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July1 S, 1983
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Pollution Pricing
The 1 970s brought environmental issuesto
the forefront of public consciousness. The
Clear Air and Water Acts and the National
Environmental Policy Act, as well as more
specialized legislation, were passedduring
the decade in an unprecedented effort to
clean up and protect the environment.
However, recent polls indicate environmental quality remains a concern of Americans despite the major efforts to regulate
pollution that followed this legislation.
Economists meanwhile have been warning
that the current structure of environmental
laws and policies are unlikely to achieve
satisfactory results. In this Letter, we explore
the economists' preferred policy of pricing
pollution.
users of the same resource costs that are
greater than the value of the resource
to them.
The Coase theorem
In concept, the simplest remedy to this
problem, of course, would be to extend
ownership rights to clean air and clean
water so that the price mechanism could be
exploited. At first glance, such a suggestion
seems impractical because of the problem of
determining who should own the resource.
. In fact, as was argued by R.H. Coase
in 1960, the efficient social use of these
resou fees in competitive markets does not
depend on who receives the rights to them.
The rights could even be assigned to the
polluter.
Economics and pollution
According to economic theory, excessive
pollution results from the failure of the
marketplace to place a correct price on
certain inherently valuable resourcesmost notably clean air and clean water. The
marketplace has no difficulty properly
pricing other important resources, such as
iron ore and labor, because the ownership of
these resources is unambiguous. In the case
of air and many sources of water, however,
ownership is unassigned and, therefore, the
resources cannot be priced and sold. The
failure to define ownership clearly is usually
due to the "joint use" natureof many natural
resources. Theairoveracity, for example, is
jointly used by all the inhabitants, but
owned by no one.
For example, if the ownership rights to a
polluted river were assigned to its polluter,
the users of the river who are bearing the
costs of the pollution would have an incentive to bribe the polluter to reduce or cease
his pollution. A profit-maximizing polluter
would have an incentive to reduce his
pollution as long as the value of the water
to other users-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
polluter may be bribed to simply cease operations completely.)
Surprisingly, the result is the same if the
pollution rights were assigned to the nonpolluting users of the river. The polluter
would have to bribe these other users to
pollute. Again, the maximum he would pay
would be the value of the water to him in his
production process or the cost of cleaning it
up after use. The production decisions of the
polluting industry and the cleanliness of the
river water would be the same as in the case
where ownership was assigned to the polluter. This notion has come to be known
as the Coase Theorem.
Without a market mechanism to allocate
these resources, they are treated costless
as
inputs to production processes despite the
fact that their loss to an alternative use (for
breathing or drinking and other production
processes) has tremendous value. Socially
unacceptable levels of pollution occur,
therefore, when jointly used clean water and
clean air resources are "overconsumedll by
certain users. Polluters impose on other
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Opinions expressed in this
do not
necessardv (e·fleet the views ot the rnan Zlgement
of the Federa! Re"serve B(,1.nk San Francisco,
of
or of the Board of Governors of th'C' Federal
Reserve Svstern.
Pollution pricing
different polluters face different pollution
abatement costs.
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 allocate and economize without further governmental oversight. But there are obvious
practical difficulties with the suggestion,
such as the wealth distribution effects of the
assignment of ownership rights and the
logistical difficulties of bringing the affected
parties together in a forum in which a price
could be negotiated.
A pollution pricing system could decrease
the total cost of achieving a given level
of environmental quality because those able
to clean up least expensively would be
induced to reduce emissions drastically and,
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 it more profitable to avoid the charge by
reducing their emissions.
As a practical solution, some economists
suggestthat ownership rights be assigned to
the government, and that the government
establish standard prices (differentiated by
location, type of pollution, and other factors)
that it will charge forthe rightto pollute.
IdeallY, these "pollution prices" would
reflect the marginal cost to society of an
additional unit of a particular pollutant.
Economists have derived such estimates
for certain pollutants. The work by Lester
Lave, for example, suggeststhat the social
cost of an additional unit of sulphur dioxide
(a common industrial air pollutant) in a
typical U.S. location in 1979 was $304
million for a one-percent decrease in atmospheric sulfates.
Pollution bubbles
There are currently no operational examples
of a pure effluent charge system or Coasetype ownership rights allocation. However,
a number of attempts to introduce a market
mechanism into emission decisions suggests
how powerful economic incentives might
be in changing polluting behavior.
Borrowing from the Coase idea of ownership of clean air, for example, the Environmental Protection Agency in the 1970s
authorized the creation of "bubbles"
-conceptual domes, over geographic areas
-under which firms are given limited rights
to clean air. A regulatory standard is maintained under each bubble. Eachfirm is given
the right to pollute up to the regulatory
standard and earns emissions credits (for
sale or future use) if it pollutes less than
the standard. Moreover, these credits can be
traded -firms desiring to increase their
emissions under the bubble can buy credits
from firms that are "under-polluting."
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
of pollution prices may need to be adjusted
later to achieve the socially desirable level
of environmental quality.
Pricing vs. regulation
The bubble concept mixes regulatory standards with market incentives to encourage
more efficient achievement of the regulatory
standard than wou Id bepossible with regulation alone. Firms for which it is very expensive to abate will buy emissions credits,
and fi rms that can abate cheaply wi II have
an incentive todo so and can profit from the
sale of the emissions credits.
Even in its least precise form, however,
economists argue that the pricing of pollution would be vastly more efficient than the
current system of regulations and standards.
Under the current system, all polluters must
conform to a single standard or face a penalty or other administrative action. A major
inefficiency of this approach arises because
2
The long-run efficacy of such a marketoriented approach is illustrated by an actual
bubble and emissions bank instituted in
Louisville, Kentucky, in 1979. After institution ofthe bubble, suspended particles,
sulphur dioxide, volatile organic compounds, and carbon monoxide emissions
from point sources declined even though the
pollution standard remained the same. An
illustration of the cost-saving effects of the
Lou isville bubble is provided by General
Electric, which faced a decision of whether
to spend $1.5 million to install pollution
control equipment to retrofit an old process
line or to shut it down. GE opted instead to
lease emissions credits banked by International Harvester, which found compliance
relatively easy. The arrangement cost GE
$60,000 instead of the $1.5 million itwould
have cost to retrofilthe old process line.
dropped from 4.21 to 3.34 million Ibs/year,
chemical oxygen demand dropped from
8.31 to 7.54 million Ibs/year and 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 litter due to bottle dis'
posal. Under the "bottle bill," the purchaser
of a beverage pays a depositthat is refunded
if the empty container is returned to the retailer. In effect, the law encourages disposal
through the retailer; if bottles are thrown by
the wayside or disposed of privately, the
consumer loses the deposit.
The retailers and bottlers did not wish
to become the avenue of disposal (or
recycling) of bottles and the law has been
controversial because of this aspect. Nonetheless, the small deposit charge radically
reduced roadside litter. In the first year
following implementation of the law,
random roadside counts indicated a container litter level of only 1 to 20 percent of
the year before. Although deposits on beverage containers remain a controversial
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 Connecticut) confirm this.
Water effluent charges
Another illustration of the power of market
incentives to induce a change in polluting
behavior lies in the charges levied against
firms todump into municipal water systems.
Levying these charges makes it necessaryfor
firms to consider the cost of polluting as
another cost in their production process.
Evidence from a study of five such systems
by Hudson, Lake and Grossman confirms
that effluent pricing stimulated changes in
firm behavior that ranged from sl ight modifications of production methods to actual
innovations in the production process.
°
The industrial city of South San Francisco
provides a specific example. The city 'Ievies
a surcharge for toxic waste disposal into the
municipal waste system based on concentration and weight of suspended sol ids
above a threshold level. In 1974, South San
Francisco made the application of the
charge much more stringent. Although
hardly a controlled experiment, the results
suggestedthe responsiveness of pollution to
pricing. In the year that the changes were
instituted, there was a dramatic drop in
pollutants entering the municipal water
system. Biochemical oxygen demand
Conclusion
Unfortunately, the attraction of pollution
pricing to economists is not widely shared
by policymakers. Explicit pricing of pollution brings its cost into the open, with
pollution pricing bearing an uncomfortable
resemblance to taxes. Nevertheless, using
regulation instead of prices does not
eliminate the cost of abatement. Indeed,
economic logic suggeststhe overall costs of
achieving a given level of environmental
quality would be lower with pricing than
with a standard regulatory approach.
Elaine Foppiano and Randall Pozdena
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BANKING DATA-TWELFTHFEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)
Selected
Assets liabilities
and
LargeCommercialBanks
Loans(gross,
adjusted) investments*
and
Loans(gross,
adjusted) total#
Commercialand industrial
Realestate
Loansto individuals
Securities loans
U.s. Treasury securities'"
Other securities'"
Demanddeposits- total#
Demanddeposits- adjusted
Savings
deposits- tctalt
Time deposits- total#
Individuals,part.& corp.
(Large negotiable CD's)
WeeklyAverages
of DailtJ Fitmres
Member BankReserve
Position
ExcessReserves(+ )/Deficiency (-)
Borrowings
Net free reserves (+ )/Net borrowed(
J(d[
Amount
Outstanding
6/29/83
163.127
141,638
44,338
56,233
23,938
2,594
8,266
13,221
41,387
28,557
66,179
65,724
59,699
18,363
Weekended
6/29/83
111
812'
701
Change
from
Change from
year ago
011 ar
o
Percen
6/22/83
837
1,733
1.1
978
877
0.7
79
159
0.2
1,291
3
- 2.2
575
151
2.5
337
190
14.9
1,781
13
27.5
- 27 - 1,025 - 7.2
1,229
550
- 1.3
588
2.1
16
35,586
116.3
- 266
- 30,158
- 31.5
518
- 26,693 - 30.9
538
- 16687
323
47.6
Weekended
Comparable
rn>riod
6/22/83
-
87
573
487
-
80
254
174
* Excludes trading account securities.
# Includes items not shown separately.
t Indudes Money Market Deposit Accounts, SuperMNOWaccounts, and N O W accounts.
Editorialcomments
maybeaddressed theeditor (Gregory
to
Tong) to theauthor•... Free
or
copies
of
this and other Federal
Reserve
publications beobtainedby callingor writing the PublicInformacan
tion Section,Federal
Reserve
Bankof SanFrandsco,
P.O.Box7702,SanFrancisco
94120.Phone
(415)
974-2246_
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