2 1 0

... ... ... S(p) with δ1 = 0.9, ... δ = 0.2, α = 0.5 . 2 d .... ... and w = 0.1 ...u ... ... ... pa pb pc pd ... ... ... .... .... ..... ...... ...... c .....u ........ .......... ............. a b ..... .................. . . . . u . . . . . . . . . . . . . . u . . . . . . . . . . . . . . . . . . . . . . . . .......................................................................................................................................................

........... ....................... ......................... .............. ......... ......... ...... ......... ........ ..... . .... ..... ...... ................. ......... .... .... ...... ......... .... ..... ...... ......... .... .... ......... .... ..... ........... ......... .... .... ...... ......... .... ..... ...... ......... .... .... ...... ......... .... ..... ...... ......... .... .... ...... ......... .... ..... ...... ......... .... ...... ......... .... ......... ...... ......... .... ..... . . . ......... . .... . ..... ...... ......... .... ...... ..... ......... .... ...... ..... ......... .... ...... ..... ......... .... ...... ..... ......... .... ...... ......... ..... .... ...... ......... ..... .... ...... ......... ..... .... ...... ......... .... ..... . ......... . . .... ...... ..... ......... .... ...... ..... ......... .... ...... ..... ......... .... . . . ......... . . . . ..... .... ...... ......... .... . . . . . . ......... . . . ..... .... ...... ...... .... . . . . . . . . . ...... ..... .... .... . . . . . . . . . . ..... .... ...... .... . . . . . . . . . ...... ..... .... .... . . . . . . . . . ...... ..... .... ...... .... ..... ...... .... ..... .... ...... ..... .... ...... ..... .... ...... ..... .... ...... ..... .... ...... . ..... .... ...... .... . ...... . . ..... .... ...... ..... .... ...... ..... .... ...... .... . . ...... . ..... .... ...... ..... .... ...... ..... .... ...... .... . . . ...... ..... .... ...... ..... .... ...... ..... .... ...... .... . . . .... ... ..

0

0.1

0.2

0.3

0.4

0.5

S(p) Fig. 14.10 Equilibrium with increasing market demand

Scenario 2: For the second case market demand p(Q) is assumed to be given, whereas the values of the efﬁciency parameters are considered variable. Figure 14.11 depicts this situation for parameter values δ1 = 0.3 and δ2 = 0.2 (S1 ), for parameter values δ1 = 0.6 and δ2 = 0.5 (S2 ), and for parameter values δ1 = 0.9 and δ2 = 0.8 (S3 ). This case is interesting insofar as a more efﬁcient ﬁshing ﬂeet (transition from S1 to S2 ) at ﬁrst yields an increasing equilibrium quantity at a decreasing market price. A further investment in the equipment resulting in an increase in efﬁciency (transition from S2 to S3 ) leads, however, to a reduced equilibrium quantity at a substantially higher price. The reason for the “inefﬁcient” ﬁshing activities result from the values of the efﬁciency parameters which are “too high” or, equivalently, from overcapacity. The excellent technical equipment of the ﬁshing boats leads to overﬁshing, and therefore to ﬁshing activities in resource stocks with inefﬁcient sizes. This refers to a sustainable total catch, which can be attained both at an efﬁcient and an inefﬁcient

262

14 Overﬁshing

size of the resource stock (cf. Figure 14.4). Only the parameter values associated with S1 yield a “normal” aggregate supply curve. With respect to consumers, S2 produces the “best” market equilibrium. 5 4 3

p 2 1 0

... ... .. ... ... ... ... .. .. ... S3 p(Q) S2 ..... .... ... ... ... ... ... ... ... ... ... ... ... ... ... .. ... ...... 3 ... ..... .u ... ... ... ...... .... . . .... 1 ... ..... .... . . ..... ..u .... ...... . . ..u. . ....... ... ....... ....... . . . . .................... 2 ..... . . . . S1 . . . . . . . ............. .. ..................... . .................. ............................................ ....................................................................................................................................................................................................................................................................................................... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ..

0

0.1

0.2

0.3

0.4

0.5

S(p) Fig. 14.11 Equilibrium with increasing values of the efﬁciency parameters

Other scenarios could be considered without, however, yielding substantially different results. Obviously, the “investment race” induced by externalities (cf. Subsection 14.2.1) bears a great deal of responsibility for these outcomes. A sufﬁciently high “efﬁciency” of the boats eventually leads to a decreasing equilibrium quantity accompanied by higher prices. An increasing demand can certainly accelerate this development, although it is not the root of the problem. Thus, the role of globalization or international trade should be considered carefully in this context. Increasing demand through, for example, increasing trade activities, tends to “uncover” the problematic issues and is therefore the ﬁrst and most prominent to be blamed for the undesired developments. The above results point, however, to the necessity of a differentiated view on this topic. The following section summarizes the results of this formal analysis and attempts to give some advice on how to tackle the global problem of overﬁshing. Some formal aspects of quota management will also be investigated. In the last section of this chapter, the resulting conclusions will then be compared with the regulations prescribed by various ﬁsheries policies, among them, most prominently, the Common Fisheries Policy (CFP) of the EU, and the US Fisheries Policy.

14.5 Conclusions from the Formal Analysis Various results of the last sections (cf. Subsections 14.2.1 and 14.2.2) already indicated the role externalities play in the context of commercial ﬁshery. The ﬁrst

14.5 Conclusions from the Formal Analysis

263

subsection will elaborate these external effects in more detail, before formal issues of a quota management system will be addressed thereafter.

14.5.1 An Analysis of Externalities in the Fishing Industry In the ﬁshing industry, the Tragedy of the Commons (cf. Subsection 5.3.3) refers to the overallocation of resources in harvesting and the ensuing reduction of resource stocks arising in a situation of free access competition. The rent that would otherwise accrue to the resource in a socially efﬁcient equilibrium instead often pays for a highly overcapitalized ﬂeet with a labor force that is possibly too large. This free access competition to the resource is ﬁrst of all characterized by “bundles” of external effects: each ﬁrm in the industry exerts a (negative) externality on all others operating in the same area, by temporarily reducing the resource stock through ﬁshing. The possibility to gain a competitive advantage by investing in equipment follows from the analysis of the dependence of proﬁts and output on the efﬁciency of the ﬁshing boats (cf. Subsection 14.2.2). It is not unlikely that such incentives to raise the efﬁciency parameters, to “engage” in an “investment race”, exist in reality. The observable overcapacity, sometimes estimated to be as high as 250% (cf. p. 247), certainly points to such a relationship. Of course, this investment race can be supported and even accelerated through various subsidies, which have always been of great importance in the ﬁsheries. Harmful ﬁshing subsidies are now widely understood to be a signiﬁcant part of the problem of overﬁshing. Subsidies are estimated to represent nearly 20% of ﬁshing industry revenue, and ﬂow to the ﬂeets, aggravating the problem of “too many boats chasing too few ﬁsh” ([9], p. viii).2 These subsidies result themselves from externalities: governments are or have to be concerned about the well-being of the national ﬁsheries. If they are not willing to support their ﬁsheries, but other countries do, then the resulting loss of competitiveness in the sense of a comparatively lower efﬁciency of the boats of the national ﬁsheries will endanger jobs, also in the industry manufacturing ﬁshing gear. Thus, national governments are, regarding subsidies for their ﬁsheries, “trapped” in the Prisoners’ Dilemma. Again, the sheer amount of subsidies ﬂowing into the ﬁsheries, provides a clear signal for the “functioning” of this dilemma. The fact that it is difﬁcult to arrive at an efﬁcient solution to the Prisoners’ Dilemma, should therefore play a role in any policy recommendations regarding subsidies to the ﬁsheries. Interestingly, these subsidies do not play the role of internalizing these external effects in the sense of a Pigou Subsidy (cf. Section 6.2). On the contrary, given that there is no supranational agency with regulatory powers, these subsidies, resulting from the Prisoners’ Dilemma, obviously tend to exacerbate the situation. 2

It should be noted here that not all subsidies are “harmful”. For example, subsidies to reduce ﬁshing capacity or subsidies to support the retraining of ﬁshers are usually considered “green light proposals” ([9], p. 77).

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14 Overﬁshing

14.5.2 Attempts to Internalize Externalities in Fisheries The root of the problem is free access competition regarding a limited resource stock. This, according to Munro/Scott, “Class I common property problem” with complete non-regulation of the ﬁsheries results in an excessive depletion of the resource ([7], p. 631). The results obtained above demonstrate that this excessive depletion, this overﬁshing, also characterizes ﬁsheries with limited entry regulations. By applying techniques of dynamic modeling, of models of optimal control theory, it is possible to derive and demonstrate this expected result in a formal context (cf. again [7], p. 637ff.). The “Class II common property problem” refers to attempts to prevent undue exploitation of the resource by limiting seasonal harvests without explicitly limiting the number of boats competing for the restricted harvests ([7], p. 631). As a consequence, there will likely be an excessive number of boats in comparison to the available resource stock. Again, this expected development is conﬁrmed by the results obtained earlier in this chapter (cf. in particular Subsection 14.3.2). Therefore, the decisive problem seems to be to control ﬁshing capacity. This could be achieved through an appropriate investment tax on ﬁshing gear, or through direct restrictions by means of, for example, permits. These two general approaches correspond, of course, to the idea of a Pigou Tax (cf. Section 6.2), or tradeable certiﬁcates (cf. Section 6.4). However, as most ﬁsheries operate in an international context, the Prisoners’ Dilemma will “stimulate” governments to support “their” ﬁsheries, for example through subsidies. The role of subsidies in the ﬁsheries will be investigated in the next subsection (cf. Subsection 14.6.1), which will also illustrate the obvious difﬁculties to “ban” certain subsidies from the ﬁsheries. Nevertheless, a “solution” by means of the classical instruments of environmental economics such as taxes and certiﬁcates cannot easily be attained either. If controlling ﬁshing capacity directly may prove to be difﬁcult due to the lack of appropriate international institutions and due to the well-known mechanisms of the Prisoners’ Dilemma, what else could be done to regulate the ﬁsheries – besides limiting entry through licenses? There is ﬁrst the possibility to establish “markets” for the ﬁsh to be caught, i.e., ﬁsheries would have to pay for the ﬁsh brought onshore, before it is sold to consumers. Flat rates with ﬁsheries paying only once for a certain period of time to gain unlimited access to the resource stock will, however, not necessarily provide the desired incentives. For various reasons, these “access prices” will probably have to be different for ﬁsheries from different countries, maybe even for the ﬁsheries in one country: Lindahl equilibria require personal prices in general (cf. Section 7.1), and the economic situations vary among the participating countries. Thus, the problems with the incentive incompatibility of Lindahl equilibria, and the problems with the Prisoners’ Dilemma will not disappear in this context and will affect relevant decisions. Moreover, whether it will be, in general, possible to stop or prevent overﬁshing through this approach, remains questionable. The elasticity of the demand for ﬁsh or ﬁsh products might play a role: if demand is rather price-inelastic, then high access prices can be “passed on” to the consumers with little or no effect on capacity or

14.5 Conclusions from the Formal Analysis

265

ﬁshing activities. In this sense, establishing property rights through these access prices, need not prove helpful to achieve the overarching goals. Moreover, ﬂat rates would certainly provide further incentives to invest in equipment, thus again contributing to overcapacity. A further approach takes up again the “Class II common property problem” and limits seasonal harvests through a quota. This can protect a ﬁsh stock from overharvesting, if the quota refer to all ﬁsheries exploiting a given stock. The international dimension of overﬁshing again becomes clear in this context. Only quota systems, which are established and agreed upon internationally, have a chance of accomplishing the desired task. In addition, the details of the quota system, such as the initial allocation of the quota, or national subsidies, may affect the ﬁnal results, especially with respect to overcapacity. Some of these issues will be addressed in the following subsection, again in the context of an industry regulated by a limited entry scheme. In summary, the international dimension of the problem seems to create serious difﬁculties for achieving an effective solution in this context. The regular approach to an internalization of the external effects can therefore not be expected to work satisfactorily. On the other hand, the existing legal institutions, mostly established by the UN such as The Law of the Sea, are not yet appropriate and detailed enough to address these issues successfully. Moreover, the existing “quasi-international” agreements such as the Common Fisheries Policy of the EU, or ﬁshery policies with an international dimension such as the US Fisheries Policy have more or less failed in their attempt to substantially reduce overcapacity or overﬁshing (cf. also Subsections 14.6.2 and 14.6.3).

14.5.3 Quota Management Systems In part as a result of similar experiences with entry limitation, many countries have moved towards adopting individual quotas and individual transferable quota schemes for regulating ﬁsheries. Rather than attempt to anticipate every possible loophole, regulators under these schemes would monitor the output of each ﬁrm. While some have argued that these individual quota schemes will fail as well, the fact remains that they are quickly becoming the regulatory norm. Issues that require examination include characterizing and evaluating the economic equilibria that will arise as a result of this form of regulation, also in their relationship to the issue of overcapacity or to other forms of expenditure that may be made in order to try and enhance the efﬁciency of ﬁrms. Assume that a “regulator” is attempting to allocate a total quota Q amongst ﬁrms in the ﬁsheries with Q ≤ QF (x). Consequently, the periodical total catch Q will not sustainably reduce the resource stock x (cf. Subsection 14.3.1).3 In keeping with the two-ﬁrm analysis with the ﬁrms characterized by the efﬁciency parameters δ1 > δ2 3 Apart from this restriction, the question of how the total quota is determined will not be addressed here. It is, as in the earlier sections of this chapter, assumed that the net growth of the resource stock will not be below the total quota. Beyond that the analysis again essentially remains static.

266

14 Overﬁshing

as in the preceding sections, the regulator’s problem to minimize economic cost can be written as follows (cf. also Subsection 11.2.2): min w · (E1 + E2 ), such that Q = q1 (E1 ) + q2 (E2 )

E1 ,E2

where qi are the production functions deﬁned in Subsection 14.2.1. The Lagrange function for this problem is given by L(E1 , E2 , λ ) = w · (E1 + E2 ) + λ (Q − q1 (E1 ) − q2 (E2 )), where λ is the associated multiplier. Differentiating this function with respect to E1 , E2 and λ leads to the necessary conditions for an interior optimum, the second-order conditions are satisﬁed due to the properties of the production functions: w = λ δ1 e−E1 (x − q2 ), w = λ δ2 e−E2 (x − q1 ), Q = q1 + q2 . Observe that the ﬁrst two equations are structurally equivalent to the ﬁrst-order conditions for proﬁt maximization (cf. Subsection 14.2.1). This shows that the optimal allocation of a quota coincides with the decentralized decisions of the proﬁtmaximizing ﬁrms. Solving the production functions for e−Ei and using this result in the above equations yields the following relationship between q1 and q2 : q2 = −

1 − δ2 δ1 − δ2 ·x+ · q1 , 1 − δ1 1 − δ1

q1 , q2 > 0.

This equation describes the relationship that must hold between q1 and q2 for an efﬁcient allocation of the quantities that each ﬁrm should produce. “Efﬁciency” implies that there is no other allocation of a given quota with a smaller total factor requirement. Together with the condition q1 + q2 = Q or q1 + q2 (q1 ) = Q with the above function q2 (q1 ) one obtains the socially optimal individual quotas: q1 =

(δ1 − δ2 )x + (1 − δ1 )Q , 2 − δ1 − δ2

q2 =

−(δ1 − δ2 )x + (1 − δ2 )Q . 2 − δ1 − δ2

These equations are valid as long as Q ≤ Q¯ where Q¯ is the theoretical maximum output the two ﬁrms would produce when w = 0. Q¯ is given by: (δ1 + δ2 − 2δ1 δ2 ) Q¯ = · x. 1 − δ1 δ2 Q¯ results from applying an arbitrarily large factor input Ei in the production function qi at w = 0, yielding e−Ei = 0 and qi = δi (x − q j ), for i, j = 1, 2, i = j.

14.5 Conclusions from the Formal Analysis

267

Of course, if q2 in the above formula for individual quotas turns out to be negative, then the optimal solution for q2 is zero and only ﬁrm 1 should produce, which is therefore allocated the full quota. The process of optimal quota determination is illustrated in Figure 14.12 for the case where δ1 = 0.5, δ2 = 0.4 and x = 2. The socially efﬁcient distribution of output must lie on the kinked line OAC. On the segment OA, only ﬁrm 1 should produce. The endpoint C corresponds to the theoretical maximum output Q¯ = 1.25. Optimal individual outputs are determined for a total quota of Q = 0.75 where the line q1 + q2 = Q intersects OAC. It is straightforward to verify that q1 /q2 > δ1 /δ2 . Just as in the case of simple limited entry, the ratio of outputs of ﬁrms should exceed the ratio of their efﬁciency parameters. Again, this implies that the more efﬁcient ﬁrm should produce more output. As a ﬁnal point, it is worth noting that allocating quotas on the basis of historic catch is generally not optimal. In terms of Figure 14.12, suppose that outputs had been set historically at H. The allocation of quota Q = 0.75 on the basis of historic catch would have to lie on the line OH at point D. Except in the unlikely case that all ﬁrms are identical, this would never be optimal. That is, only in the case where all ﬁrms are identical and the historic quotas were optimally distributed would it be subsequently optimal to allocate a new quota on the basis of historic shares in the total quota. 1.25 1 0.75

q2

...... .

...... .

...... .

...... .

...... .

...... .

...... .

...... .

...... .

Allocation of quota for δ1 = 0.5 und δ2 = 0.4 ...... .

...... . ...... . ...... . ...... ...... ...... . ...... ...... ...... ...... . ...... ...... ...... . ...... ...... ...... . ...... ...... ...... . ...... ...... ...... . ...... ...... ...... . ...... ...... ...... . ...... ...... ...... . ...... . . . . . ...... . ...... . . ........ ...... . . . . . . . . ...... . ...... . ...... .................. . ...... ................. . . . . . . . . . ...... . ...... ...... ......... . . . . . . . . . ...... ...... ......... ...... . . . . . . . . . ...... ...... ......... . . . . . . . . . . . . . . . ...... ...... ......... ...... . . . . . . . . . ...... ...... ......... . . . . . . . . . . . . . . ...... . ...... ......... ...... . . . . . . . . ...... . ........

....u H........... . . . u . C D ......... u ....... . u . 0.25 . . B .... ...... O A ............ ... 0 ..u.........................................................u. 0 0.25 0.5 0.75 q1 0.5

1

1.25

Fig. 14.12 Optimal allocation of quota

If historic catch leads or might lead to the allocation or reallocation of individual quota, then there remains an incentive to invest in equipment in order to “stay ahead”, in order to attain a better position ahead of the competitors. This should be observed whenever the allocation of quota is an issue. There is an additional aspect regarding quotas, which deserves a more careful observation. Assume that individual quotas qi (Q) are below the proﬁt-maximizing levels qi (p, w0 , x), i = 1, 2. An increase in the factor price w would then normally

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reduce the proﬁt-maximizing output (cf. Subsection 14.2.2). However, as long as qi (Q) is below the optimal, the proﬁt-maximizing quantity, an increase in the factor costs increases the pressure to recover rising costs through an increase in revenue. Attempts to (illegally) exceed the individual quota to get closer to the proﬁtmaximizing output will therefore accompany increasing factor costs, and ﬁsheries continue to be characterized by short-term decision-making although the introduction of quota should help to implement long-term management plans: “the practice of putting short-term economic and social interests before long-term ecological imperatives had only ended up undermining the very economic interests which it was meant to protect” characterizes the situation in the words of the CFP ([2], p. 7). In this sense, quota management can also lead to effects which are adverse and not intended in the ﬁrst place.

14.6 Fisheries Policies The theoretical considerations of the last sections have demonstrated that the international dimension of most ﬁsheries creates severe difﬁculties for a policy, which aims at reducing overcapacity and abolishing overﬁshing. In this context, this section will investigate two prominent ﬁsheries policies, the Common Fisheries Policy (CFP) of the EU, and the US Fisheries Policy. The analysis will mainly refer to the general goals of the policies, and the various instruments applied to achieve these goals. The ﬁrst subsection provides a general survey on the role of subsidies in the ﬁshing industry. Subsidies to ﬁsheries are a global phenomenon and, together with the externalities, are at the root of the problems of overcapacity and overﬁshing.

14.6.1 Subsidies and Overcapacity in the Fishing Industry Fishery subsidies have a long history, which is, as in the case of the United States of America, Canada, Norway and many other countries, hundreds of years old. Very often, these subsidies were aimed at developing the domestic ﬁsheries with the goal of expanding the industry in an increasingly competitive and international environment. While these expansionary subsidies were perceived to help the local communities, subsidies to reduce capacity, which were developed after overﬁshing became a reality some decades ago, are difﬁcult to implement ([10], p. 14ff.). Therefore, subsidies seem to be “natural” for most ﬁsheries, and ﬁsheries are used to these subsidies. On 10 December 1982, the United Nations Convention on the Law of the Sea opened for signature. It entered into force on 16 November 1994 and, among other things, extended the Exclusive Economic Zones (EEZ) to assign property rights to the coastal states for ﬁshing in coastal waters. This was a ﬁrst answer to the fact that ﬁsh stocks began to show signs of depletion as large ﬁshing vessels exploited ﬁsh

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stocks far from their native shores. As of 17 December 2010, 161 states are parties to this Convention.

The Law of the Sea (excerpt from [18], p. 25) The key rights and obligations of “The United Nations Convention on the Law of the Sea” relating to ﬁshing include: • Coastal States have sovereign rights in a 200-nautical mile exclusive economic zone (EEZ) with respect to natural resources and certain economic activities, including ﬁshing; • Land-locked and geographically disadvantaged States have the right to participate on an equitable basis in exploitation of an appropriate part of the surplus of the living resources of the EEZ’s of coastal States of the same region or sub-region; • States bordering enclosed or semi-enclosed seas are expected to cooperate in managing living resources, environmental and research policies and activities; • States are bound to prevent and control marine pollution and are liable for damage caused by violation of their international obligations to combat such pollution; • All States enjoy the traditional freedoms of ﬁshing on the high seas; they are obliged to adopt, or cooperate with other States in adopting measures to manage and conserve living resources; • Signatory states are obliged to settle by peaceful means their disputes concerning the interpretation or application of the Convention. Disputes can be submitted to the International Tribunal for the Law of the Sea established under the Convention, to the International Court of Justice, or to arbitration. Although parties are obliged to manage and conserve the living resources provided by the seas, the issue of potentially harmful subsidies is not explicitly addressed in the “Law of Sea”. The associated agreement relating to the “Conservation and Management of Straddling Fish Stocks and Highly Migratory Fish Stocks”, however, sets out various important principles for the conservation and sustainable management of ﬁsh stocks. This agreement encourages cooperation between states to ensure conservation and optimum utilization of ﬁsheries resources both within and beyond the exclusive economic zone (cf. [14]). It entered into force on 11 December 2001. As of 18 December 2010, 78 states are parties to the agreement, considerably less than to the Convention. Important ﬁshing states, such as Mexico or Thailand, did not yet sign the agreement; China signed, but because of reservations concerning some provisions has not yet ratiﬁed the agreement.

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In its 1999 special study on trade and environment, which is still relevant for today’s ﬁsheries, the WTO considered subsidies an important part of the problem of overcapacity in the ﬁsheries:

Subsidies and Overﬁshing (excerpt from [18], p. 24f.) Fishing subsidies are common. However, the lack of transparency and the multitude of subsidies make quantiﬁcation difﬁcult. But according to a rough estimation by FAO (1993) on the basis of the difference between revenue and estimated costs of ﬁshing, global ﬁshery subsidies must be in the order of $54 billion annually to make the industry break even. Another estimation by Milazzo (1998) of the World Bank is more conservative, suggesting subsidies in the range of $14 to $20 billion annually, or 17 to 25 per cent of the industry’s revenue. Another indication of the prevalence of subsidies is the overcapitalization of the industry. According to some estimates, the gross tonnage that is trawling the seas is more than twice what would actually be needed. That is, there is an enormous overcapacity maintained by government subsidies. Thus, the removal of these subsidies would not just be to the beneﬁt of the environment, but also to taxpayers who foot the bill twice by higher taxes and less ﬁsh on their tables. Whatever the “true” subsidies may be, they are arguably part of the problem. It should be stressed, however, that it depends also on the kind of subsidies granted. Obviously, if subsidies are paid to retiring capacity rather than to expand it, subsidies may even ease the problem given the current overcapitalization of the industry. However, only a careful analysis of each subsidy program can reveal whether the effect is to expand or contract ﬁshing capacity. A case in point is “buyback” arrangements of worn-out ﬁshing boats and gear that on the surface may look like a retirement scheme. However, it will only serve a conservation purpose if the retired boats and gears are not replaced by new and possibly more efﬁcient equipment. If no such restrictions are imposed, the end result would only be to encourage further capacity investments by reducing the investment costs of the industry. The 2002 reform of the CFP addressed, among other things, also the issue of the subsidies, which “were carefully redirected to support the life of coastal communities while the industry restructures and ﬂeet capacity is reduced: aid for the building of new capacity was discontinued, while responsibility for capacity management reverted to the Member States” ([2], p. 7). Moreover, the EU Commission recently concluded “that while EU ﬁshing capacity overall is declining, the reduction is coming too slowly (on average, an annual reduction of 2-3% over the last 15 years) for it to have any substantial impact on ﬁshing pressure and thus alleviate the poor state of many EU ﬁsh stocks, in particular demersal stocks. It is estimated that technological creep runs at around 2-4% annually, thus effectively canceling out any nominal reduction” ([2], p. 19). And “subsidies and other forms of aid have too

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often played a perverse role, maintaining ﬁshing capacity in excess of what is economically and ecologically justiﬁed” ([2], p. 20). The “World Trade Report 2010” adds that “subsidies to natural resource industries, such as ﬁsheries, will worsen the exploitation of stocks that already suffer from open access” ([19], p. 13). Thus, ﬁshery subsidies not only have a long history, but also a long life. As more or less all countries with access to the sea support their ﬁsheries in one way or the other, the Prisoners’ Dilemma prevents them, in general, from reducing their subsidies unilaterally. This seems to be conﬁrmed by the “World Trade Report 2010” stating that “subsidies to ﬁsheries are large in absolute terms and as a share of total production” (cf. [19], p. 12). With this background information on subsidies, the following subsections investigate the most important provisions of the ﬁsheries policies of the EU and the US.

14.6.2 Evaluating the Common Fisheries Policy of the EU The Common Fisheries Policy (CFP) was formally created in 1983, but its origins date back to the early 1970s, when ﬁsheries were originally part of the Common Agricultural Policy of the EU. The following brief characterization of the CFP is taken from [2]. The main concern in those early days was to avoid conﬂict between nations, at a time when many countries around the world were extending their territorial waters, until the Law of the Sea enabled the creation of Exclusive Economic Zones (EEZs) extending 200 nautical miles from the coastline. In this context, the member states of the EU agreed to grant free mutual access to each others’ waters, so that each nation’s traditional ﬁshing grounds and practices could be preserved. As a result, the CFP helped to deal with the complex, overlapping patterns of mutual access on which Europe’s ﬁsheries depend. The success of the policy can be measured by the fact that, a quarter of a century later, ﬁsheries disputes between member states of the EU are settled peacefully by negotiation. The focus now is on the alarming decline of ﬁsh stocks in European waters, 88% of which are assessed to be overﬁshed. Various “principles” characterize the CFP. The principle of relative stability is one of the oldest. Total Allowable Catches (TACs) for each ﬁsh stock are shared between the member states of the EU according to a ﬁxed allocation key, which is, however, based on their historic catches. The purpose of relative stability is to prevent repeated arguments over how quotas should be allocated, and to provide ﬁshers with an environment which is stable relative to the overall state of the ﬁsh stock in question. This reference to “historic catches” with respect to the allocation of individual quota brings the efﬁciency question back to mind: such an allocation will, in general, not be efﬁcient (cf. Subsection 14.5.3). Moreover, as these quotas have to be adjusted from time to time, it is a good idea to invest in equipment for a “pole position” for the next reallocation. The mismatch between ﬁsh stocks and ﬁshing

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capacity increased the incentive to bend and break rules. Although the need for effective compliance with regulations is now universally accepted, the existing legal framework seems to be inadequate and not properly applied by the member states of the EU, who are to some extent in charge of the implementation of the CFP. For these reasons, the attempt to “control the controllers” constitutes another core issue of the CFP. The enforcement of the CFP rules is the work of the member states. It is up to the national inspectors to monitor what gear is being used, or how many tons of ﬁsh are caught and then landed. The EU Commission has its own inspectors, but they do not police the ﬁshers. Rather, their role is to inspect the control systems put in place by the member states, and make sure that the CFP rules are enforced effectively and fairly across the whole of the EU. Of course, the incentive of the member states to monitor and report the activities of their ﬁsheries is limited – for good reason. In order to establish trust between the various groups and organizations involved in ﬁshing the Commission has created Regional Advisory Councils (RACs), giving a wide range of stakeholders a real opportunity to inﬂuence policy development on an ongoing basis. The RACs provide ﬁsheries managers from the member states with an insight into issues which may affect their ﬂeets, but which also go far beyond their national borders. They allow ﬁshers to work more closely with scientists, for example from the “European Commission’s Scientiﬁc, Technical and Economic Committee for Fisheries” established in 1993. And perhaps most importantly, these RACs provide a real opportunity for stakeholders from different sectors and different countries to meet regularly to argue out their differences and discuss their common interests and problems. But again, the member states are responsible for the implementation and control of the ﬁsheries policy, and they are in a strategic situation with the other member states. Planning for the long term is more than a step away from short-term decisionmaking, which has, in the Commission’s words, “led to very small decreases in the impact of ﬁshing. Only three stocks under TACs (. . . ) are exploited consistently with the commitments made at the UN World Summit on Sustainable Development in Johannesburg in 2002 about maximum sustainable yield. Continuing to set TACs at much higher levels than advised means that ﬁsheries have been taking a high risk. And all the more so as many of these TACs are substantially overshot due to insufﬁcient enforcement” ([2], p. 15). The details of the medium-term plans proposed by the Commission vary from one stock to another, but they all share certain core principles, mentioned thereafter (cf. again [2], p. 15): • they set harvest control rules for the stock, based on clear quantiﬁable biological targets, and a graduated approach to achieving them over time; • they usually limit the maximum year-on-year variation in TACs to 15% in either direction, unless there is an imminent risk of the stock collapsing, so as to provide minimum stability for the industry; and • TACs and quotas are accompanied by a scheme to limit effort in line with annual changes in ﬁshing possibilities.

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Especially the last item, limiting the effort by, for example, limiting the days at sea or changes in ﬁshing gear, has proved difﬁcult to manage and to monitor. Moreover, there are doubts about the contribution of these regulatory measures to stock recovery, as ﬁsheries have “reacted” to these interferences (cf. [2], p. 16). Technical measures, such as minimum mesh sizes, closed areas and seasons, and limits on by-catches are accompanying the long-term planning. These measures are also meant to reduce discarding of unwanted ﬁsh, which is sometimes estimated to be as high as 30% ([2], p. 17). Again, the effect of these regulations depends on their successful implementation which requires a careful monitoring of all ﬁshing activities. Since 1995, there has been a speciﬁc structural fund dedicated to ﬁsheries. The “Financial Instrument for Fisheries Guidance” (FIFG) ran until the end of 2006. Certain priorities for funding seemed to be in conﬂict with one another, such as support for the reduction of ﬁshing effort and capacity on the one hand, and aid to modernize and renew the older segments of the European ﬂeet on the other. Also for this reason, the “European Fisheries Fund” (EFF), which became operational on 1 January 2007, was introduced, with the following priorities for action (cf. [2], p. 31): • helping the ﬂeet adapt ﬁshing capacity and effort to available ﬁsh resources; • support to aquaculture, inland ﬁshing, processing and marketing of ﬁsheries and aquaculture products; • aid for organizations which represent the collective interest of the sector; • sustainable development of ﬁsheries-dependent areas; and • technical assistance to member states to facilitate the delivery of aid. Whether this support from the EFF constitutes a “good” subsidy or a “harmful” subsidy depends on the details. Thus, a “sustainable development of ﬁsheries-dependent areas” can aim to sustain jobs in the ﬁshing industry or to create alternative jobs.

A Vision for European Fisheries by 2020 (excerpt from the Green Paper of the Commission ([1], p. 4)) Mankind’s main source of high-quality animal protein and healthy fat, ﬁsh, is a growing market again and has re-established itself as a regular ﬁxture in the diet of the more than half a billion European consumers. The continuous decline of catches by the European ﬂeet came to an end around 2015. Although Europe continues to rely heavily on ﬁsh imports, the proportion is starting to reverse. Fish caught or produced in Europe is valued and recognized by consumers as high-quality produce. Rampant overﬁshing, with a large impact on coastal economies, has become a thing of the past. Nearly all of Europe’s ﬁsh stocks have been restored to their maximum sustainable yields. For many stocks, this means that they have increased considerably compared to 2010 levels. Fishermen

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earn more from these larger ﬁsh populations composed of mature and bigger ﬁsh. Young people from coastal communities once again consider ﬁshing as an attractive and stable means to make a living. . . . Outside Europe, the EU continues its work to promote good maritime governance and responsible ﬁshing worldwide. Agreements with third countries now give higher priority to enhancing the European contribution to local ﬁsheries development, investment and good maritime governance. New regional programmes to improve the control and scientiﬁc monitoring of ﬁsh stocks are in place and involve most of the world’s larger ﬁshing nations.

In the introduction to the “Green Paper” of 2009 mentioned above, the Commission admits that “the above vision for the future is a far cry from the current reality of overﬁshing, ﬂeet overcapacity, heavy subsidies, low economic resilience and decline in the volume of ﬁsh caught by European ﬁshermen. The current CFP has not worked well enough to prevent those problems” (cf. [1], p. 4f.). Thus, once again the Commission wants to return to the exploitation of healthy and abundant stocks by overcoming the “structural failings of the policy” with a fundamental reform of the CFP. The priorities refer to, among others (cf. the web site of [1]): • putting an end to ﬂeet overcapacity by developing mechanisms capable of adapting ﬂeet quantity to available resources; • refocusing the CFP’s main objective on maintaining healthy, sustainable and exploitable stocks; • adapting the orientation of ﬁsheries governance from today’s centralized control by the Council of Fisheries Ministers, which adopts all decisions, towards regionalized (but not nationalized) implementation of the principles laid down at Community level; • involving the sector further in resource management and implementation of the CFP, for example by moving towards results-based management; • developing a culture of compliance with rules by obliging the sector and the member states to apply CFP measures more effectively. In summary, it thus appears the main problems of overcapacity and overﬁshing have been addressed with the CFP, but not really solved yet. A sustainable solution can probably only be expected through a CFP, which is administered by the Commission and not delegated to the member states. Only then might it become possible to avoid the dreadful effects of the Prisoners’ Dilemma, at least within the EU.

14.6.3 A Glance at the US Fisheries Policy In the US, the National Marine Fisheries Service (NMFS) of the National Oceanic and Atmospheric Administration (NOAA) is the federal agency, which is, as a divi-

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sion of the Department of Commerce, responsible for the management, conservation and protection of living marine resources within the United States’ Exclusive Economic Zone. The agency assesses and predicts the status of ﬁsh stocks and ensures compliance with ﬁsheries regulations. Moreover, it works to reduce wasteful ﬁshing practices, to promote sustainable ﬁshing practices and to prevent lost economic potential associated with overﬁshing, declining species and degraded habitats (cf. NMFS’s web site [17]).

Mission of the NMFS: Stewardship of living marine resources through science-based conservation and management and the promotion of healthy ecosystems ([17]) NOAA Fisheries is responsible for the management, conservation and protection of living marine resources within the United States Exclusive Economic Zone. NOAA Fisheries also plays a supportive and advisory role in the management of living marine resources in coastal areas under state jurisdiction, provides scientiﬁc and policy leadership in the international arena and implements international conservation and management measures as appropriate. Under this mission, the goal is to optimize the beneﬁts of living marine resources to the Nation through sound science and management. This requires a balancing of multiple public needs and interests in the sustainable beneﬁts and use of living marine resources, without compromising the longterm biological integrity of coastal and marine ecosystems. Many factors, both natural and human-related, affect the status of ﬁsh stocks, protected species and ecosystems. Although these factors cannot all be controlled, available scientiﬁc and management tools enable the agency to have a strong inﬂuence on many of them. Maintaining and improving the health and productivity of these species is the heart of our stewardship mission. These activities will maintain and enhance current and future opportunities for the sustainable use of living marine resources as well as the health and biodiversity of their ecosystems.

In their 2004 paper, Sanchirico/Hanna (cf. [8]) mention that of the 259 major ﬁsh species residing in US territorial waters, 43 have population levels below their biological targets (“overﬁshed”) and another 41 are being ﬁshed too hard (“subject to overﬁshing”). The vessels and ﬁshing power of many US ﬁsheries exceed levels that would maximize economic returns to society, and in 2009 there were already 46 overﬁshed species out of 260 ([16], p. 1). With two commissions set up to study the US ﬁshery management, the US ocean policy has been subjected to a systematic and broad-scale assessment since 2004. The 1976 Fishery Conservation and Management Act (FCMA) managed US ﬁsheries under command-and-control regulations that govern the total size of the catch,

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minimum ﬁsh size, type of gear, season length, and areas open to ﬁshing. When the allowable catch is subject to competition, ﬁshers have no ownership over the ﬁsh until they are caught. This creates a race for ﬁsh. Therefore a ﬁrst recommendation was to end “the race for ﬁsh” ([8], p. 46). Other regulatory measures referred to “setting catch limits” and “separating allocation and conservation decisions” with the goal to prevent short-term economic considerations from overriding scientiﬁc considerations regarding sustainability of ﬁsh stocks. In addition to these immediate problems longer-term problems should be addressed with more systematic approaches. Sanchirico/Hanna recommend ecosystem approaches and a reorganization of the relevant institutions ([8], p. 50f.). This prepared the ground for the Magnuson-Stevens Fishery Conservation and Management Reauthorization Act, which was signed by President Bush on January 12, 2007. The new law mandates the use of annual catch limits and accountability measures to end overﬁshing, provides for widespread market-based ﬁshery management through limited access privilege programs, and calls for increased international cooperation ([17]). The NOAA catch share policy, which went into effect on November 4, 2010, includes speciﬁc programs such as “limited access privilege” and “individual ﬁshing quota” programs. Catch share is a general term for several ﬁshery management strategies that allocate a speciﬁc portion of the total allowable ﬁshery catch to individuals, cooperatives, communities, or other entities. Each recipient of a catch share is directly accountable to stop ﬁshing when its exclusive allocation is reached (cf. [15]). The NOAA Fisheries Ofﬁce of International Affairs works with a variety of domestic and international partners striving to accomplish the following goals and objectives (cf. again [17]): • • • • • • •

promote ecosystem-based ﬁsheries management; control ﬁshing capacity; combat illegal, unreported and unregulated ﬁshing; strengthen regional ﬁsheries management organizations; secure equitable access for US ﬁshers to shared living marine resources; increase assistance to developing states; ensure food security.

The US are a member of a group calling themselves “Friends of the Fish” (also including Argentina, Australia, Chile, Colombia, New Zealand, Norway, Iceland, Pakistan and Peru). This is an informal coalition seeking to signiﬁcantly reduce ﬁsheries subsidies in the context of the negotiations launched by the Doha Ministerial Conference to clarify and improve WTO disciplines on ﬁsheries subsidies (cf. [4] for a Communication to the WTO). How to evaluate the US Fisheries Policy? The US have always preferred a “weak” government regarding regulation of the economy. This might be one of the reasons for “mild” regulations of the national ﬁsheries in comparison to the CFP of the EU. Moreover, due to the large EEZ of the US, the international dimension of the ﬁsheries seems to play a smaller role. Nevertheless, the US consider subsidies one of

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the main reasons for overﬁshing, which is also increasingly bothering US ﬁsheries. A level playing ﬁeld is demanded, especially regarding ﬁsheries subsidies. As the situation of the national ﬁsh stocks in the US is no better than elsewhere in the world, it remains to be seen whether the catch share programs, among the other instruments, prove to be an effective tool to reduce the “race for ﬁsh”.

14.7 Overﬁshing: A Summary Increasing globalization exacerbates the environmental issue of overﬁshing for a variety of reasons. First of all, there is the increasing demand for ﬁsh resulting from an increasing world population and simultaneously increasing trade relations. Moreover, due to technological innovations ﬁsheries from all parts of the world meet outside the Exclusive Economic Zones of their countries to catch ﬁsh. Thus, technological development contributes towards globalization. The problem of overﬁshing is further complicated through various externalities which induce, among other things, a “race for investment”. Globalization and the ensuing increasing demand for ﬁsh in combination with continuously ﬂowing subsidies for the ﬁsheries stimulate investment in efﬁcient equipment. In conclusion, as is the case for a global policy to reduce greenhouse gas emissions, a global ﬁsheries policy is needed. This policy has to internalize the externalities affecting the behavior of ﬁsheries both on a local and an international level. Moreover, this policy has to tackle the intricacies of the Prisoners’ Dilemma both with respect to subsidies and with respect to monitoring the agreements. Thus, policy problems intensiﬁed through increasing globalization and ranging from fundamental information deﬁcits to a bundle of externalities on a local level, to the Prisoners’ Dilemma on the level of the countries, characterize the issue of overﬁshing. Fisheries policies, if they exist at all, show little effect up to now. On a national level, the authorities have to deal with the difﬁcult problem of supporting ﬁsheries on the one hand and protecting the ﬁsh stocks on the other. Globalization lifts this problem on an international level without, however, having the authorities to tackle it adequately. Overﬁshing will certainly remain one of the great challenges of national and international environmental policy. What would be needed ﬁrst of all is a global system of individual quotas, allocating certain quantities of certain species of ﬁsh to individual ﬁsheries worldwide. Of course, these quotas would have to specify not only the quantities, but also the ﬁshing grounds or the time periods, for which they are valid. The greatest problem would certainly be the implementation of such a system. Questions of a “fair” allocation of the quotas would have to be discussed and solved. Moreover, the issue of “measuring, reporting and verifying”, which is currently of relevance in the international climate negotiations (cf. the report on the Copenhagen Conference on p. 118), would prove to be even more difﬁcult – in comparison to the

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already complicated case of measuring, reporting and verifying global reductions of greenhouse gas emissions. In addition to that, such a system of quotas would not yet diminish the incentives for a “race for investment”. Because those ﬁshing crews with the best equipment would still have an advantage regarding the “effort” required to locate and catch the ﬁsh. For this reason, subsidies for ﬁsheries and overcapacity would continue to remain an issue. The issue of overﬁshing thus demonstrates all the difﬁculties which arise with a multitude of externalities both on a national and an international level.

References 1. EU (2009) Green Paper “Reform of the Common Fisheries Policy”, European Commission, Brussels Cf. also http://ec.europa.eu/ﬁsheries/reform/intro/summary/index_en.htm. Cited Dec 2010 2. EU (2009) The Common Fisheries Policy. A user’s guide. European Commission http://www.ec.europa.eu/ﬁsheries/documentation/publications/pcp2008_en.pdf. Cited Dec 2010 3. FAO (2009) The state of world ﬁsheries and aquaculture 2008. FAO, Rome http://www.fao.org/docrep/011/i0250e/i0250e00.htm. Cited Dec 2010 4. Friends of Fish (2009) Fisheries Subsidies. Communication to the WTO Negotiating Group on Rules http://docsonline.wto.org/imrd/directdoc.asp?DDFDocuments/t/tn/rl/W243.doc. Cited Dec 2010 5. Kolbert E (2010) The scales fall: is there any hope for our overﬁshed oceans? The New Yorker, August 02, 2010: 70-73 6. Kreps DM (1990) A course in microeconomic theory. Harvester Wheatsheaf, New York 7. Munro GR, Scott AD (1985) The economics of ﬁsheries management. In: Kneese AV, Sweeney JL (eds) Handbook of natural resource and energy economics, vol. II, Ch. 14, NorthHolland, Amsterdam 8. Sanchirico JN, Hanna SS (2004) Sink or swim time for U.S. ﬁshery policy. Issues in Science and technology, Fall 2004: 45-52 9. Schorr DK (2004) Crafting new rules on ﬁshing subsidies in the World Trade Organization. WWF Position Paper and Technical Resource http://www.wto.org/english/forums_e/ngo_e/posp43_wwf_e.pdf. Cited Dec 2010 10. Schrank WE (2003) Introducing ﬁsheries subsidies. FAO Fisheries Technical Paper. No. 437, Rome 11. Smith JB, Weber S, Wiesmeth H (1990) Heterogeneity, interdependence and ﬁrm behavior in ﬁsheries. Discussion paper. York University, Toronto 12. Smith JB, Weber S, Wiesmeth H (1991) Implementation of quota management policies in resource industries. Discussion paper. York University, Toronto 13. Spence AM (1975) Blue whales and applied control theory. In: Gottinger HW (ed) Systems approaches and environmental problems, Vandenhoeck and Ruprecht, Göttingen 14. UN (1995) Agreement for the implementation of the provisions of the United Nations Convention on the Law of the Sea of 10 December 1982 relating to the Conservation and Management of Straddling Fish Stocks and Highly Migratory Fish Stocks http://www.un.org/Depts/los/convention_agreements/convention_overview_ﬁsh_stocks.htm. Cited Dec 2010 15. US (2009) NOAA: Catch share policy http://www.nmfs.noaa.gov/sfa/domes_ﬁsh/catchshare/docs/draft_noaa_cs_policy.pdf. Cited Dec 2010

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16. US (2009) NOAA: National Marine Fisheries Service (2009 Report to the Congress): The status of U.S. ﬁsheries. NOAA 2010 http://www.nmfs.noaa.gov/sfa/statusofﬁsheries/sos_full28_press.pdf. Cited Dec 2010 17. US (2010) NOAA: http://www.nmfs.noaa.gov. Cited Dec 2010 18. WTO (1999) Trade and environment (1999) Special Studies 4, WTO publications, Geneva 19. WTO (2010) World Trade Report 2010: Trade in natural resources, WTO publications, Geneva

Chapter 15

Integration of Trade and the Environment

Abstract Whereas Chapter 13 addressed the legal framework conditions of international trade in its relation to the environment, this chapter attempts an integration of trade and the environment. By means of a formal model, Bhagwati’s genuine problems, related to the integration of trade and the environment, are analyzed. The results show that the interaction of these – according to Bhagwati – most important issues on the global agenda is not always straightforward. It should be stressed in particular that the interests of the environment are not necessarily sacriﬁced when they are in conﬂict with those of free trade. From a formal point of view, the analysis considers subgame-perfect Nash equilibria of a game, modeling the strategic interaction of governments, producers and consumers. Further sections refer to the issue of harmonization of environmental standards, and to the effects of a tariff on equilibrium standards.

15.1 Bhagwati’s “Genuine Problems” In one of his numerous contributions on international trade, Bhagwati investigates genuine problems, pointing to potentially serious conﬂicts between free trade and the environment ([3], p. 164ff.), in contrast to some obviously fallacious arguments (cf. also Section 13.4): Unfair Trade: Differences in environmental regulations, which are supposed to lead to differences in international competitiveness, constitute probably the most important objection to free trade. Non-tariff import restrictions of the US include, for example, a ban on imports of marine mammal products, shrimp, and tuna from countries found not to be in compliance with US environmental provisions (cf. the trade policy review of the US in [16]). Race to the Bottom: Independent governments may compete for scarce investment through alternating reductions in environmental standards. Associated with this is the concern of various social movements against the current model of corporate globalization that WTO includes rules that undermine national and interH. Wiesmeth, Environmental Economics: Theory and Policy in Equilibrium, Springer Texts in Business and Economics, DOI 10.1007/978-3-642-24514-5_15, © Springer-Verlag Berlin Heidelberg 2012

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national legislation designed to protect peoples’ environment (cf., for example, the relevant statements of the “Our World is Not for Sale” network [12]). Ethical preferences: An argument against free trade can also be found in the attempts to impose one’s ethical preferences on other nations. Animal rights activists sometimes use the treatment of animals in various countries to postulate trade sanctions against these countries. Welfare Loss: The increasing production activities accompanying free trade lead to a degradation of the environment, which cannot be compensated through rising consumption possibilities. The increasing volume of truck trafﬁc in North America is sometimes used as an objection against NAFTA. The strict advancement of globalization with consequences for some countries, which were perceived as threatening, prepared the path for the “Battle of Seattle” in the context of the WTO Ministerial Conference in Seattle in 1999. This conference was confronted with many conﬂicting goals and alliances. The developing countries claimed that they derive no beneﬁt from opening their markets; the EU defended their agricultural markets; the US insisted on reducing tariffs on ecommerce, biotechnology and ﬁnancial services; moreover, a network of activists lined up against all sides and protested against the various WTO rules (cf. the report in [8]). Pascal Lamy, the then EU Trade Commissioner, expressed his concern shortly after the conference: “Many environmentally concerned observers seem to see in WTO a threat to environmental policy-making sovereignty. But they seem to miss the vision of WTO as an opportunity for the better integration of environmental policy, be it precaution, consumer information, or the reduction of some ecologically damaging policies, into the trade mechanism. Trying to disconnect trade and the environment is a false prejudice where environment would be the loser” ([10]). The riots at later WTO Ministerial Conferences, for example in Geneva 2009, show, however, that the WTO is still considered an “essential plank of globalization”, as Uri Dadush, Senior Associate and Director, Carnegie Endowment International Economics Program, states: U. Dadush1 “WTO Reform: The Time to Start is Now” (excerpt from [5]) The World Trade Organization (WTO) is an essential plank of globalization. Imperfect and incomplete as WTO disciplines are, they provide a degree of predictability and stability to trade relations, the value of which has been brought home

yet again by the global ﬁnancial crisis. In a world of sluggish growth and burgeoning protectionist pressures, the importance of rules increases and the need to strengthen them becomes more urgent. But, to a worrying degree, the WTO is today

1 Reprinted by permission of the publisher from “WTO Reform: The Time To Start Is Now”, Uri Dadush (Washington, DC; Carnegie Endowment for International Peace, 2009). pp##. www.carnegieendowment.org

15.2 Trade and the Environment: A Formal Approach

living off the gains of its predecessor, the GATT (General Agreement on Tariffs and Trade) system. In crucial aspects of its traditional mission, namely reducing actual and bound (which is to say, maximum allowable) tariffs, the WTO has become increasingly ineffectual. In newer areas, such as cutting agricultural subsidies and opening up markets for services trade, it has so far failed to deliver. Sluggish WTO negotiations

283

have been overtaken by unilateral (that is, autonomous) liberalization as well as by bilateral and regional processes. Furthermore, in areas of crucial concern to the international community, such as food security, international ﬁnancial regulation in the wake of the global ﬁnancial crisis, and the trade aspects of climate change, the WTO is nowhere to be found. ...

Given this background and information, the following sections then intend to bridge the gap between trade and the environment. An integration of trade and the environment is attempted by means of a formal model, which also allows a closer study of Bhagwati’s “genuine problems”, and an investigation of the now prominent issue of harmonizing environmental standards.

15.2 Trade and the Environment: A Formal Approach The formal model to be introduced in this section assumes that the production or the consumption of commodities leads to regional or international environmental problems, which affect the well-being of the economic agents. The environmental degradation can be reduced by diverting part of the production factor to clean-up processes or to cleaner technologies. In some sections, the presentation follows the paper by Weber/Wiesmeth (cf. [15]).

15.2.1 The Model There are two countries in which two consumption commodities can be produced with the factors labor and environment. The production functions with parameters βi j are given by: fi j (ei , zi j ) = βi j (1 − ei )zi j for i, j = 1, 2. ei with 0 ≤ ei ≤ 1 denotes an aggregated environmental standard in country i, and Zi is the supply of the factor “labor”, which is offered completely inelastically in country i. Moreover, country i has a comparative advantage in the production of commodity i, i = 1, 2. This implies then for the values of the parameters βi j :

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15 Integration of Trade and the Environment

β21 β11 > . β12 β22 Gains from trade are therefore assumed to arise only from comparative cost advantages, and alternative sources such as economies of scale or incomplete competition weakened through international trade are not considered (cf. [6] for example for a comprehensive theory of international trade).

Note 15.1. The restriction of the model to two countries, two commodities and two factors reduces the complexity of the presentation. Considering “environment” as a factor implies that environmental commodities can be employed in the production processes and “used up”, at least to a certain extent. The resulting environmental degradation is then assumed to be rehabilitated through natural attenuation till the next period (cf., for example, [11] for a review of natural attenuation from a normative perspective). Moreover, the factors labor and environment are substitutes: a lower pollution of the environment can be compensated by employing more labor. A higher level of the environmental standard reduces cet. par. the quantities of the consumption commodities, perhaps because some other factors, which are not explicitly mentioned in the model, have to be redirected to the environmental sector, or because part of the labor is needed for environmental purposes. The value of the environmental standard indicates the level up to which environmental degradation is prevented or cleaned up. The consumers in both countries are characterized by identical and homothetic preferences, represented by the utility function ui , i = 1, 2 (cf. Note 15.2 below for the concept of homothetic preferences): αi2 αi3 ui (xi1 , xi2 , e) = xαi1i1 · xi2 · e such that αi j ≥ 0 and αi1 + αi2 = 1.

For “regional” environmental effects e := ei for i = 1, 2; for cross-border or “international” environmental effects e := 0.5 · (e1 + e2 ). The parameters αi j , i, j = 1, 2, represent the share of the income spent on commodity j in country i. Parameter αi3 indicates the propensity to the environment in country i. A higher value of αi3 implies that the consumers in country i derive cet. par. higher beneﬁt from a cleaner environment.

Note 15.2. As in Subsection 5.1.1 the assumption of identical, homothetic preferences for the consumers in each country generates a representative consumer. This allows a comparatively simple solution for the problem of choosing an optimal environmental standard: the utility of the representative consumer will function as a guideline for the environmental policy. This utility also includes the environmental standard, which is identical in both countries

15.2 Trade and the Environment: A Formal Approach

285

for an international environmental effect, a characteristic property of public commodities (cf. Section 5.3). Regional environmental effects originate in one of the countries and affect directly only the consumers of this country. International environmental effects have consequences for the consumers in both countries. It is, of course, possible to respect the impact of special climatic conditions, for example prevailing wind, on the environmental effects. Weber/Wiesmeth introduce impact factors (cf. [15]), which will, however, not be considered here. The market mechanism governs production and consumption of the commodities, including the allocation of the factor labor under the condition of perfect competition. The environmental standards are chosen by environmental institutions in the countries. International agreements, such as the Kyoto Protocol, are not assumed to inﬂuence these decisions. Each country will, however, respect the decision of the other, the consequence of a strategic interaction. The solution concept of a Nash equilibrium, more precisely, a subgame-perfect Nash equilibrium, will then be applied to arrive at the ﬁnal outcome (cf., for example, [9], Ch. 12.7). The model therefore integrates not only trade and the environment, but also aspects of perfect competition (with respect to free trade) and market failure (with respect to environmental effects). This “strategic interaction” with respect to the environmental policy in an international trade setting has been addressed in several publications. Ulph ([14]) analyses eco-dumping with strategically acting producers and governments. Batabyal ([2]) investigates the possibility of a welfare loss resulting from an environmental policy under the framework conditions of a Cournot game. Further publications of Conrad ([4]) and Barrett ([1]) in this context respect oligopolistic market structures in contrast to perfect competition in the model considered here. e1

e2

(e1 , e2 )

v1 (e1 , e2 )

........ ... .. .. ..... . ... .............. ..... . . . ............. ............. ....... . . ............. ............. ............. .... .... .... ............. ............. ............. . . .. . . . . . . . . . . . ............. . ............. . . .. .... .. ............. ............ ............. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... ... . .. .......... .. ............. ............. ............. ..... .... ............. ............. ... ............. ............. ............. ... .... ............................. ............. ............. .... ........................ ....................................................................................................................................................................................... ............. ... ............. . ..................... . ............. . . . . . . ............. ............. ... . . ............. ............. ............. ... ............. ..... .... ............. ............. ............. ... ............. ............. ............. .. ... ............. ............. ... ............. ............. ............. ... ... ............. ............. ............. ............. .... ..... ..... ............. ............. ............... . .. ............ ........... ... ... .. ... .. . . ... . ... ..... .......

u

Country 1

e

e

e

u

e

e

Country 2

u

u

v2 (e1 , e2 )

Fig. 15.1 Structure of the game with simultaneous decisions on the standards

Figure 15.1 illustrates the structure of the game: the two countries choose simultaneously e1 and e2 respectively. This is depicted in the graph with the information set [0, 1] for country 2, after country 1 has ﬁxed e1 . Once (e1 , e2 ) is known to the eco-

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15 Integration of Trade and the Environment

nomic agents, a unique equilibrium allocation xi j (e1 , e2 ), i, j = 1, 2, results, yielding utility levels vi (e1 , e2 ) := ui (xi1 (e1 , e2 ), xi2 (e1 , e2 ), e) (cf. also Note 15.3). The goal is then to investigate subgame-perfect equilibria of this game depending on regional or international environmental effects, on autarky or free trade. The basic deﬁnitions are as follows: Deﬁnition 15.1 (Autarky Equilibrium). An autarky equilibrium in country i, i = 1, 2, is given by an allocation (xiAj , zAij , eAi ) j=1,2 , prices (wAi , pAi1 , pAi2 ) and standards (eA1 , eA2 ) such that: • xiAj = fi j (eAi , zAij ) for j = 1, 2, • the factor allocation (zAi1 , zAi2 ) with zAi1 + zAi2 = Zi maximizes proﬁt, A , xA ) maximizes utility in country i given the budget • the commodity bundle (xi1 i2 A A A wi · Zi and given (e1 , e2 ), A , xA , e) with eA given, and x depending on e and eA , j = i. • eAi maximizes ui (xi1 ij i j j i2 Deﬁnition 15.2 (Free Trade Equilibrium). A free trade equilibrium is given by an allocation (xiTj , zTij , eTi )i, j=1,2 , prices (wTi , pT1 , pT2 ), i = 1, 2, and standards (eT1 , eT2 ), such that for i, j = 1, 2: • x1T j + x2T j = f1 j (eZ1 , zT1 j ) + f2 j (eT2 , zT2 j ), • the factor allocation (zTi1 , zTi2 ) with zTi1 + zZi2 = Zi maximizes proﬁt, T , xT ) maximizes utility in country i given the budget • the consumption bundle (xi1 i2 wTi · Zi and given (eT1 , eT2 ), T T • eTi maximizes ui (xi1 , xi2 , e) with eTj given, and xi j depending on ei and eTj , j = i.

Note 15.3. Both autarky and free trade equilibria constitute subgame-perfect equilibria of the game illustrated in Figure 15.1: the equilibrium quantities xi j , i, j = 1, 2, of the consumption commodities are functions of (e1 , e2 ), and the environmental institutions choose these standards in order to maximize utilities, thereby observing these dependencies. The assumption of identical and homothetic preferences guarantees unique equilibrium allocations (zi j (e1 , e2 ), xi j (e1 , e2 )) for i, j = 1, 2, and for each choice of standards (e1 , e2 ). Clearly, subgame-perfect equilibria require complete information on the dependence of equilibrium quantities xi j and utilities ui on (e1 , e2 ). The environmental institutions in charge of choosing the standards are assumed to have acquired the necessary information through a process of learning, for example (cf. again [9], Ch. 12.7, for the concept of a subgame-perfect Nash equilibrium). The following subsections contain the detailed solutions for autarky and free trade equilibria with both regional and international environmental effects. Thereafter, the analysis will focus on the transition from autarky to free trade. In this context, some of Bhagwati’s “genuine problems” will be investigated.

15.2 Trade and the Environment: A Formal Approach

287

15.2.2 Autarky Equilibrium A solution to the game considered here can be obtained by backward induction (cf. again [9], Ch. 12.7). For given values of e1 and e2 the unique equilibrium allocation xi j (ei ), i, j = 1, 2, will be derived from the market mechanism. Thereafter, standards will be chosen to maximize ui (xi1 (ei ), xi2 (ei ), e), i = 1, 2, in the sense of a (subgameperfect) Nash equilibrium. Assume now that (e1 , e2 ) is ﬁxed by the government agencies and known to the economic agents. The transformation curve in country i is given by a straight line with slope βi2 /βi1 in absolute terms, determining autarky equilibrium prices pAi1 /pAi2 = βi2 /βi1 . As the budget set of the consumer corresponds to the aggregate supply set, the ﬁrst-order condition for utility maximization requires the equality of the MRS with the price ratio (cf. also Subsection 5.1.2). One thus obtains for the equilibrium allocation depending on e1 , resp. e2 : A A (e1 ) = α11 β11 (1 − e1 )Z1 , x12 (e1 ) = α12 β12 (1 − e1 )Z1 , x11 A A x21 (e2 ) = α21 β21 (1 − e2 )Z2 , x22 (e2 ) = α22 β22 (1 − e2 )Z2 .

Inserting these results into the utility functions with regional or international environmental effects leads to the maximization problem of the environmental institutions in both countries. The solution yields the reaction curves e1 = e1 (e2 ) and e2 = e2 (e1 ) respectively (cf. also Subsection 14.2.2 for reaction curves in a different context). Regional Environmental Effects: For the case of regional environmental effects A A in autarky, utility vR,A i (ei ) = ui (xi1 (ei ), xi2 (ei ), ei ) in country i is only dependent on this country’s standard ei . This is an immediate consequence of the fact that the two countries are economically and ecologically completely separated. The optimal values of the standards, the equilibrium values, follow then from the ﬁrst-order conditions: eR,A 1 =

α13 α23 , eR,A . 2 = 1 + α13 1 + α23

Observe that the equilibrium values depend only on the propensities to the enR,A vironment αi3 , and α13 > α23 implies eR,A 1 > e2 . Moreover, as the externalities are “suppressed” in this case, the individual decisions of the countries regarding the environmental standard are efﬁcient: there is no (e1 , e2 ) such that R,A R,A vR,A i (ei ) > vi (ei ) for the two countries. International Environmental Effects: For the case of international environmental A A effects in autarky, utility vI,A i (e1 , e2 ) = ui (xi1 (ei ), xi2 (ei ), 0.5(e1 + e2 )) of country i is also affected by the choice of the standard e j by the other country. The crossborder environmental pollution affects the well-being of the consumers in both countries. The indifference curves of the “indirect” utility functions vI,A i (e1 , e2 ), i = 1, 2, are convex (cf. Figure 15.2), and the equilibrium values result from the

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15 Integration of Trade and the Environment

intersection of the reaction curves (cf. also Note 15.4): eI,A 1 =

α13 + α13 α23 − α23 , α13 + α13 α23 + α23

eI,A 2 =

α23 + α13 α23 − α13 . α23 + α13 α23 + α13

Of course, these values represent the equilibrium values only if they are nonnegative. Otherwise, one obtains a boundary solution with one of the standards assuming the value 0. The equilibrium values depend only on the propensities to the environment αi3 , although the values of both countries affect each standard. I,A Again, α13 > α23 implies eI,A 1 > e2 .

Note 15.4. To obtain the reaction curves it is sufﬁcient to consider the “simpliαi3 for i = 1, 2, because ﬁed” utility functions vI,A i (e1 , e2 ) = (1 − ei ) · (e1 + e2 ) none of the remaining constant factors affect the solution of the ﬁrst-order condition. Differentiating this expression with respect to ei yields then the reaction curves ei (e j ) = (αi3 − e j )/(αi3 + 1) for i = j. The convexity of the indifference curves associated with the utility functions vI,A i (e1 , e2 ) guarantees that the second-order conditions are satisﬁed. 1 0.8 0.6

e2 eI,A 2 0.2 0

.. ... . Indierence curve .. .. of Country 1 .. . . ............................................. ........................................................ . . . . . . . . . . . . . . .......... . Indierence curve ............... ...... ......... . . . . . .... . . of Country 2 . . . . . . . ... .... ...... . . ... . . . . ........................ . ......... ....... ....... ....... ... ... .. ... .. ..... ... .. ... .. .... .......u...................... I,A I,A ... (e1 , e2 ) ≈ (0.19, 0.37) .... . .. .. .. . . .. .. .... .. .. .... α11 = 0.60, α12 = 0.40, α13 = 0.7 .. .... .. .... α21 = 0.75, α22 = 0.25, α23 = 0.9 .. .... .. .. 0

eI,A 1

0.4

0.6

0.8

1

e1 Fig. 15.2 Autarky equilibrium with international environmental effects

An increase in the standard of one country provides better environmental conditions for all and therefore raises, cet. par., utility in the other country. As these external effects are not internalized (cf. Chapter 6), the resulting equilibrium is not efﬁcient. More precisely, equilibrium standards should be raised bilaterally. This situation is illustrated in Figure 15.2: both countries would beneﬁt from standards located in the lens formed by the two convex indifference curves. However, the Prisoners’ Dilemma interferes with the realization of these mutually beneﬁcial gains.

15.2 Trade and the Environment: A Formal Approach

289

15.2.3 Free Trade Equilibrium For the free trade equilibrium, the assumptions of the model imply a complete specialization of the two countries in the production of one of the two commodities. As β11 /β12 > β21 /β22 , country 1 will produce only commodity 1, and country 2 will produce only commodity 2, due to comparative advantage (cf., for example, [6]). One arrives at the following values for xiTj (e1 , e2 ) for i, j = 1, 2, for (e1 , e2 ) given: T T x11 (e1 , e2 ) = α11 β11 (1 − e1 )Z1 , x12 (e1 , e2 ) = α21 β22 (1 − e2 )Z2 , T T (e1 , e2 ) = α22 β22 (1 − e2 )Z2 . x21 (e1 , e2 ) = α12 β11 (1 − e1 )Z1 , x22

Note 15.5. Assume that the values (e1 , e2 ) of the environmental standards are given. With prices (p1 , p2 ) the utility maximizing consumption bundles (x11 (p1 , p2 ), x12 (p1 , p2 )) and (x21 (p1 , p2 ), x22 (p1 , p2 )) are derived. One obtains, for example: x11 (p1 , p2 ) = α11 β11 (1 − e1 )Z1 , x12 (p1 , p2 ) =

p1 α12 β11 (1 − e1 )Z1 . p2

This requires that the MRS is equal to the price ratio, and that the value of this consumption bundle corresponds to the value of the quantity of commodity 1 produced in complete specialization. Similarly, one derives (x21 (p1 , p2 ), x22 (p1 , p2 )). From the equilibrium condition for commodity 1 x11 (p1 , p2 ) + x21 (p1 , p2 ) = β11 (1 − e1 )Z1 , one obtains the equilibrium prices, which then yield the above equilibrium values for xiTj (e1 , e2 ), i, j = 1, 2. T (e , e ) of commodity 2 in country 1 for exObserve that consumption x12 1 2 ample depends on the values e2 , β22 and Z2 of country 2. This is a consequence of the complete specialization: only country 2 produces commodity 2 in free trade equilibrium. From the resulting indirect utility functions one derives again the reaction curves. As explained in Note 15.4 these utility functions can be simpliﬁed for solving the ﬁrst-order condition by omitting all constant factors. Regional Environmental Effects: For the case of regional environmental effects T T in free trade, utility vR,T i (e1 , e2 ) = ui (xi1 (e1 , e2 ), xi2 (e1 , e2 ), ei ) of country i depends on the standards in both countries. An increase in the standard in one country will, however, reduce utility in the other, because a smaller quantity of the commodity will be produced and exported (cf. Figure 15.3). In this sense, international trade “exports” or “internationalizes” regional environmental effects. Equilibrium standards for regional environmental effects and free trade are given

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15 Integration of Trade and the Environment

by: eR,T 1 =

α13 α23 , eR,T = . α11 + α13 2 α22 + α23

Beyond the propensities to protect the environment, αi3 , the relative importance of the consumption commodities, as measured by αii , affects the value of the equilibrium standard. This is a consequence of international trade and the assoR,T if and only if α13 /α11 > α23 /α22 . ciated specialization. Therefore, eR,T 1 > e2 R,T For α13 > α23 it is, thus, still possible that eR,T 1 < e2 holds: if the consumer in country 1 has a high propensity to protect the environment α13 , but also gains a high utility from the consumption of commodity 1 resulting in a high value of α11 , country 1 might consider a lower environmental standard in order to guarantee a large production quantity of commodity 1. In a certain sense, the economy “outplays” the ecology in such a situation. Consequently, it is no longer possible, to conclude from an observed low level of environmental standards that there is a similarly low level of propensity to protect the environment. 1 0.8 0.6

e2

eR,H 2 0.2 0

α11 = 0.2, α12 = 0.8, α13 = 0.5 ........................................... .............................α21 = 0.4, α22 = 0.6, α23 = 0.5 .................... ............... Indierence curve ......... ....... ...... of Country 2 .... ... ... . ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ...... .. ....... .. ... .. ...... ... .. ... .. ..... .. .. ...u . . . ..................................... . . . . . . . . . . . .... ...... ........ Indierence curve ...................... .... . .. .... ... . . .... . . . . . . . . . of Country 1 ....... . . ... . .... .... . ... . . . . ... . . . . . . . . . . . . . . . . . . . . . ... . . . . ... ................................................ . ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... ..................... .. .... . ... . .... . ... 0

0.2

0.6 eR,H 0.8 1

0.4

1

e1 Fig. 15.3 Free trade equilibrium with regional environmental effects

A lower standard in one country provides better production possibilities in this country and therefore raises, cet. par., utility in the other country. Again, as these external effects are not internalized (cf. Chapter 6), the resulting equilibrium is not efﬁcient: equilibrium standards should be lowered bilaterally. This situation is illustrated in Figure 15.3 with both countries deriving higher utility from standards in the lens formed by the two convex indifference curves. International Environmental Effects: For the case of international environmental T T effects in free trade, utility vI,T i (e1 , e2 ) = ui (xi1 (e1 , e2 ), xi2 (e1 , e2 ), 0.5(e1 +e2 )) of country i depends again on the standards in both countries. This time, however, an increase in the standard of one country, has both a positive and a negative effect on the other country. Utility increases through the improved environmental

15.2 Trade and the Environment: A Formal Approach

291

situation, but might decrease through a reduced supply of the imported commodity. Consequently, an unambiguous result is not attainable in this case. The equilibrium values of the standards are obtained by applying the provisions of Note 15.4 accordingly: eI,T i =

αi3 α j j + α13 α23 − α j3 αii for i, j = 1, 2 and i = j. α13 α22 + α13 α23 + α11 α23

I,T Also in this case one obtains eI,T 1 > e2 if and only if α13 /α11 > α23 /α22 , and a higher propensity to protect the environment is neither necessary nor sufﬁcient for a higher value of the environmental standard. The investigation of efﬁciency properties of the equilibrium is now more complicated as already indicated above. A concrete situation is illustrated in Figure 15.4 with equilibrium I,T values (eI,T 1 , e2 ) ≈ (0.20, 0.74) for the standards. This example demonstrates that a small increase of the standard of country 1 together with a small decrease of the standard in country 2, corresponding to a location to the right and down of the Nash equilibrium, will increase utility in both countries.

1

e2

..... ..... ...... ..... ......

. ..... ...... ............................................................................................ ...... ...... .............. ..... ...... . . . . . . . . . ....... Country 2 Nash ... ...... ..... ..... ...... ...... .... Equilibrium ...... ..... ...... I,T ....... ....... ....... ....... ....... ....... ue . . . . . . . ... e2 ...... .... ..... Country 1 ..... ...... ...... .. ...... .................... . ..... . . . . . . . . . . . . . ...... . . . . . . . . . . . . . . . . . . . ........... ...... .... .... ...... ... ................. 0.6 ......... .... .......... ...... ..... ........................... ... . e . ............ ..... .. . . .. ...................... ....................... ... .............. .. ........... .. ...................................................................................... . . . ....................................... . 0.4 ... .... ...... ...... ...... ..... ...... ...... ...... . . . . ... ...... .... ...... ...... . ..... ....... ....... ...... . . . . . ... ... ...... ...... ...... .... ..... ...... ...... . ...... . . . ... . . ...... . . . . .. . ... .. ...... ... .. ... .

0.2 0

α11 = 0.60, α12 = 0.40, α13 = 0.7 α21 = 0.75, α22 = 0.25, α23 = 0.9

0

eI,T 1

0.4

0.6

0.8

1

e1

Fig. 15.4 Free trade equilibrium with international environmental effects

In addition to indifference curves and the Nash equilibrium, Figure 15.4 shows the “bliss points” for the two countries, the combination of the standards yielding maximum utility for each country. As a consequence, the indifference curves, although convex, are closed in the situation considered here. The following section analyses the effects of a transition from autarky equilibrium to free trade equilibrium, thereby investigating some of Bhagwati’s “genuine problems” (cf. Section 15.1).

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15 Integration of Trade and the Environment

15.3 Trade and the Environment: The Formal Integration Bhagwati was in particular concerned about the issues of “unfair trade”, “race to the bottom”, and “welfare loss” in the context of trade and the environment (cf. Section 15.1). First, these issues will be investigated in the formal model introduced above. Thereafter, the question of harmonizing the environmental standards will be addressed. The issue of “ethical preferences” can, however, not be discussed and analyzed in the context of this simple model.

15.3.1 From Autarky to Free Trade This subsection will help to analyze the effects of a transition from autarky to free trade. The results will show that “unfair trade” is a complicated issue, that a “race to the bottom” is not possible in the context of this model, and that “welfare losses” may happen but, at least in this model, not because of a further degradation of the environment. Regional and international environmental effects will be considered separately. Regional Environmental Effects: “Unfair trade” often links different environmental standards to different propensities to the protection of the environment. Countries with low standards are therefore “admonished” to adjust their standards appropriately. The following example shows, however, that a comparable attitude towards the environment, i.e., equal propensities, can lead to quite different equilibrium standards: α11 = 0.2; α12 = 0.8; α13 = 0.5; β11 = 3; β12 = 1; Z1 = 40, α21 = 0.9; α22 = 0.1; α23 = 0.5; β21 = 1; β22 = 2; Z2 = 50. R,A R,T One obtains for the equilibrium standards: eR,A 1 = e2 ≈ 0.333, however, e1 ≈ R,T 0.714 and e2 ≈ 0.833, although α13 = α23 . > eR,A for The issue of a “race to the bottom” can be excluded because eR,T i i i = 1, 2. The gains from trade allow not only more consumption, but also higher environmental standards, a result, which was already mentioned in the context of Bhagwati’s “fallacies” (cf. Section 13.4). “Welfare losses”, when they happen in the context considered here, are due to environmental standards which are too high and which unduly restrict the production possibilities in the economies of the two countries. This is in contrast to the common argumentation that increased production activities due to free trade lead to a higher pollution of the environment: the gains from trade can be used to protect the environment. Consider the following concrete example:

α11 = 0.05, α12 = 0.95, α13 = 0.5, β11 = 3, β12 = 1, Z1 = 40; α21 = 0.90, α22 = 0.10, α23 = 0.5, β21 = 1, β22 = 2, Z2 = 50.

15.3 Trade and the Environment: The Formal Integration

293

One obtains for the equilibrium utility values in this example: vR,A 1 ≈ 13.337 > R,A R,T and v ≈ 14.902 > 7.881 ≈ v . 12.118 ≈ vR,T 1 2 2 International Environmental Effects: An example for the issue of “unfair trade” can be obtained similarly to the above example with regional environmental I,A effects. A “race to the bottom” will not happen in the sense that eI,A 1 + e2 < I,T eI,T 1 + e2 . Thus, it is possible that one of the equilibrium standards decreases in a free trade context, but not both of them together. Impact factors could, however, complicate this analysis considerably (cf. [15]). “Welfare losses” can result from too much or too little concern for the environment, from environmental standards in equilibrium which are too high or too low. Consider the following example: α11 = 0.05, α12 = 0.95, α13 = 0.5, β11 = 3, β12 = 1, Z1 = 40; α21 = 0.90, α22 = 0.10, α23 = 0.5, β21 = 1, β22 = 1, Z2 = 50. Calculating the equilibrium utility levels for this example yields: vI,A 1 ≈ 17.532 > I,A I,T and v ≈ 18.277 > 17.055 ≈ v . 14.999 ≈ vI,T 1 2 2

Note 15.6. The results obtained in this comparatively simple formal model yield insight into relations which are not easily accessible without formal “support”. They can therefore provide valuable help with respect to the task of integrating trade and the environment.

The next subsection illustrates brieﬂy some questions regarding the harmonization of environmental standards. This is a common policy tool and is considered to be a “remedy” against “unfair trade”.

15.3.2 Harmonizing Environmental Standards The results of the last subsection demonstrate that issues such as “unfair trade” have to be treated with caution. Initiatives to harmonize environmental standards are, however, most often based on this issue: they should pave the way for free trade, provide for a “level playing ﬁeld”. Title XX “Environment” of the “Treaty of the Functioning of the European Union” ([7]) addresses in Article 191 “harmonization measures answering environmental protection requirements”, which “shall include, where appropriate, a safeguard clause allowing member states to take provisional measures, for noneconomic environmental reasons, subject to a procedure of inspection by the Union”. Thus, harmonization appears to be a common tool, although “Union policy on the

294

15 Integration of Trade and the Environment

environment shall aim at a high level of protection taking into account the diversity of situations in the various regions of the Union”. The following considerations conﬁrm the doubts regarding a harmonization of environmental standards, at least under the framework conditions of the formal model introduced above. Free Trade and Regional Environmental Effects: The equilibrium values of the R,T standards, (eR,T 1 , e2 ), are inefﬁcient: a small decrease of both standards leads to higher utility values for both countries. A relative harmonization in the sense of an identical proportional decrease can beneﬁt both countries, whereas an absolute harmonization towards the lower value is only better for the country with the lower standard. Figure 15.5 illustrates the situation. 1

........................................... ............................. ....................Country 2 ............... ......... Result with ....... ...... .... downward 0.6 ... ... harmonization @@ R u ........................u............................... . . . . . . . . . . . . eR,T . . . . . . . . . . 2 . . ....... ....... . ..... ........... ... ... 6 ........ . . . . . . . . ... . . . . . . . . Country 1 . . . . . . ... . . . . . . . ........ .... ... . . . . . . . . . . . . . . 0.2 . . . . . . . . . . . . . . . . . . . . . u . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interval for relative ..... ....................................................... ... . harmonization .. ... 0 0 0.2 0.4 0.6 eR,T 0.8 1 1 0.8

e2

...... ...... ...... ...... ...... . . . . . ... ...... ...... ...... ...... ...... ...... . . . . . ... ...... ...... ...... ...... ...... ...... . . . . . ... ...... ...... .. ...... ......... ........ ...... ......... ...... ........ ...... . . . . . ........ ...... ......... . . . . . . . . . . . . .... ...... ...... ......... ........ ...... ......... ...... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... ....... .......................... ....... ....... ....... ....... ....... ......................... ....... ....... ....... ....... ....... ....... ..... ........ . . . . . . . . . . . . .... ... ......... ...... ........ ...... ......... ...... ........ ...... ......... ...... ......... ...... . . . . . . . . . . . . . ... ...... ...... ........ ...... ......... ...... ........ ........ ...... ......... ...... ........ ...... . . . . . . . . . . . . . ... ....... ...... ........ ...... ........ ...... ........ ...... ................ . ...... ...... ................ . . . . . ..... ........ .............. ............... ........

e1 Fig. 15.5 Harmonization: free trade and regional environmental effects

Autarky and International Environmental Effects: The analysis of this case is similar to the one above, except that a “successful” relative harmonization requires a proportional increase in all standards and that an absolute harmonization to the higher standard beneﬁts the country with the higher standard (cf. Figure 15.2). Free Trade and International Environmental Effects: The structure of the inefﬁI,T ciency of the equilibrium standards (eI,T 1 , e2 ) is difﬁcult to judge: one standard can be too high, whereas the other one can be too low to reach a situation which is better for both countries. Figure 15.6 depicts such a situation together with a possible range [ehl , ehu ] for an absolute harmonization with ehl and ehu denoting the optimal harmonized standards for country 1 and country 2 respectively (cf. Figure 15.4 for the parameter values applied). Whereas country 2 will be worse off – in comparison to the Nash equilibrium – for any value e ∈ [ehl , ehu ] of harmonized standards, country 1 will be better off,

15.4 Regulation

295

at least for values of e close to ehl . In this case, harmonization produces ambiguous results. An absolute harmonization to the higher or to the lower equilibrium standard will, in the concrete case above, be harmful for both countries. 1

e2

. ...... ...... ...... ......

.... ...... ............................................................................................ ...... ...... ............... ..... ...... ...... ......... Country 2 Nash ...... . . . . .. ...... ...... ...... .... ...... ..... Equilibrium ... ...... ...... I,T ....... ....... ....... ........ ....... ....... ue ...... . . . . . . . e2 ... ... ... ...... Country 1 .. ...... ...... ..... ..... ...... .. ...... ........................................................ . . ...... . . . . . . . ....... .. . .. ............ 0.6 ........... ..... .. ............ .......... ..... ...... e ... ....................... ............ ..... .. . . . . . . . . ..... .... . .............. ehu ..... ..... ..... ..... .............................................................. ..... ..... ....................................................u ... ......... ........ ......... . . ehl ..... ..... ..... ..... ..... .......... ..... .......................................................................................u .. ..... ...... .... ... ... ..... ...... . . . . . .... . ...... ... ... ... ..... ...... .. ...... .. .......... .. .. . ...... . . . . . . .. .. . 0.2 ........ ..... ...... .... . . . . .. .. . .. ...... . . . . .. .. ...... ... ... ... ...... ...... . . . . . . .. .. . .. ...... ...... . ...... . . . . . . . .. .. . 0 ... I,T 0 e1 ehl ehu 0.6 0.8

1

e1

Fig. 15.6 Harmonization: free trade and international environmental effects

In summary, harmonization of environmental standards produces mixed results. In general, it will be safe to assume that a country postulating harmonization in one way or the other, will beneﬁt from it. In addition, as the case “Free Trade and Regional Environmental Effects” demonstrates, a mutually beneﬁcial harmonization may require a downward adjustment of the standards. The next section of this chapter investigates the effect of a tariff on environmental standards in equilibrium. Thus, is it possible to “motivate” the other country to raise the environmental standard by imposing a tariff on its export commodity? Section 12.2 investigated an analogous question for the negotiations in the international climate conferences.

15.4 Regulation In the context of the results obtained so far, one can ask whether regulatory interferences with supply and demand of the consumption commodities can have a positive effect on the environment and on welfare. In particular, is it possible to stimulate the protection of the environment by unilateral measures such as taxes or subsidies, quota or tariffs, lump sum payments or transfers? What will happen to welfare in the country enacting a particular measure? What will happen to welfare in the country affected by this measure? This section will investigate consequences of a tariff. For further measures in this context cf. [15], Section 6.

296

15 Integration of Trade and the Environment

Obviously this issue can only be addressed in the framework of free trade. The analysis, however, covers both regional and international environmental effects. The investigation refers to the effects of a simple proportional tax on the consumption of commodity 2 in country 1. Observe that because of complete specialization of country 1 in the production of commodity 1, this tax has all the qualiﬁcations of an import tariff on this commodity. Assume therefore that t > 0 is a proportional tax on the consumption of commodity 2 in country 1. For ﬁxed values of e1 and e2 deﬁne Y1 (e1 ) := β11 (1 − e1 )Z1 and Y2 (e2 ) := β22 (1 − e2 )Z2 . One then obtains the following conditions characterizing the free trade equilibrium in country 1 with equilibrium prices p = (p1 , p2 ): p1 x11 + p2 x12 = p1Y1 (e1 ) and α12 p1 x11 = α11 pt2 x12 , where pt2 = p2 (1 + t) is the price paid by consumers and p2 is the production price for commodity 2. Assume that the tax revenue is returned to the households in the form of a lump sum payment. By solving these equations, one arrives at the value of x12 depending on prices p: x12 =

p1 α12Y1 (e1 ) . p2 (1 + α11t)

Similarly, utility maximization in country 2 yields x22 = α22Y2 (e2 ). Consequently, the relative equilibrium prices result from the equilibrium condition x12 + x22 = Y2 (e2 ): α21 (1 + α11t)Y2 (e2 ) p1 . = p2 α12Y1 (e1 ) Thus, the following results hold for the free trade equilibrium: x11 (e1 , e2 ) =

α11Y1 (e1 )(1 + t) , x12 (e1 , e2 ) = α21Y2 (e2 ) 1 + α11 t

x21 (e1 , e2 ) =

α12Y1 (e1 ) , x22 (e1 , e2 ) = α22Y2 (e2 ). 1 + α11 t

Consider now the indirect utility functions V1t (e1 , e2 ) and V2t (e1 , e2 ) representing the above equilibrium consumption levels. Given the structure of these equilibrium values for the consumption commodities one immediately observes that the equilibrium values for the environmental standards e1 and e2 are not affected by the value of t. More speciﬁcally: V1t (e1 , e2 ) =

1+t 1 ·V10 and V2t (e1 , e2 ) = ·V 0 , 1 + α11 t 1 + α11 t 2

with Vi0 (e1 , e2 ) denoting indirect utility for the case t = 0. Thus, the introduction of a tariff does not change equilibrium values of the environmental standards. One of the reasons for this result is certainly provided by complete specialization in free

15.5 Stackelberg Equilibrium

297

trade: production of the two commodities is cet. par. not affected by the imposition of a tariff. Of course, the change in international prices due to the tariff has a positive effect on the welfare of country 1, which can improve its competitive situation in relation to country 2 under the tariff: V1t (e1 , e2 ) > V10 (e1 , e2 ) for t > 0. Thus such a tariff, which is meant to stimulate higher environmental standards, beneﬁts the country imposing the tariff, but has no effect on the environmental standards at all, at least under the assumptions of this example. The last section of this chapter addresses the issue of “leadership” regarding the choice of the environmental standards. Again, a similar issue was discussed in Section 12.2 in the context of reductions of greenhouse gas emissions. The gametheoretic structure of the model is adjusted to allow for sequential decision-making with respect to the environmental standards. The concept of a Stackelberg equilibrium can then be applied to investigate the relevant effects.

15.5 Stackelberg Equilibrium It is now assumed that country 1 chooses e1 whereupon country 2 “adjusts” optimally with a value e2 = e2 (e1 ). This, however, is expected by country 1, which takes e2 (e1 ) into account when choosing e1 . The result is a Stackelberg equilibrium with country 1 being the Stackelberg leader (cf., for example, [13], Section 13.5 for more details on this equilibrium concept). e1

(e1 , e2 )

e2 e u

e

v1 (e1 , e2 ) u

. ............ ......................... ............. ............. ......................... ............. .............. .......................... ............. ............. ......................... ............. ............. ......................... ............. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... ...... ......................................... .... ............. .......................... ......... .......................... ............. .............................................................. ......... ......................... ............. ............. . ......... .......................... ............. ....................................... ......... ......................... ...................... ....................................... ......... ............. ............. ......... ............. ............. . . . . . . . . ......... ............. ............. ......... ............. ............. ......... ............. ............. ......... ............. ............. ......... .............. ............. ......... ............. .............. ......... ............. ............. . ............. . . . . . ............. ......... ........... ... ..

u

u

e

Country 1

e

Country 2

u

v2 (e1 , e2 )

Fig. 15.7 Structure of the game with sequential decisions on the standards

In the following, the case of autarky with international environmental effects will be investigated ﬁrst. Of interest is the behavior of the two countries: will country 2 raise the standard as a Stackelberg follower? Will the sum of the equilibrium standards I,A increase in comparison to eI,A 1 + e2 ? A ﬁrst answer is provided by the reaction curve e2 = e2 (e1 ) of country 2, which is given by e2 (e1 ) =

α23 − e1 α23 + 1

298

15 Integration of Trade and the Environment

for values of e1 such that e2 (e1 ) ≥ 0, otherwise e2 = 0 (cf. Note 15.4). Thus, for values of e2 > 0, the reaction curve is a straight line with negative slope [−1/(α23 +1)], which is less than 1 in absolute terms. Therefore, an increase in e2 in comparison I,A to eI,A 2 will lead to a lower value of e1 , again in comparison to e1 , and vice versa. Consequently, country 1 can only “stimulate” country 2 by lowering its own standard. e2 (e1 ) will now be inserted into the indirect utility function of country 1, yieldα13 by omitting all constant factors in ing vI,A 1 (e1 , e2 (e1 )) = (1 − e1 ) · (e1 + e2 (e1 )) the utility function which are not relevant for solving the ﬁrst-order condition (cf. Note 15.4). Maximizing vI,A 1 (e1 , e2 (e1 )) with respect to the choice of the environmental standard e1 yields for interior solutions: eS1 =

α13 − 1 α23 + α13 α23 − α13 + 1 and eS2 = . α13 + 1 α23 + α13 α23 + α13 + 1

I,A S Again for an interior solution eS1 < eI,A 1 and e2 > e2 (cf. Note 15.7). Moreover, because the slope of the reaction curve e2 (e1 ) of country 2 is less than 1 in absolute terms, the decrease in the value of e1 will not be compensated by the increase in I,A e2 and the sum eS1 + eS2 will be smaller than eI,A 1 + e2 . Consequently, this “policy” induces country 2 to raise the standard, but at the expense of an even lower standard for country 1.

1 0.8 0.6

e2

eS2 eI,A 2 0.2 0

. ... Indierence curve ... .. of Country 1 .... . ............................. ....................................................................... . . . . . . . . ........ .................. ...... Indierence curve ........... . . . . ... . . . . ...... . . . . . of Country 2 . . . . . ...... . ... ... .... ..... ..u.................... ....... . . . . . . . ........................................................... .. ..................... u ....... ....... . ....... . .. ... .. .. ........ .. ... .. ......... .......... .. ... I,A .................... .. .. ....... ............ (eI,A ...... ............... ... . . 1 , e2 ) ≈ (0.19, 0.37) . . ...... . . . . . . . . . . . . . . ... .. . ............... ...... . ... ...... . ............... . .... ... ...... ............... . . .... ...... ............... ... . ...... . ............... e2 (e1 ) . . . .... ...... ... ............... . . . . . . .... .... .............. . ... ... . 0

eI,A 1

0.4

0.6

0.8

1

e1 Fig. 15.8 Stackelberg equilibrium in autarky with international environmental effects

This result remains valid for the case of a boundary solution for (eS1 , eS2 ). Then eS1 = 0 and eS2 = α23 /(α23 + 1). This situation is illustrated in Figure 15.8 with the parameter values taken from Figure 15.2. In particular, α13 = 0.7 < 1.

15.5 Stackelberg Equilibrium

299

Note 15.7. Assume an interior solution eS1 > 0 and eS2 > 0 for the Stackelberg equilibrium. Then one obtains immediately for eS2 : eS2 =

α23 + α13 α23 − α13 + 1 α23 + α13 α23 − α13 > = eI,A 2 . α23 + α13 α23 + α13 + 1 α23 + α13 α23 + α13

Moreover, because α13 > 1, the following inequality holds for the values eS1 and eI,A 1 : eS1 =

α13 − 1 α23 (α13 − 1) α13 + α23 (α13 − 1) = < = eI,A 1 . α13 + 1 α23 (α13 + 1) α13 + α23 (α13 + 1)

A comparable analysis is possible for the case of free trade with international environmental effects. The results depend, however, on the concrete parameter values. In particular, although the reaction curve of country 2 again has a negative slope, I,T which is less than 1 in absolute terms, it is possible that eS1 + eS2 exceeds eI,T 1 + e2 . In this sense, trade can provide the incentives for higher environmental standards in aggregate. Such a situation is illustrated in Figure 15.9: the Stackelberg equilibrium is located above the dashed straight line with slope equal to −1, passing through the former Nash equilibrium. 1

e2

.... ...... ...... ......

. ...... ...... .......................................................................................................... ..... ...... .............. . ...... ...... ...... . . . . . . . . . . . ... ...... ...... . Stackelberg ........... Country 2 ...... ...... ...... . .... ..... ...... ........................................ ....... Equilibrium ...... ... ...... . . ..................u . . e ..... ...........................u .. .. .. ... ...... ................................. ....... ....... ....... ....... ....... .......... ........... ...... ...... ...h eS . ... ...... .................................... 2 ..... ...... ...... ... .. .................... . . . . . . . . . . ...... . . . . . . . ... . . . ... . . ..... . .. . . .. . . . . . . . .... . . . . . . . . . . . . . . . . . . . . . . . . ................................. .......... .. . ..... . ... ....... . ...... ................................. .. ...... ..... .... .... .... ... ............. . 0.6 ................ ....... ... ...... . .......................... . ........... ...... ...... . . . ...... .. . e . . . ... e (e ) ............ ..... .. . . 2 1 ..... . ...... . . . . . . . . . . . ..................... ... .......................... . . . . . ............................. .. .. ................................................................................. ....... ....... .. ... . .......... ............................ ...... .... . ... 0.4 . . ...... . .. . . . . ...

0.2 0

... ... .... ...... .. .......... ... .... ...... .. ......... ...... . . . ... . . ... ... .. .......... .. . ........ ... ........ .. ....... ...... .. ... ...... . . . . . . . .. ...... . . . . . . .. ... ... ...... . . . . . . . ...... . . . . . . . .. .. .. ...... . . ... . . .. .. ...... . . ... . . . . . ..

Country 1

...... .

...... .

...... .

...... .

...... .

...... .

. α11 = 0.60, α12 = 0.40, ......α = 0.7 .....13 .. .. ...... α21 = 0.75, α22 = 0.25, α23..... = . 0.9 ..

0

eI,T 1

eS 1

.....

0.4

0.6

0.8

...... .

.....

1

e1

Fig. 15.9 Stackelberg equilibrium in free trade with international environmental effects

The following remarks summarize the main results of this chapter and draw some conclusions for environmental policy.

300

15 Integration of Trade and the Environment

15.6 Integrating Trade and the Environment: A Summary Concluding this chapter, the integration of trade and the environment, as introduced and developed in the various sections by means of a formal model, provides insights into sometimes complex and not always predictable relationships. In particular, the gains from trade interact in a complicated manner with the beneﬁts from a cleaner environment, where the gains from trade seem to be used, at least to some extent, to increase the protection of the environment. Harmonizing environmental standards seems to produce the results it wants to avoid: it leads to “unfair trade”, when a country with a higher propensity to protect the environment, but with a lower environmental standard (cf. Subsection 15.3.1) is forced to raise its standard; and harmonization induces lower standards when applied to the case of regional environmental effects and free trade (cf. Subsection 15.3.2), thus initiating a “race to the bottom”. Regulatory interferences with supply and demand need not affect the equilibrium levels of the environmental standards. In particular, a tariff on the import commodity does not necessarily induce the other country to raise its environment standard. Tariffs therefore do not constitute an appropriate tool for a successful environmental policy in this context. However, due to the fact that a tariff can raise welfare in the country imposing it, there will be an incentive for applying this tool – with a reference to low environmental standards in the other country. Finally, leadership with respect to choosing environmental standards also produces diverse results. Surprisingly, only the case of international environmental effects in the context of free trade can increase aggregate standards, i.e., the sum of the standards. This result depends, however, on the parameter values selected. In all other cases, aggregate standards will be below the aggregate standards obtained in the original Nash equilibrium. “Leadership” in the sense of a Stackelberg leader will therefore not necessarily prove helpful for environmental policy. This corresponds qualitatively to the results obtained in the context of the principal-agent approach to the international climate negotiations (cf. Section 12.2). As a ﬁnal consequence, these mixed results leave some room for environmental policy in its interaction with trade policy, although – and this follows from the above analysis – there will always be arguments for enhancing trade or for reducing trade with respect to the effects on the environment.

References 1. Barrett S (1994) Strategic environmental policy and international trade. J Pub Eco 54:325– 338 2. Batabyal A (1998) Games governments play. An analysis of national environmental policy in an open economy. Ann Reg Sci 32:237–251 3. Bhagwati J (1993) Trade and the environment: the false conﬂict? In: Zaelke D, Orbuch P, Housman RF (eds) Trade and the environment: law, economics and policy. Island Press, Washington

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4. Conrad K (1994) Emission taxes and international market share rivalry. In: Ierland, van EC (ed) International environmental economics. Elsevier, Amsterdam 5. Dadush U (2009) WTO reform: the time to start is now. Carnegie Endowment for International Peace, Policy Brief 80, Washington http://carnegieendowment.org/ﬁles/WTO_reform.pdf. Cited Dec 2010 6. Ethier WJ (1995) Modern international trade, 3rd edn. Norton, New York 7. EU (2010) The Treaty on the Functioning of the European Union. Ofﬁcial Journal of The European Union 53:47–199 http://eur-lex.europa.eu/JOHtml.do?uri=OJ:C:2010:083:SOM:EN:HTML. Cited Dec 2010 8. Hornblower M et al (1999) The meeting: the battle in Seattle. Time.com http://www.time.com/time/magazine/article/0,9171,992681,00.html. Cited Dec 2010 9. Kreps DM (1990) A course in microeconomic theory. Harvester Wheatsheaf, New York 10. Lamy, P (2000) Trying to deconnect trade and environment is a false prejudice where environment would be the loser. Speech of the then EU Trade Commissioner http://trade.ec.europa.eu/doclib/html/120153.htm. Cited Dec 2010 11. Lingner S (2003) Legitimacy of tolerating limited environmental pollution? The case for natural attenuation. Poiesis Prax 2:73–78 http://dx.doi.org/10.1007/s10202-003-0038-1. Cited Dec 2010 12. Network “Our World Is Not For Sale” http://www.ourworldisnotforsale.org/en. Cited Dec 2010 13. Perloff JM (2001) Microeconomics. Addison-Wesley, Boston 14. Ulph A (1996) Environmental policy and international trade when governments and producers act strategically. J Env Eco Man 30:256–281 15. Weber S, Wiesmeth H (2003) From autarky to free trade: the impact on environment and welfare, Jahrbuch für Regionalwissenschaft 23:91–115 16. WTO (2008) Trade policy review (United States of America): trade policies and practices by measure) http://www.wto.org/english/tratop_e/tpr_e/s200-03_e.doc. Cited Dec 2010

Index

agreement cost sharing, 68, 117 environmental agreement, 19, 31–41, 68, 72, 100, 117, 132, 211–213, 215, 231, 239, 265, 269, 285 ﬁsheries, 265, 268–277 trade, 30–31, 212, 229–242 EU, 235–237 GATT, 212, 231–234, 237, 239, 242, 283 NAFTA, 231, 235, 237–240 WTO, 30, 134, 212, 230–234, 240, 269, 270, 276, 281–283 allocation φ -allocation, 112, 120 allocation mechanism, 4, 39, 56, 77, 108, 111, 114 core, 4, 108–111, 132, 213–225 cost sharing, 39, 51, 68, 112, 121 market mechanism, 3, 47, 51, 53, 56–59, 64, 79, 84, 114, 285 allocation problems, 3, 47–49, 51, 53–75, 77, 114, 133, 168, 179 feasible allocation, 49, 51, 55, 57, 104, 109, 119 Arrow, K. impossibility theorem, 51, 156 Australia cap and trade policy, 207 climate policy, 39 WEEE policy, 162

China climate policy, 46 environmental awareness, 20–22 environmental issues, 20–22 renewable energy, 22, 46 Coase Theorem, 67, 78, 82, 98–101 property rights, 67, 78, 79, 82, 87, 91, 98–101, 246, 265, 268 transaction costs, 78, 96, 98, 100 command-and-control policy, 135–136, 139–157 commodity environmental commodity, 3, 24, 27–31, 45–48, 74, 77, 105, 168, 171, 211, 284 public commodity, 29, 39, 48, 66–75, 77, 89, 128, 285 competition-price mechanism, 129–131 Copenhagen Accord, 39, 71, 73 core, 4, 108–111, 132, 214–225 core allocation, 109, 110, 120–122 core equivalence, 114–117, 120, 121, 128 core property, 108–111, 113 cost-beneﬁt analysis, 156–157 cost-share equilibrium, 68, 111–117, 128

Bhagwati, J. trade and environment, 30, 241, 242, 281–283, 286, 291, 292

e-waste, 29, 160–167 efﬁciency cost efﬁciency, 187–191 ecological efﬁciency, 141–142 economic efﬁciency, 77 Pareto Criterion, 48–52

Cancun Agreements, 40 cap and trade policy, 207–208

distribution of income, 51, 55, 98 double dividend, 70 ecotax, 191–195

H. Wiesmeth, Environmental Economics: Theory and Policy in Equilibrium, Springer Texts in Business and Economics, DOI 10.1007/978-3-642-24514-5, © Springer-Verlag Berlin Heidelberg 2012

303

304 Pareto efﬁciency, 48, 53–75, 77, 80, 85, 104, 105, 110, 113, 116, 121, 151, 153, 287, 288, 290, 291 emission certiﬁcates, 37, 78, 82, 89–91, 136, 195–208 EU ETS, 199–203 US policy, 203–207 chloroﬂuorocarbons, 29, 46, 47 greenhouse gases, 19, 20, 22–24, 29, 37, 46, 71, 74, 100, 107, 133, 175, 199–208, 213–225 immission, 61, 135, 136, 139–142, 189–191, 196–199 sulfur dioxide, 50 energy, 14, 16, 19, 22, 36–41, 50, 71, 149, 167, 172, 215, 230 renewable energy, 139, 143, 149, 155, 157, 168–173, 175–178, 207–208, 231, 240 environmental agreement, 19, 31–41, 68, 72, 100, 117, 132, 211–213, 215, 231, 239, 265, 269, 285 environmental awareness, 24, 45–47, 70, 163, 213 environmental commodity, 3, 24, 27–31, 45–48, 77, 168, 171, 211, 284 global, 74, 105, 211 environmental effect, 3, 47, 48, 59–66, 77–89, 129, 149, 151, 263–265, 287 internalization, 66, 77–101, 105, 106, 152, 264–265 environmental issues energy, 14, 16, 19, 22, 36–41, 50, 71, 149, 167, 172, 215, 230 renewable energy, 139, 143, 149, 155, 157, 168–173, 175–178, 207–208, 231, 240 ﬁne dust, 141 transboundary, 27–41, 229–242 acid rain, 28 climate change, 13, 19, 23, 31, 36–41, 117–122, 199, 208, 213, 230, 240 globalization, 27, 29, 253, 262, 281–300 overﬁshing, 30, 61, 70, 135, 245–278 ozone layer, 28–29, 46–48, 67 environmental policy, 4–5, 83, 90, 99 climate policy, 14, 19, 20 adaptation, 36, 219–225 CDM project, 37, 218–219 mitigation, 36, 214–219 renewable energies, 175–178 command-and-control policy, 135–136, 139–157 cost-beneﬁt analysis, 156–157 economic feasibility, 149–157

Index framework conditions, 48, 49, 64–66, 77, 83, 92–95, 97, 106, 128, 133, 139–144, 146, 148, 150, 157, 165, 167, 170, 171, 173, 175–179, 211, 223, 225, 229–231, 241, 285, 294 integrated, 5, 13, 143, 159–180 international, 5, 13, 27–41, 101, 211–225 cap and trade policy, 207–208 principal-agent approach, 74, 131, 212–219, 300 market-oriented policy, 136 certiﬁcates, 4, 19, 37, 78, 79, 82, 83, 89–91, 99, 136, 195–208, 264 pollution rights, 78, 79, 82, 91–98 pollution tax, 4, 15, 19, 24, 136, 184–195 price-standard approach, 136, 183–208 polluter pays principle, 16, 33, 78, 87, 136, 196, 236 remediation, 134–135 transfer of technology, 219 willingness to pay, 14, 19, 24, 47, 51, 156 environmental standards, 1, 4, 29, 139–144, 230, 283–299 harmonization, 230, 235, 293–295 environmental technology, 21, 22 economically feasible, 150–157 economically reasonable, 150–157 equilibrium autarky equilibrium, 287–288 cost-share equilibrium, 68, 111–117, 128 equilibrium allocation, 57, 58, 64–66, 81, 82, 92, 96, 104, 112, 151, 152, 154, 286, 287, 289, 291 equilibrium with external effects, 63–66, 127 ﬁshery bioeconomic equilibrium, 255–259 ﬁxed-stock equilibrium, 250–253 market equilibrium, 259–262 free trade equilibrium, 289–291 Lindahl equilibrium, 89, 103–113, 121, 128, 264 market equilibrium, 56–59, 63–66, 81, 84, 90, 150, 151, 154 Nash equilibrium, 74, 122, 247, 250 subgame-perfect, 285–295 price system, 57 Stackelberg equilibrium, 297–299 Strong Nash equilibrium, 117 European Union climate policy, 46, 73, 100, 214 Common Fisheries Policy, 247, 271–274 Directive on WEEE, 161 Emission Trading System, 37, 199–203, 215

Index Environment Action Programme, 13 environmental awareness, 14–15 environmental issues, 13–17, 133 environmental policy, 235–237, 294 Treaties European Coal and Steel Community, 235 European Economic Community, 235 Single European Act, 235 Treaty of Amsterdam, 236 Treaty of Lisbon, 237 Treaty of Maastricht, 236 extended producer responsibility, 5, 147, 159–167 design for environment, 147, 161 external effect, 3, 47, 48, 59–66, 77–89, 129, 149, 151, 249, 253, 263–265, 287 internalization, 66, 77–101, 105, 106, 152, 264–265 reciprocal nature, 78, 87–89, 98 ﬁshery biological growth, 254–255 equilibrium bioeconomic equilibrium, 255–259 ﬁxed-stock equilibrium, 250–253 market demand, 260 market equilibrium, 259–262 market supply, 259–262 Nash equilibrium, 247, 250 mass contact model, 249 maximum sustainable yield, 254, 255, 272 overcapacity, 251, 259, 261, 264, 265, 268–271 investment race, 253, 262, 263 overﬁshing, 245–278 production function, 248 mass balance restriction, 251 quota management system, 265 short-run supply, 247–253 ﬁshery policy EU Common Fisheries Policy, 247, 265, 271–274 limited entry licensing scheme, 248 quota management, 265–268 subsidies, 247, 253, 263, 268–271 UN Food and Agriculture Organization, 246 US Fisheries Policy, 265, 274–277 GATT, 212, 231–234, 237, 239, 242, 283 Committee on Trade and Environment, 234 Dispute Settlement Body, 234 tuna-dolphin case, 234 Uruquay Round, 234 Germany

305 Clean Air Action Plan, 141 climate policy, 214 Closed Substance Cycle Act, 149 Federal Immission Control Act, 135, 142 Integrated Waste Management, 173–175 Packaging Ordinance, 143, 144, 147–149, 174–175 reﬁllables quota issue, 143–149 Renewable Energy Sources Act, 176–178, 231 Stuttgart 21, 141 WEEE policy, 163–165 growth biological growth, 254–255 economic growth, 20, 22 population growth, 22 India Action Plan on Climate Change, 23 climate policy, 22 environmental awareness, 22–23 environmental issues, 22–23 population growth, 22 renewable energy, 22, 23 informational requirements, 4, 15, 82, 87, 100, 101, 107, 114, 117, 127–136, 139–141, 149, 159, 161, 164, 175, 179, 183, 186–189, 191, 195, 197, 199, 213, 214, 277, 286 International Monetary Fund, 218 Japan cap and trade policy, 207 Fukushima Nuclear Catastrophe, 14, 95 WEEE policy, 165–167 Kyoto Protocol, 37–41, 70–74, 114, 117–122, 211, 231, 240 Cancun Agreements, 40 Clean Development Mechanism, 37, 218 CDM project, 37, 218–219 Certiﬁed Emission Reductions, 37, 218 Copenhagen Accord, 39 International Emissions Trading, 37 Joint Implementation, 38 Emission Reduction Units, 38 Marrakesh Accords, 37, 38 Lindahl equilibrium, 89, 103–113, 121, 128, 264 core property, 109, 110 market equilibrium, 56–59, 63–66, 81, 84, 90, 150, 151, 154

306 market mechanism, 3, 47, 51, 53, 56–59, 64, 79, 84, 114, 285 market-oriented environmental policy, 136 certiﬁcates, 4, 19, 37, 78, 79, 82, 83, 89–91, 99, 136, 195–208, 264 pollution rights, 78, 79, 82, 91–98 pollution tax, 4, 15, 19, 24, 136, 184–195 price-standard approach, 136, 183–208 Marrakesh Accords, 37, 38 NAFTA, 231, 235, 237–240 Nash equilibrium, 74, 122, 247, 250 reaction functions, 249, 251, 287, 289 subgame-perfect, 285–295 natural attenuation, 61, 135, 189, 284 New Zealand cap and trade policy, 207 overﬁshing, 30, 61, 70, 135, 245–278 Pareto Criterion, 49, 56, 140 potential Pareto improvement, 156 Pigou Tax, 4, 78, 82–88, 90, 91, 98, 105, 106, 127–129, 152, 154, 185, 193, 263, 264 Porter, M. ﬁrst-mover advantage, 231 Porter Hypothesis, 231, 240 principal-agent approach, 74, 131, 212–219, 300 Prisoners’ Dilemma, 67–74, 107, 120, 122, 240, 263–265, 271, 274, 288 proﬁt proﬁt maximization, 57, 63, 64, 66, 69, 80, 87, 88, 92–97, 100, 106, 122, 249, 250, 252, 266, 267, 286 zero proﬁt condition, 59, 65, 81, 85, 87, 93, 104, 151, 152 property rights, 67, 78, 79, 82, 87, 91, 98–101, 246, 265, 268 public commodity, 29, 39, 48, 66–75, 77, 89, 128, 285 local, 28, 66 public-private partnership, 143, 175 Private Finance Initiative, 142–143, 171, 174, 175 Regional Trade Agreements EU, 235–237 NAFTA, 235, 237–240 Samuelson Condition, 104, 105, 113, 116, 121, 215, 216, 221 Smith, A. invisible hand, 48

Index South Korea cap and trade policy, 207 Spence, A.M. growth function, 254 standards environmental standards, 1, 4, 29, 139–144, 230, 283–299 harmonization, 230, 235, 293–295 sustainable development, 2, 13, 31, 33, 36, 132, 168, 191, 192, 238, 247, 269, 273 Switzerland cap and trade policy, 208 tax ecotax, 51, 191–195 double dividend, 191, 192 investment tax, 264 pollution tax, 4, 15, 19, 24 trade agreement, 30–31, 212, 229–242 EU, 235–237 GATT, 212, 231–234, 237, 239, 242, 283 NAFTA, 231, 235, 237–240 WTO, 30, 134, 212, 230–234, 240, 269, 270, 276, 281–283 certiﬁcates, 19, 78, 82, 83, 89–91, 184, 195–208 comparative advantage, 283–299 pollution rights, 78, 98–101 tariff, 295–297 trade and environment, 30–31, 131, 229–242, 281–300 ethical preferences, 282 integration, 240–242 race to the bottom, 282, 292–293 unfair trade, 281, 292–293 welfare loss, 282, 292–293 Tragedy of the Commons, 4, 74–75, 148, 263 UN Brundtland Report, 1, 31, 33 Food and Agriculture Organization, 246 Law of the Sea, 265, 268 Exclusive Economic Zones, 268, 271 UNCED, 31–41 Agenda 21, 33–36 Rio Declaration, 31–33 UNFCCC, 36–37 Kyoto Protocol, 37–41, 117–122, 231 United States of America Cap and Trade Policy, 203–207 Clean Air Act, 18, 141 Clean Energy and Security Act, 133 climate policy, 46

Index Earth Day, 17 environmental awareness, 17–20 environmental issues, 17–20 Environmental Protection Agency, 18, 141 Fisheries Policy, 274–277 catch share policy, 276 Tennessee Valley Authority, 19 Waxman-Markey Bill, 133 utility function Cobb-Douglas, 55, 58 homothetic, 55, 150, 152, 156, 215, 284 waste biodegradable, 170, 171, 176–177 e-waste, 29, 160–167 recycling, 5, 16, 132, 139, 143–146, 149, 151–156, 171–176, 179, 186 reusable packaging, 143–149 waste management, 14, 132 integrated, 5, 132, 167–175

307 WEEE, 160–167 WEEE, 29, 160–167 Australia, 162 European Union, 161 Germany, 161, 163–165 Japan, 162, 165–167 Nigeria, 163 United States of America, 162 Whitaker, J.C. Earth Day, 17 World Bank, 218 World Wildlife Fund, 245, 246 WTO, 30, 134, 212, 230–234, 240, 269, 270, 276, 281–283 Battle of Seattle, 240, 282 Doha Declaration, 239 Marrakesh Agreement, 234 Regional Trade Agreements, 235–240 EU, 235–237 NAFTA, 237–240