1. HS 232
Lecture 8 23rd
January 2025
Climate change as an environmental externality
2. Recap
• What is climate mitigation
• Why mitigation is a positive externality and a public good
• Why it is under produced
• Mitigation and Market Failure
• Policy Interventions to Correct Market Failure – Direct and Indirect
methods
3. Negative Externality in Burning Fossil Fuels
• Burning fossil fuels is a classic example, where the external costs
include air pollution, greenhouse gas emissions, health issues, and
environmental degradation.
• The gap between the market equilibrium and the socially optimal
level reflects the overproduction of fossil fuels, which results in
external costs being imposed on society.
4. 1. Marginal Private Cost (MPC, Blue Dashed
Line): Represents the direct costs borne by producers or
consumers of fossil fuels.
2. Marginal Social Cost (MSC, Red Solid Line): Reflects the
total costs to society, including external costs such as
pollution and climate change.
3. Marginal Benefit (MB, Green Solid Line): Represents the
declining benefits from fossil fuel use.
Key Points:
Market Equilibrium (Blue Point): Occurs where MPC =
MB. Here, the market produces more fossil fuels than is
socially optimal because external costs are not accounted
for.
Socially Optimal Level (Red Point): Occurs where MSC =
MB, accounting for external costs. This results in lower
fossil fuel consumption.
The gap between the market equilibrium and the socially
optimal level represents the overproduction of fossil fuels,
leading to societal harm. Policy measures like carbon taxes or
emission regulations aim to align private costs with social costs,
reducing this gap.
5. Public bad
Characteristics of a Public Good:
• Non-excludability: No one can be excluded from enjoying the benefits
of the good.
• Non-rivalry: One person’s use of the good doesn’t reduce its
availability to others.
Negative externalities like pollution share the non-excludable and non-
rivalrous features of public goods but represent undesirable outcomes.
Therefore, they are classified as public bads, not public goods.
6. Regulations to internalize these costs
Direct methods
Carbon Tax
• A carbon tax directly imposes a fixed cost on every ton of CO₂ emitted.
• It raises the price of fossil fuels, making carbon-intensive activities more
expensive.
• How It Works:
• Firms and individuals are incentivized to reduce emissions by switching to cleaner
energy sources, improving energy efficiency, or adopting greener technologies.
• Example:
• Sweden’s Carbon Tax:
• Sweden implemented a carbon tax in 1991, starting at $23/ton CO₂ and now exceeding
$130/ton.
• The tax significantly reduced emissions while the economy grew, as businesses and
consumers shifted toward renewable energy and energy-efficient practices.
7. How Carbon Tax Reduces Fossil Fuel Consumption:
• Internalizes External Costs:
• Fossil fuel consumption generates negative externalities, such as greenhouse gas
emissions. A carbon tax aligns private costs with social costs by adding a price to
carbon emissions.
• Price Signal:
• The tax increases the price of fossil fuels, making renewable energy and energy
efficiency measures more competitive.
• Behavioral Change:
• Higher prices discourage wasteful energy consumption, encouraging consumers to
adopt energy-efficient practices and producers to invest in cleaner technologies.
• Revenue Recycling:
• Instead of simply adding this revenue to the general budget, governments can
reinvest or redistribute these funds in targeted ways to maximize their
environmental and social benefits.
8. Revenue Recycling:Potential Uses:
• Funding Renewable Energy Projects: Revenue can be directed toward developing and deploying
renewable energy infrastructure, such as solar, wind, or hydropower projects, helping transition
to cleaner energy sources.
• Subsidizing Green Technologies: Support can be provided to innovative technologies like electric
vehicles, energy-efficient appliances, or carbon capture systems, reducing their cost and
increasing accessibility.
• Reducing Other Taxes: Governments can reduce taxes like income or payroll taxes to offset any
economic burden on households or businesses caused by the carbon tax. This is often referred to
as a "tax shift" or "double dividend" strategy.
• Investing in Climate Adaptation: Funds can support climate resilience measures, such as
improving infrastructure to withstand extreme weather or protecting vulnerable ecosystems.
• Supporting Low-Income Households: Revenue can be used to provide rebates or direct payments
to households disproportionately affected by increased energy costs, ensuring the carbon tax
remains equitable.
• Amplifying the Mitigation Effect: By recycling revenue into green initiatives, governments can
accelerate the reduction of emissions beyond what would occur through the price signal alone.
This dual approach (pricing carbon + funding solutions) creates a more robust response to climate
change.
9. Benefits of Revenue Recycling:
• Reduces economic impacts and public resistance to carbon pricing.
• Drives innovation in clean energy and technology.
• Ensures fairness by compensating vulnerable groups.
• Strengthens public acceptance of carbon taxes by showing tangible
benefits.
10. Cap-and-Trade System
• A cap-and-trade system sets a limit (cap) on total emissions and allows firms to
trade emission permits in a market.
• Firms that reduce emissions below their cap can sell unused permits to others.
• How It Works:
• By creating a market price for carbon, firms are incentivized to cut emissions in cost-
effective ways.
• Example:
• European Union Emissions Trading System (EU ETS):
• The EU ETS caps emissions from power plants, industrial facilities, and airlines.
• Firms buy or sell allowances, encouraging innovation in clean technologies.
• The system has contributed to a steady decline in emissions across the EU.
11. Cap and Trade : Market based approach
• Cap: The government or regulatory body sets a maximum limit (cap) on
the total amount of emissions (usually measured in tons of CO2 or
equivalent gases) that can be emitted by all companies or industries
within the program. This cap is usually reduced over time to encourage
emission reductions.
• Allocation of Allowances: Companies or entities covered by the cap
receive emission allowances (permits) that give them the right to emit a
specific amount of greenhouse gases. These allowances may be
distributed through:
• Free allocation (based on historical emissions or other criteria)
• Auctions, where companies bid for the permits.
12. • Trading: If a company emits fewer emissions than its allowance, it
can sell or trade the excess allowances to other companies that may
need more. This creates a financial incentive for businesses to reduce
their emissions—those who can reduce emissions at a low cost can
sell their surplus allowances, while those facing higher costs of
reduction can buy additional allowances.
• Monitoring and Enforcement: Regular monitoring ensures companies
comply with their emissions limits. If companies exceed their cap,
they may face penalties, such as having to purchase additional
allowances or pay fines.
13. Example:
• The European Union Emissions Trading System (EU ETS) is one of the
largest and most well-known examples of a Cap-and-Trade system.
Under the EU ETS, industries such as power generation,
manufacturing, and aviation are subject to emissions caps. The
European Commission sets an overall cap on emissions from these
sectors and allocates a portion of allowances either through free
distribution or auctions. Companies can trade these allowances in a
market, providing financial incentives to reduce emissions. Over time,
the cap is reduced to ensure that total emissions continue to fall.
14. Key Benefits:
• Cost-Effectiveness: The market-based nature of cap-and-trade allows
emissions reductions to occur where they are cheapest, as companies
with lower abatement costs can reduce more and sell allowances to
those with higher costs.
• Incentives for Innovation: By putting a price on carbon, the system
encourages businesses to innovate and adopt cleaner technologies to
reduce their emissions.
• Environmental Integrity: The cap ensures that total emissions do not
exceed the set limits, contributing to the overall reduction of GHG
emissions.
15. Key Challenges:
• Market Volatility: The price of permits can fluctuate significantly
depending on demand and supply.
• Unpredictable prices make it difficult for businesses to plan long-term
investments in cleaner technologies.
• Example: In the EU Emissions Trading System (EU ETS), prices
dropped dramatically during its initial phases due to an oversupply of
permits, reducing the incentive to reduce emissions.
• Political and Regulatory Issues: The setting of the cap, the allocation
of allowances, and the design of the trading system are subject to
political negotiation, which may lead to compromises that limit the
system's effectiveness
16. • Initial Allocation of Permits:
• Deciding whether to allocate emissions permits for free or auction them is
contentious.
• Free allocation can lead to "windfall profits" for companies that receive
permits but don't need to reduce emissions significantly.
• Auctioning permits, while economically efficient, might increase costs for
businesses and lead to political pushback.
• Carbon Leakage:
• Industries in countries with stringent cap-and-trade policies might relocate to
regions with less stringent regulations, resulting in no global emissions
reduction.
• Example: Some European industries voiced concerns that stricter caps under
the EU ETS would force them to move operations to non-EU countries with
lax regulations.
17. • Administrative Complexity:
• Designing, implementing, and monitoring a cap-and-trade system requires
significant administrative capacity and enforcement mechanisms to ensure
compliance.
• Example: Ensuring accurate emissions reporting and verification in
California’s Cap-and-Trade Program has been resource-intensive.
• Equity Concerns:
• Higher compliance costs for industries may be passed on to consumers,
disproportionately affecting low-income households.
• Example: In California’s program, higher fuel prices due to carbon trading
raised concerns about affordability for disadvantaged communities.
18. • Environmental Effectiveness:
• Setting a cap that is too high can lead to minimal emissions
reductions, while a cap that is too low can harm the economy.
• Example: During the early phases of the EU ETS, the cap was set too
high, resulting in an oversupply of permits and negligible reductions in
emissions.
Although programs like the EU ETS have demonstrated the potential for
success, their effectiveness depends on strong oversight, robust caps,
and complementary policies to address economic and social impacts.
