Market FailureMarket Failure

Fixing inefficiency without creating Fixing inefficiency without creating moremore

One IdeaOne Idea

The budget also includes revenue from a national cap-The budget also includes revenue from a national cap-and-trade systemfor greenhouse gas emissions, which and-trade systemfor greenhouse gas emissions, which would come from auctioning off emissions permits to would come from auctioning off emissions permits to industries. The climate program would generate nearly industries. The climate program would generate nearly $650 billion between 2012 and 2019, according to $650 billion between 2012 and 2019, according to Obama's proposal.Obama's proposal.

About $80 billion of the climate revenues would go About $80 billion of the climate revenues would go toward Obama's proposed middle-class tax cut each toward Obama's proposed middle-class tax cut each year beginning in 2012, the draft says, and the year beginning in 2012, the draft says, and the government would spend $15 billion per year on "clean" government would spend $15 billion per year on "clean" energy technologies. In his address to Congress on energy technologies. In his address to Congress on Tuesday, Obama said those technologies would include Tuesday, Obama said those technologies would include wind power, solar power, advanced biofuels, "clean wind power, solar power, advanced biofuels, "clean coal" and more efficient cars and trucks.coal" and more efficient cars and trucks.

February 26, 2009 Obama's draft budget projects cap-February 26, 2009 Obama's draft budget projects cap-and-trade revenueand-trade revenue

Efficient AllocationEfficient Allocation

Marginal BenefitMarginal Benefit A measure of the benefits of the A measure of the benefits of the

next unit of the activitynext unit of the activity Marginal CostMarginal Cost

A measure of the costs of the next A measure of the costs of the next unit of the activityunit of the activity

MB=MCMB=MC efficiencyefficiency

Marginal BenefitsMarginal Benefits

Who gains from some allocation Who gains from some allocation of resources?of resources?

How much do they gain?How much do they gain? What are the various What are the various

dimensions of that gain?dimensions of that gain?

Marginal CostsMarginal Costs

Who pays for some allocation of Who pays for some allocation of resources?resources?

How much do they give up?How much do they give up? What are the various What are the various

dimensions of the costs?dimensions of the costs?

The Concept is SimpleThe Concept is Simple

Find the level of activity where Find the level of activity where MB=MCMB=MC

Zero profits drive resourcesZero profits drive resources Marginal Revenue Products Marginal Revenue Products

allocate revenues allocate revenues

Adding DimensionsAdding Dimensions

When we talk of the consumer’s When we talk of the consumer’s location in a spatial sense, we can location in a spatial sense, we can equally talk of the country in which equally talk of the country in which the consumer is located, the time of the consumer is located, the time of day, month or year at which the day, month or year at which the consumer would prefer to purchase consumer would prefer to purchase the commodity, or the consumer’s the commodity, or the consumer’s most preferred product variety in the most preferred product variety in the sense of Lancaster.sense of Lancaster.

Greenhut, Norman and Hung (1987)Greenhut, Norman and Hung (1987)

Private Property?Private Property?

TrespassTrespass NuisanceNuisance Are individuals islands?Are individuals islands?

ExternalitiesExternalities

An externality is an effect of a An externality is an effect of a purchase or use decision by one purchase or use decision by one set of parties on others who did set of parties on others who did not have a choice and whose not have a choice and whose interests were not taken into interests were not taken into account. account.

Classic example of a negative Classic example of a negative externalityexternality Pollution, generated by some Pollution, generated by some

productive enterprise, and productive enterprise, and affecting others who had no affecting others who had no choice and were probably not choice and were probably not taken into account.taken into account.

An example of a positive An example of a positive externalityexternality The effect of a well-educated The effect of a well-educated

labor force on the productivity of labor force on the productivity of a companya company

The result is public education – The result is public education – or that is the argument.or that is the argument.

Graph TimeGraph Time

Coase (1960),Coase (1960),

The spawn of which lead in two distinct The spawn of which lead in two distinct directions. directions.

The so-called Coase Theorem, based on The so-called Coase Theorem, based on the assumption of zero transaction costs, the assumption of zero transaction costs, led directly and indirectly to the private led directly and indirectly to the private property rights school of thought: individual property rights school of thought: individual actions can lead to efficient allocations as actions can lead to efficient allocations as long as property rights are designated. long as property rights are designated.

Stigler first coined the term “Coase Stigler first coined the term “Coase Theorem” to explain the theory of Theorem” to explain the theory of internalizing externalities.internalizing externalities.

Coase’s real purpose was quite Coase’s real purpose was quite the opposite.the opposite.

““The world of zero transaction The world of zero transaction costs has often been described costs has often been described as a Coasian world. Nothing as a Coasian world. Nothing could be further from the truth. could be further from the truth. It It is the world of modern economic is the world of modern economic theory, one which I was hoping theory, one which I was hoping to persuade economists to to persuade economists to leaveleave.” (Coase, 1988, 174, .” (Coase, 1988, 174, emphasis added.).emphasis added.).

He realized the importance of He realized the importance of transaction costs.transaction costs. When transaction costs are relevant, as When transaction costs are relevant, as

is the case in most of the currently is the case in most of the currently appropriate areas of discussion, Coase appropriate areas of discussion, Coase argued against the private solution. argued against the private solution.

The recognition of transaction costs not The recognition of transaction costs not only alters consumption behavior, but only alters consumption behavior, but also changes our way of knowing and also changes our way of knowing and forms of social organization by forms of social organization by requiring non-market institutions to requiring non-market institutions to intercede in the decision processes.intercede in the decision processes.

Internalizing the ExternalitiesInternalizing the Externalities

Graph againGraph again System benefitsSystem benefits

APS January 2010APS January 2010 Cost of net electricityCost of net electricity Basic service chargeBasic service charge $1.82$1.82 Delivery service chargeDelivery service charge $3.35$3.35 Environmental benefits surchargeEnvironmental benefits surcharge $0.86$0.86 Federal environmental improvement surchargeFederal environmental improvement surcharge $0.02$0.02 Competition rules compliance chargeCompetition rules compliance charge $0.03$0.03 System benefits chargeSystem benefits charge $0.19$0.19 Power supply adjustmentPower supply adjustment -$0.10-$0.10 MeteringMetering $2.60$2.60 Meter readingMeter reading $1.79$1.79 BillingBilling $2.02$2.02 Generation of electricityGeneration of electricity $4.46$4.46 Transmission and ancillary servicesTransmission and ancillary services $0.49$0.49 Transmission cost adjustmentTransmission cost adjustment $0.21$0.21 Interim rate surchargeInterim rate surcharge $0.07$0.07

Cost of electricity you usedCost of electricity you used 17.8117.81

Literally Nickel and DimingLiterally Nickel and Diming

Taxes and feesTaxes and fees

Regulatory assessmentRegulatory assessment$0.05$0.05

State sales taxState sales tax $1.00$1.00 County sales taxCounty sales tax $0.21$0.21 City sales taxCity sales tax

$0.00$0.00 Franchise feeFranchise fee

$0.00$0.00

Cost of electricity with taxes and feesCost of electricity with taxes and fees$19.07$19.07

Total charges for electricity servicesTotal charges for electricity services $19.07$19.07

Amount of electricity from APSAmount of electricity from APS

Meter reading on Jan 20 Meter reading on Jan 20 77947794 Meter reading on Dec 21 Meter reading on Dec 21 7484 7484 Total electricity from APS, in kWh Total electricity from APS, in kWh 310 310

Amount of electricity creditedAmount of electricity credited Meter reading on Jan 20 Meter reading on Jan 20 86298629 Meter reading on Dec 21 Meter reading on Dec 21 84138413 Total electricity credited, in kWh Total electricity credited, in kWh 216 216 Last month's kWh creditLast month's kWh credit 0 0

Net electricityNet electricity Electricity from APS, in kWh Electricity from APS, in kWh 310310 Minus electricity credited, in kWh Minus electricity credited, in kWh 216216 Minus last month's kWh creditMinus last month's kWh credit 0 0 Net electricity, in kWh Net electricity, in kWh 94 94

A Simple IdeaA Simple Idea

Collect: Collect: We must use mechanisms to establish a We must use mechanisms to establish a price for emissions and collect this pollution-based price for emissions and collect this pollution-based revenue to help fund a smart transition to a low-revenue to help fund a smart transition to a low-emission economy. emission economy.

Use elasticities to estimate the variation between Use elasticities to estimate the variation between the private market price and the social equilibrium the private market price and the social equilibrium price.price.

Forecasting toolsForecasting tools

Cap, Collect, and Invest ““Invest: Invest: We We mustmust invest this revenue to invest this revenue to

accelerate research, widespread accelerate research, widespread commercialization, and adoption of new commercialization, and adoption of new clean energy and efficiency technologies; clean energy and efficiency technologies; ensure that American workers and ensure that American workers and communities are buffered against near-communities are buffered against near-term price increases; and invest in term price increases; and invest in measures to prepare for and adapt to the measures to prepare for and adapt to the effects of global warming that are already effects of global warming that are already locked into the system, both here in the locked into the system, both here in the United States and in vulnerable, developing United States and in vulnerable, developing countries.”countries.”

http://www.americanprogress.org/issues/http://www.americanprogress.org/issues/2008/06/pdf/auction_revenue.pdf2008/06/pdf/auction_revenue.pdf

Cap and TradeCap and Trade

The goal: The goal: To steadily reduce carbon To steadily reduce carbon dioxide and other greenhouse gas dioxide and other greenhouse gas emissions from economic activity as part of emissions from economic activity as part of a larger plan for curbing global warming.a larger plan for curbing global warming.

The cap:The cap: Each large-scale emitter, or company, will Each large-scale emitter, or company, will

have a limit on the amount of greenhouse have a limit on the amount of greenhouse gas that it can emit. The firm must have an gas that it can emit. The firm must have an “emissions permit” for every ton of carbon “emissions permit” for every ton of carbon dioxide it releases into the atmosphere. dioxide it releases into the atmosphere. These permits set an enforceable limit, or These permits set an enforceable limit, or cap, on the amount of greenhouse gas cap, on the amount of greenhouse gas pollution that is released. Over time, the pollution that is released. Over time, the limits become stricter, allowing less and limits become stricter, allowing less and less pollution, until the ultimate reduction less pollution, until the ultimate reduction goal is met.goal is met.

The trade:The trade:

It will be relatively cheaper or easier for It will be relatively cheaper or easier for some companies to reduce their emissions some companies to reduce their emissions below their required limit than others. below their required limit than others. These more efficient companies, who emit These more efficient companies, who emit less than their allowance, can sell their less than their allowance, can sell their extra permits to companies that are not extra permits to companies that are not able to make reductions as easily. This able to make reductions as easily. This creates a system that guarantees a set creates a system that guarantees a set level of overall reductions, while rewarding level of overall reductions, while rewarding the most efficient companies and ensuring the most efficient companies and ensuring that the cap can be met at the lowest that the cap can be met at the lowest possible cost to the economy.possible cost to the economy.

The profits:The profits: If the federal government auctions the If the federal government auctions the

emissions permits to the companies required emissions permits to the companies required to reduce their emissions, it would create a to reduce their emissions, it would create a large and dependable revenue stream. These large and dependable revenue stream. These financial resources could be used to achieve financial resources could be used to achieve critical public policy objectives related to critical public policy objectives related to climate change mitigation and economic climate change mitigation and economic development. The federal government can development. The federal government can also choose to “grandfather” allowances to also choose to “grandfather” allowances to the polluting firms by handing them out free the polluting firms by handing them out free based on historic or projected emissions. This based on historic or projected emissions. This would give the most benefits to those would give the most benefits to those companies with higher baseline emissions companies with higher baseline emissions that have historically done the least to reduce that have historically done the least to reduce their pollution.their pollution.

From:From:

Investing in a Green Economy; Investing in a Green Economy; Using Cap-and-Trade Auction RUsing Cap-and-Trade Auction Revenue to Help American Familievenue to Help American Families and Spur Clean Energy Innoves and Spur Clean Energy Innovationation))

http://http://www.americanprogress.org/www.americanprogress.org/issues/2008/06/pdf/issues/2008/06/pdf/auction_revenue.pdfauction_revenue.pdf

http://www.state.mn.us/mn/exterhttp://www.state.mn.us/mn/externalDocs/Commerce/GovernancnalDocs/Commerce/Governance_Options_for_Carbon_Cap__Te_Options_for_Carbon_Cap__Trade_Revenue_022009040546_rade_Revenue_022009040546_GovernanceOptions_CapAndTrGovernanceOptions_CapAndTrade.pdfade.pdf