Environmental and energy economics

Lecture Moderate A. Sustainability 1 21.09

What is "sustainability"? Externatilites. Hanley Ch.2, Tietenberg Ch 2

2 29.09

Market failure Tietenberg Ch 2

3 05.10

Global warming Tietenberg Ch 16

4 12.10

First-best optimal instruments Second-best instruments (subsidies)

Tietenberg Ch 14 Cramton

5 19.10

Optimal extraction of exhaustible sources: the basic model & extensions

Tietenberg, Ch.5

B. Fossil fuels: Oil, Gas & Coal 6 26.10

Oil. Security of supply. Shale oil, oil shale (kerogen), tar sands (bitumen). Peak oil, Huber curves and reserves

BP BP 2013 Edwards p.68-92, 126-157 IER Smil: Memories of peak oil Smil 2010: power density primer

7 02.11

Gas. Security of supply: short-term & long-term. The crucial difference between oil and gas. Bilateral monopoly. "pipe wars".

Shively-GAS, Chap 1, 2, 10 Ratner Shively-GAS Stern

C. Electricity markets 8 09.11

Fundamentals of electricity: The system Shively-E Ch.1, 2, 4, 5, 6, 7. Biggar Ch. 2

9 16.11

Fundamentals of electricity: Generation Shively-E Ch. 4. Edwards p.93-112 +117 (California)

10 23.11

Generation: Trading simulation 1a & 1b Edwards p.259-271 Stoft p.33-45, 123-129

11 30.11

Generation: optimal investment, screen curves, load duration curve, missing money & capacity payments and subsidies

Stoft p.33-45, 123-129

D. Climate policy

12 07.12

Renewable energy sources: - costs & benefits - the costs of intermittency - LCOE and its drawbacks - the utility dead-spiral

Borenstein 2012 Marcantonini Taylor Boehringen Hirth Smil 2010 Smil 2014 Reader

13 14.12

E. Enviromental survival: Past and future

- The Green paradox - Disasters, myths and miracles

Tietenberg, Ch.5 Morris Wilson

17.12 Exam for exchange students (not for "domestic" ones)

• SUSTAINABILITY

• Hanley, Chap. 2

• What is sustainability?

• What is sustainability?– Utilitarian approach: look at the discounted

sum of well-being of all people over time.– Kantian approach: Future generations have

moral rights to a level of well-being no less than our own.

– Should we use a discount factor or not?

– Should we use a discount factor or not?- Value of goods is not less because it is later in

time+ Assets saved now grow with the real interest rate

in time and are thus worth more in the future

• What defines a sustainable path?1. Outcome oriented

• Utility calculations

2. Capital oriented• Capital stock calculations

• What defines a sustainabile path?1. Outcome oriented

• Utility calculations– Representative agent

[ ]U t

[ ] 0dU tdt

• Utility not decreasing

• Ramsey (or Solow) model?– Remember macroeconomics

– Are the outcomes sustainable?

[ ] dtMaxU C t e

(1 ) ( )t t t tsuchthat K K Y C

tY

[ ]C t

t

Yes

• Ramsey (or Solow) model?– Remember macroeconomics

– Are the outcomes sustainable?

[ ] dtMaxU C t e

(1 ) ( )t t t tsuchthat K K Y C

tY

[ ]C t

t

No

• Ramsey (or Solow) model?tY

[ ]C t

t

Sustainable

• What is drawback of this approach?• We only talk about utility -> human satisfaction is the

focal center.• No mention of natural stocks.

• What defines a sustainable path?1. Outcome oriented

• Utility calculations

2. Capital oriented• Capital stock calculations• What is capital?

– Man-made capital Km– Human capital Kh– Natural captital Kn– Social capital Ks

• Weak sustainability

• Different sorts of capital are substitutable.

M H Nt t t tK K K K 0tdK

dt

• John Hartwick (1977, AER) “Intergenerational equity and the investing of rents from exhaustible resources”

• Rules for “Weak sustainability

• Does the consumption of non-renewable assets imply a decrease in consumption?– Oil, gas, coal extracted and burned– Forests, pristine nature replaced by cities

• If the capital stock is kept constant, consumption may not decrease.

M H Nt t t tK K K K 0tdK

dt

• What should Saudi-Arabia do to be weakly sustainable?– Extracting oil– Invest the rents in human and man-made

capital– Do they do this?

• Not really

• What oil and gas country is weakly sustainable?– Norway– Rents are invested in the “oil fund”.

• What is the drawback of this definition of sustainability?

• We may want to keep a stock of pristine nature

• Problem with weak sustainability– Assumes perfect substitution between

different forms of capital

• Weak sustainability

• Different sorts of capital are substitutable.

M H Nt t t tK K K K 0tdK

dt

• Strong sustainability

0NtdK

dt 0

NN N tt

dKK K anddt

or

No reduction in natural assets!

• A subset of the natural assets is deemed essential

• May not be degraded!

Examples:• The ozon layer• Amazon forest• Global temperature

0N

N N tt

dKK K anddt

• A subset of the natural assets is deemed essential

• May not be degraded!

• What is this the essential subset of the natural assets?• Possible answers:

1. Existing level2. “Level consistent with the critical level”3. (Something in between)

• Possible answers:

• Suppose we have an answer to this (we set some level)– For global temperature– For fish stocks– For pristine forest

• How do we measure such a level?– Should they be measured in physical or

monetary units?• Physical: Aggregation problem

– How to aggregate the different elements of KN?» oak tree + a blue whale?

– Category woodlands:» Is a sitka pruce as valuable as native Scots pine or

an ancient oak?

• Monetary:– How much is a human’s life and how much that of a

whale, a tree or fresh air?

• “Mother ship earth”• environment - economic system is a closed

system.

• first law of thermodynamics– energy and matter can neither be created nor

destroyed• second law of thermodynamics (entropy

law)– entropy increases– Entropy is a measure of disorder

• How to diminsh pollution– In an as efficient as possible way?

• Applied on carbon emissions by the electricity sector in the EU:–How to create a framework that

leads to cleaner electricity?

2mT 4mT 5mT

A B C

Emissions:

2mT 4mT 5mT

A B C

Emissions:

4$/T 5$/T 20$/TAbatement cost:

2mT

A B C

4$/T 5$/T 20$/TAbatement cost:Abatement-investment

7$/T

5mT4mT1mT

1$/T

Emissions:

A B C

Abatement cost:Abatement-investment ?Emissions:

A B C

Abatement cost:Abatement-investment

Emissions:

A B C

EMISSION PERMIT MARKET

Competition for

permits

Solution 1:EU Emission Trading Scheme (EU-ETS)

• 2005- end 2007: Phase 1 (test phase)

• 2007- end 2012: Phase 2 (6.5% below 2005 level)

• 2012- end 2020: Phase 3 (linear 1.74% reduction/year)Kyoto Protocol

Reduction of 21%

• Qm is the chosen quantity of production

• A+B+D= profit• B+D+C= external

costs.

• Q* is the optimal level of production– Implying an

optimal level of pollution

• How to improve this outcome?– Tax– Set property

rights and leave to bargaining

• Lecture 1 finish

• Coase Theorem

• Coase (1960): Set property rights and leave to bargaining

1. Polluter has property rights

– Victim suffers cost B+D+C at Qm

– Victim offers bϵ[D,C+D] to produce at Q*

• Coase (1960): Set property rights and leave to bargaining

2. Victim has property rights

– Polluter produces 0

– Polluter offers bϵ[B,A+B] to victim to produce at Q*

• What are the assumptions of the Coase Theorem (1960)?– No transaction costs!

• Cost of the effort of contracting• Free riding problems• Not a general equilibrium approach -> Wealth

effects may affect preferences.

Debreu & Arrow, 1954. Existence of an Equilibrium for a Competitive Economy, Econometrica.

• Coase theorem is a special case of a general equilibrium.

• Examples

1. Does an externality exist? Positive or negative?

2. Does the Coase theorem apply? 3. If Coase theorem does not apply which

government tools are best 1. quantity regulation2. taxes/subsidies3. tradeable

1. British Petroleum drills for oil in the gulf coast2. Carbon emissions from vehicles3. Your upstairs neighbors throwing an awesome,

but loud party4. Buying a car with added safety features that

prevent the drivers/passengers deaths in the event of an accident

5. Bringing crying babies on a plane

1. Does an externality exist? Positive or negative?2. Does the Coase theorem apply? 3. If Coase theorem does not apply which government

tools are best 1. quantity regulation2. taxes/subsidies3. tradeable

• An natural gas company in San Francisco owns many pipelines running underneath what is now populated areas.

• The company can invest $u in the maintenance of the pipes. Maintenance affects two things:– less gas lost. Value of lost gas = 1/u– less damage to land above the pipes. Value

of damage = 3/u

• Externality?• What is the social optimum?

• The social optimum minimizes total costs:

–Value of lost gas = 1/u–Value of damage = 3/u

The social optimum?

• Optimal maintenance is u*=2• The value of lost gas is ½ • Value of nature damage is 3/2.• Total costs are: 2 + ½ + 3/2 = 4

• The gas company will solve:

–Value of lost gas = 1/u–Value of damage = 3/u

No owner of the land?

• Private maintenance is uP=1• The value of lost gas is 1 • Value of land damage is 3.• Total costs are: 1 + 1 + 3 = 5

• In the social optimum, the social costs were 4.• Thus, there is a deadweight loss: 5-4= 1.

• Suppose now that the gas company owns the land above the pipes.

• What level of u will they choose now? • Is this optimal?

• The gas company will solve:

–Value of lost gas = 1/u–Value of damage = 3/u

Joint ownership of gas and land

• This is optimal• Thus, there is no deadweight loss

• Suppose now that Jimmy Fallon, an ordinary private citizen, owns the property above the plant and can costlessly sue the natural gas company for the losses to his property.

• What level of u will be chosen by the natural gas company?

• How much will be paid from the gas company to Jimmy Fallon?

• The lawsuit imposes a cost on the gas company• How large?

– P(u)= 3/u

• The gas company will solve:

–Value of lost gas = 1/u–Value of damage = 3/u

Costless enforcement of property right by land

owner

• This is optimal• Thus, there is no deadweight loss• The company pays 3/2 to Jimmy

• No dealing • What level of u is chosen by the gas company

when no one owns the land above the pipes?• Now what is the value of lost gas? What is the

value of land damage? • The gas company will solve:

• What if the courts are imperfect?• For every $1 in actual damage, only 50%

of the damage can be recouped in court.• So, if the true damage to Jimmy is L, the

gas company will only pay L/2

• The gas company will solve:

–Value of lost gas = 1/u–Value of damage = 3/u

Only half of property right can be enforced by

land owner

• The social costs are now

• DWL =

• Suppose the gas company owns the property. What level of u will be chosen? Is this efficient?

• Why does ownership make a difference here? Coase theorem says it shouldn’t make a difference

• No perfect property rights (can only be enforced for only 50% )

• Extra exercises

• Two power plants provide power to all of Cambridge: an MIT plant and a Harvard plant. Both power plants burn coal to produce electricity, and consequently produce smog as a by-product.

• The MIT power plant could reduce its smog by xM at a total cost of:

• The Harvard power plant could reduce its smog by xH at a total cost of:

• The Cambridge government hires a team of environmentalists who calculate that the total benefit of smog abatement to the city of Cambridge is

Costs:

Benefit:

What is the socially optimal level of abatement?

Social optimum

• The Cambridge government considers imposing a tax on power production.

• What tax should it impose to reach the socially optimal abatement?

Socially optimal level of abatement:

What tax reaches the socially optimal abatement?• What is the marginal damage?• -100 -> Set tax=100 per unit of production

Costs:

Benefit:

Taxing

• Suppose that instead of taxation, the Cambridge government tries to regulate quantities.

• However, the city of Cambridge cannot write a law for each firm, so it simply declares that all Cambridge power plants must cut down on smog by xC= 1 units each year.

• How suboptimal is this?

Socially optimal level of abatement:

Compare marginal costs of reduction:• M: MC=10 x 1 = 10• H: MC= 14 x 1 +10 = 24

Costs:

Benefit:

Reduce each by 1 unit

• Suddenly, an economist is voted in as Mayor of Cambridge.

• She declares that each Cambridge power plants must cut down on smog by 5 units.

• However, she declares that firms will be able to competitively 5 trade permits that will allow them NOT to abate.

• She grants MIT 5 permits and Harvard 0 permits.

• As a result, Harvard is expected to abate by 5 units, and MIT nothing.

• Assume that MIT and Harvard act as perfectly competitive permit traders

Socially optimal level of abatement:

Costs:

Benefit:

Reduce by 5 units in total,

trade 5 permits

2: (5 ) 5(5 )M MM Max p y y 2: 7(5 ) 10(5 )

Hy H H HH Min y y p y

Let: be the amount of permits M holds be the amount of permits H holds

M

H

yy

2: (5 ) 5(5 )My M MM Max p y y

10(5 ) 050 10

10 50

510

M

M

M

M

p yp y

y ppy

2: 7(5 ) 10(5 )Hy H H HH Min y y p y

14(5 ) 10 070 14 10 80 14

8014

H

H H

H

y pp y y

py

510Mpy

8014H

py 5 M Hy y

800 10024 3

805 510 14

8010 1414 800 1024 800

33.3

p p

p p

p pp

p

Costs:

Benefit:

Reduce by 5 units in total,

trade 5 permits

33.335 1.6710My

80 33.3314Hy

MMC 33.33

HMC 14 1.67 10 23.33 10

33.3346.67 3.33

14

Is this optimal?