Elaine Foppiano

Randall Pozdena

English

Research Papers in Economics

July1S, 1983
---------------
Pollution Pricing
The 1970s brought environmental issues to
the forefront ofpublic consciousness. The
Clear Air and Water Acts and the National
Environmental Policy Act, as well as more
specialized legislation, were passed during
the decade in an unprecedented effortto
clean upand protectthe environment.
However, recent polls indicate environ-
mental quality remains aconcern ofAmer-
icans despite the major efforts to regulate
pollution that followed this legislation.
Economists meanwhile have been warning
that the current structure ofenvironmental
laws and policies are unlikelyto achieve
satisfactory results. In this Letter, we explore
the economists' preferred policyofpricing
pollution.
Economicsand pollution
According to economic theory, excessive
pollution results from the failure ofthe
marketplace to place acorrect price on
certain inherently valuable resources-
most notably clean air and clean water. The
marketplace has no difficulty properly
pricing other important resources, such as
iron oreand labor, becausetheownershipof
these resources is unambiguous. In the case
ofairand many sources ofwater, however,
ownership is unassigned and, therefore, the
resources cannot be priced and sold. The
failuretodefineownershipclearly is usually
duetothe "jointuse" natureofmany natural
resources. Theairoveracity, forexample, is
jointly used by all the inhabitants, but
owned by noone.
Without a market mechanism to allocate
these resources, they are treated as costless
inputs to production processes despite the
fact that their loss to an alternative use (for
breathing or drinkingand other production
processes) has tremendous value. Socially
unacceptable levels ofpollution occur,
therefore, when jointlyused clean water and
clean air resources are "overconsumedll by
certain users. Polluters impose on other
1
users ofthe same resource costs that are
greater than the value ofthe resource
to them.
The Coase theorem
In concept, the simplest remedy to this
problem, ofcourse, would be to extend
ownership rights to clean air and clean
water so thatthe price mechanism could be
exploited. At first glance, such asuggestion
seems impractical because ofthe problem of
determining who should own the resource.
. In fact, as was argued by R.H. Coase
in 1960, the efficient social use ofthese
resou fees in competitive markets does not
depend on who receives the rights to them.
The rights could even be assigned to the
polluter.
For example, ifthe ownership rights to a
polluted river were assigned to its polluter,
the users ofthe river who are bearing the
costs ofthe pollution would have an incen-
tive to bribe the polluterto reduce orcease
his pollution. A profit-maximizing polluter
would have an incentive to reduce his
pollution as long as the value ofthe water
to otherusers-as reflected in the bribe- is
greater than its value to his use or greater
than the cost to him of installing equipment
to abate the pollution. (In the extreme, the
pollutermay be bribed tosimplycease oper-
ations completely.)
Surprisingly, the result is the same ifthe
pollution rights were assigned to the non-
polluting users ofthe river. The polluter
would have to bribe these other users to
pollute. Again, the maximum he would pay
would be the valueofthe watertohim in his
production process orthe cost ofcleaning it
upafteruse. The productiondecisionsofthe
polluting industry and the cleanliness ofthe
river water would be the same as in the case
where ownership was assigned to the pol-
luter. This notion has come to be known
as the Coase Theorem.IPcg;cd!~1F©:J lJ« cg;~~1F\o/~
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Opinions expressed in this n~~\'vsletter do not
necessardv (e·fleet the views ot the rnanZlgement
of the Federa! Re"serve B(,1.nk of San Francisco,
or of the Board of Governors of th'C' Federal
Reserve Svstern.
Pollution pricing
Creating markets for clean air and clean
water is appealing because the forces of the
marketplace, which function so well in
other contexts, can be relied upon to allo-
cate and economizewithout further govern-
mental oversight. But there are obvious
practical difficulties with the suggestion,
such as the wealth distribution effects ofthe
assignment ofownership rights and the
logistical difficulties ofbringing the affected
parties together in aforum in which a price
could be negotiated.
As a practical solution, some economists
suggest that ownership rights be assigned to
the government, and thatthe government
establish standard prices (differentiated by
location,typeofpollution, and otherfactors)
that itwill charge forthe rightto pollute.
IdeallY, these "pollution prices" would
reflect the marginal cost to society ofan
additional unitofa particular pollutant.
Economists have derived such estimates
for certain pollutants. The work by Lester
Lave, for example, suggests that the social
cost of an additional unitofsulphur dioxide
(a common industrial air pollutant) in a
typical U.S. location in 1979 was $304
million for aone-percentdecrease in atmos-
pheric sulfates.
In general, such pseudo-market pricing
exercises are complicated by the difficulty
in devising unambiguous values for such
pollution costs as illness and loss of life.
As a practical matter, reasonable estimates
ofpollution prices may need to be adjusted
later to achieve the socially desirable level
ofenvironmental quality.
Pricing vs. regulation
Even in its least precise form, however,
economists argue that the pricing ofpollu-
tion would be vastly more efficient than the
current system ofregulations and standards.
Underthe current system, all polluters must
conform to a single standard or face a pen-
alty or other administrative action. A major
inefficiencyofthis approach arises because
2
different polluters face different pollution
abatement costs.
A pollution pricing system could decrease
the total cost ofachieving agiven level
ofenvironmental quality becausethose able
to clean up least expensively would be
induced to reduceemissions drasticallyand,
in the process, compensate those for whom
it would be prohibitively expensive to
clean up. Charging for reducing emissions
achieves this effect automatically; those
with inexpensive clean-up alternatives will
find itmore profitabletoavoid the charge by
reducing their emissions.
Pollution bubbles
There are currently nooperational examples
ofa pure effluentcharge system orCoase-
type ownership rights allocation. However,
a numberofattempts to introduce a market
mechanism intoemission decisionssuggests
how powerful economic incentives might
be in changing polluting behavior.
Borrowing from the Coase idea ofowner-
ship ofclean air, forexample, the Environ-
mental Protection Agency in the 1970s
authorized the creation of"bubbles"
-conceptual domes, overgeographic areas
-underwhich firms are given limited rights
to clean air. A regulatory standard is main-
tained undereach bubble. Each firm is given
the right to pollute up to the regulatory
standard and earns emissions credits (for
sale or future use) ifit pollutes less than
thestandard. Moreover, these credits can be
traded-firmsdesiring to increase their
emissions underthe bubble can buy credits
from firms that are "under-polluting."
The bubble concept mixes regulatory stan-
dards with market incentives to encourage
moreefficientachievementofthe regulatory
standard than wouId be possible with regu-
lation alone. Firms for which it is very ex-
pensive to abate will buy emissions credits,
and fi rms that can abate cheaply wiII have
an incentivetodoso and can profitfrom the
sale ofthe emissions credits.The long-run efficacy ofsuch a market-
oriented approach is illustrated by an actual
bubble and emissions bank instituted in
Louisville, Kentucky, in 1979. After institu-
tion ofthe bubble, suspended particles,
sulphur dioxide, volatile organic com-
pounds, and carbon monoxide emissions
from pointsources declined even though the
pollution standard remained the same. An
illustration ofthe cost-saving effects ofthe
Louisville bubble is provided by General
Electric, which faced a decision ofwhether
to spend $1.5 million to install pollution
control equipment to retrofit an old process
line orto shut it down. GE opted instead to
lease emissions credits banked by Interna-
tional Harvester, which found compliance
relatively easy. The arrangement cost GE
$60,000 instead ofthe $1.5 million itwould
have cost to retrofilthe old process line.
Water effluent charges
Another illustration ofthe power ofmarket
incentives to induce a change in polluting
behavior lies in the charges levied against
firms todumpinto municipal watersystems.
Levyingthese charges makes itnecessaryfor
firms to consider the cost ofpolluting as
another cost in their production process.
Evidence from a study offive such systems
by Hudson, Lake and Grossman confirms
that effluent pricing stimulated changes in
firm behaviorthatranged from slightmodifi-
cations ofproduction methods to actual
innovations in the production process.
The industrial city ofSouth San Francisco
provides a specific example. The city'Ievies
a surcharge for toxic waste disposal into the
municipal waste system based on concen-
tration and weight ofsuspended solids
above a threshold level. In 1974, South San
Francisco made the application ofthe
charge much more stringent. Although
hardly a controlled experiment, the results
suggested the responsiveness ofpollution to
pricing. In the year that the changes were
instituted, there was adramatic drop in
pollutants entering the municipal water
system. Biochemical oxygen demand
3
dropped from 4.21 to 3.34 million Ibs/year,
chemical oxygen demand dropped from
8.31 to 7.54 million Ibs/yearand suspended
solids dropped from 2.64 to 1.61 million
Ibs/year.
Solid waste pricing
Pollution pricing also has an application in
solid waste management. In 1972, Oregon
instituted a policy akin to pollution pricing
to reduce roadside litterdue to bottle dis'
posal. Underthe "bottlebill,"the purchaser
ofabeverage pays adepositthat is refunded
ifthe empty container is returned to the re-
tailer. In effect, the law encourages disposal
through the retailer; ifbottles are thrown by
the wayside or disposed ofprivately, the
consumer loses the deposit.
The retailers and bottlers did not wish
to become the avenue ofdisposal (or
recycling) ofbottles and the law has been
controversial because ofthis aspect. None-
theless, the small deposit charge radically
reduced roadside litter. In the first year
following implementation ofthe law,
random roadside counts indicated acon-
tainer litter level ofonly 1° to 20 percentof
the year before. Although deposits on bev-
erage containers remain acontroversial
method of"pricing" bottle litter, Oregon's
experience provides further evidence that
pricing is an effective way of influencing
pollution behavior. Experiences in the five
other states that implemented bottle bills
(Vermont, Maine, Michigan, Iowa and Con-
necticut) confirm this.
Conclusion
Unfortunately, the attraction ofpollution
pricing to economists is notwidely shared
by policymakers. Explicit pricing ofpollu-
tion brings its cost intothe open, with
pollution pricing bearing an uncomfortable
resemblance to taxes. Nevertheless, using
regulation instead ofprices does not
eliminate the costofabatement. Indeed,
economic logic suggests the overall costs of
achieving a given level ofenvironmental
quality would be lowerwith pricing than
with a standard regulatory approach.
Elaine Foppiano and Randall PozdenaSSV1:> lSl:lI:l
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Change from
year ago
011 P
Change
from
6/22/83
Amount
Outstanding
6/29/83
Selected Assets and liabilities
Large Commercial Banks
BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millions)
o ar ercen
Loans (gross, adjusted) and investments* 163.127 837 1,733 1.1
Loans (gross, adjusted) - total# 141,638 877 978 0.7
Commercial and industrial 44,338 159 79 0.2
Real estate 56,233 3 - 1,291 - 2.2
Loans to individuals 23,938 151 575 2.5
Securities loans 2,594 190 337 14.9
U.s. Treasury securities'" 8,266 - 13 1,781 27.5
Othersecurities'" 13,221 - 27 - 1,025 - 7.2
Demand deposits - total# 41,387 1,229 - 550 - 1.3
Demand deposits - adjusted 28,557 16 588 2.1
Savings deposits - tctalt 66,179 - 266 35,586 116.3
Time deposits - total# 65,724 518 - 30,158 - 31.5
Individuals, part. & corp. 59,699 538 - 26,693 - 30.9
(Large negotiable CD's) 18,363 323 - 16687 47.6
Weekly Averages
ofDailtJ Fitmres
Member Bank Reserve Position
Excess Reserves (+)/Deficiency(-)
Borrowings
Net free reserves (+)/Netborrowed(
Weekended Weekended Comparable
6/29/83 6/22/83 vear~alJorn>riod
111 87 80
812' 573 254
701 - 487 - 174
* Excludes trading account securities.
# Includes items notshown separately.
t IndudesMoneyMarket Deposit Accounts, SuperMNOW accounts, and NOWaccounts.
Editorialcommentsmay be addressedtotheeditor(Gregory Tong) ortotheauthor•...Freecopiesof
this and otherFederal Reserve publications can be obtained by calling orwriting the Public Informa-
tionSection, Federal Reserve BankofSan Frandsco,P.O. Box 7702, San Francisco 94120. Phone (415)
974-2246_

Pollution pricing

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Pollution pricing

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Research Papers in Economics