Lecture 2 Climate Finance: Some Financial Implications PDF

Lecture 2 Climate Finance: Some Financial Implications Climate Finance Prof João Amaro de Matos Venice, Ca’ Foscari April 9th, 2024 Climate Finance: Some Financial Implications Agenda Capital Structure Cost of Capital Climate Risk and Cost of C...

Lecture 2 Climate Finance: Some Financial Implications Climate Finance Prof João Amaro de Matos Venice, Ca’ Foscari April 9th, 2024 Climate Finance: Some Financial Implications Agenda Capital Structure Cost of Capital Climate Risk and Cost of Capital Penalty vs Costs of Change Externalities and Regulation Externalities and market failure Command-and-control regulation Market-oriented environmental tools Types of market-oriented tools Costs and benefits of environmental laws International environmental issues The trade-off between economic output and environmental protection Climate Finance | João Amaro de Matos 2 Capital Structure Climate Finance | João Amaro de Matos 3 The Capital structure issue A project may be financed in two different ways: With your own resources (equity 𝑆) With someone else’s resources (debt 𝐵) The value 𝑉 of a project is decomposed between the value to the shareholders (𝑆) and the value to the debtholders (𝐵): 𝑉 =𝑆+𝐵 The capital structure is characterized by the ratio 𝐵/𝑆 Climate Finance | João Amaro de Matos 4 The Capital structure issue Different corporations have different captal structures. This raises several questions: Is there an optimal capital structure? Is capital structure determined to maximize value 𝑉? What is the impact of more or less debt on value? What are the capital structure determinants per industry? How do those determinants depend on market timings? Climate Finance | João Amaro de Matos 5 The Capital structure issue The debate on how capital structure may afect the value 𝑉 involves two extreme visions: The traditional view argues that there should be an optimal structure that maximizes the value of organizations; Modigliani e Miller who provide the argument that the capital structure cannot create value in the absence of arbitrage opportunities. In-between both views there is intermediate one: That of net income. Market imperfections (including taxes and fiscal benefits of debt) allow managers to shape capital structure in such a way to maximize the value 𝑉 of the firm. Climate Finance | João Amaro de Matos 6 Capital structure: M&M Results Homogeneous Expectations Homogeneous risk class Perpetual Cash Flows Perfect Capital Markets: Perfect Competition; Borrowing/lending rate the same for individuals and organizations; Equal access to all relevant information; No transaction costs; No taxes. Climate Finance | João Amaro de Matos 7 Capital structure summary: No Taxes In a world of perfect markets without taxes the value of a firm is not affected by its capital structure. Proposition M&M I: 𝑽𝑳 = 𝑽𝑼 Proposition M&M I holds true as the shareholders may obtain any type of desired payoff by using homemade leverage. Proposition M&M II states that the presence of debt increases the risk to the shareholders and increases its expected payoff as a linear function of the debt-equity ratio 𝑩 𝑹𝒔 = 𝑹𝟎 + 𝑹𝟎 − 𝑹𝒃 𝑺 Climate Finance | João Amaro de Matos 8 Capital structure summary: With Taxes In a world of perfect markets with taxes the value of a firm grows with debt. Proposition M&M I: 𝑽𝑳 = 𝑽𝑼 +𝑻𝒄 𝑩 Proposition M&M I holds true as the shareholders may obtain any type of desired payoff by using homemade leverage and benefiting from the tax advantage of debt. Proposition M&M II states that the presence of taxes decreases the rate at which the expected return increases as a function of 𝑩 the debt-equity ratio, 𝑹𝒔 = 𝑹𝟎 + 𝑺 𝑹𝟎 − 𝑹𝒃 𝟏 − 𝑻𝑪 𝑳 Climate Finance | João Amaro de Matos 9 Cost of Capital Climate Finance | João Amaro de Matos 10 Cost of Capital and Capital Market Line (CML) The goal is to relate the relate the cost of capital with the risk of the project. The shareholders’ risk is the risk of the shares of the firm No debt ⇒ 𝑅0 = 𝑅𝑓 + 𝛽0 𝐸𝑀 − 𝑅𝑓 With debt ⇒ 𝑅𝑠 = 𝑅𝑓 + 𝛽𝑠 𝐸𝑀 − 𝑅𝑓 In what follows we assume that debt is riskless: 𝛽𝑏 = 0 ⇒ 𝑅𝑏 = 𝑅𝑓. Climate Finance | João Amaro de Matos 11 Cost of Capital and Capital Market Line (CML) From the security market line (CAPM) we have 𝑅𝑠 = 𝑅𝑓 + 𝛽𝑠 𝐸𝑀 − 𝑅𝑓 𝑅0 = 𝑅𝑓 + 𝛽0 𝐸𝑀 − 𝑅𝑓 It follows that ⇒ 𝑅𝑠 −𝑅0 = 𝛽𝑠 − 𝛽0 𝐸𝑀 − 𝑅𝑓 But remember from M&M II that: 𝐵 𝐵 𝑅𝑠 = 𝑅0 + 𝑅0 − 𝑅𝑏 1 − 𝑇𝐶 ⇒ 𝑅𝑠 − 𝑅0 = 𝑅0 − 𝑅𝑓 1 − 𝑇𝐶 𝑆𝐿 𝑆𝐿 Climate Finance | João Amaro de Matos 12 Cost of Capital and Capital Market Line (CML) Making equal both right-hand sides of ⇒ 𝑅𝑠 −𝑅0 = 𝛽𝑠 − 𝛽0 𝐸𝑀 − 𝑅𝑓 𝐵 ⇒ 𝑅𝑠 − 𝑅0 = 𝑅0 − 𝑅𝑓 1 − 𝑇𝐶 𝑆𝐿 Leads to 𝐵 ⇒ 𝛽𝑠 − 𝛽0 𝐸𝑀 − 𝑅𝑓 = 𝛽0 𝐸𝑀 − 𝑅𝑓 1 − 𝑇𝐶 𝑆𝐿 Isolating 𝛽𝑠 we obtain: 𝐵 𝛽𝑠 = 1 + 1 − 𝑇𝐶 𝛽0 𝑆𝐿 Climate Finance | João Amaro de Matos 13 Climate Risk and Cost of Capital Climate Finance | João Amaro de Matos 14 Climate Risk and the Cost of Capital Climate risk can have significant implications for the cost of capital for firms. The cost of capital represents the required return or discount rate that investors expect in exchange for investing in a company's equity or debt. Climate risk can affect the cost of capital in several ways: Climate Finance | João Amaro de Matos 15 Climate Risk and the Cost of Capital 1. Increased Risk Perception: Climate-related risks, such as physical risks from extreme weather events, regulatory risks, or reputational risks, can increase investors' perception of the overall risk associated with a company. Higher perceived risk leads to higher expected returns to compensate investors for taking on that risk. As a result, the cost of equity capital tends to increase for companies exposed to climate risks. Climate Finance | João Amaro de Matos 16 Climate Risk and the Cost of Capital 2. Valuation Impact: Climate-related risks can affect the valuation of a company's assets and future cash flows. For instance, companies operating in sectors vulnerable to climate change, such as fossil fuel industries, may face devaluation of their assets due to concerns about stranded assets or potential regulatory restrictions. The lower asset valuations can lead to higher perceived risk and, consequently, higher costs of capital. Climate Finance | João Amaro de Matos 17 Climate Risk and the Cost of Capital 3. Regulatory and Policy Changes: Climate-related regulations and policies, such as carbon pricing or emissions reduction targets, can have direct financial impacts on companies. Compliance costs, increased taxation, or potential penalties associated with climate-related regulations can increase the overall cost structure of a company, affecting its profitability and, subsequently, the cost of capital. Climate Finance | João Amaro de Matos 18 Climate Risk and the Cost of Capital 4. Physical Risk and Business Disruptions: Climate change can result in physical risks that directly impact business operations. Extreme weather events, sea-level rise, or supply chain disruptions can cause business interruptions, property damage, or increased insurance costs. These physical risks introduce additional uncertainties and potential costs for companies, which can be reflected in the higher cost of capital. Climate Finance | João Amaro de Matos 19 Climate Risk and the Cost of Capital 5. Reputational Risks and Stakeholder Perception: Climate-related concerns and the perceived environmental and social responsibility of a company can influence stakeholder perception and reputation. Negative public perception, protests, or consumer boycotts associated with a company's climate practices can harm its brand image and potentially affect its market value. Reputational risks can increase the cost of capital by reducing investor confidence and raising concerns about future revenue streams. Climate Finance | João Amaro de Matos 20 Climate Risk and the Cost of Capital 6. Transition Risks: The transition to a low-carbon economy and efforts to mitigate climate change can create risks and uncertainties for companies. Sudden shifts in market preferences, technological advancements, or changes in regulations can impact the viability and profitability of certain business models. Uncertainty about the transition to a low-carbon economy can increase the perceived risk and cost of capital for companies operating in carbon-intensive sectors. Climate Finance | João Amaro de Matos 21 Penalty vs. Costs of Change Climate Finance | João Amaro de Matos 22 Penalty and cost of implementation Above we described the main factors that may affect the cost of capital. Let us start with a simper exercise in our MM context, though. Regulations impose changes in procedures that come at a cost 𝑐 in perpetuity, or otherwise imposes a penalty τ, also in perpetuity. Both these things reduce the cash flow to the shareholders. The first exercise is to understand if, ceteris paribus, the Propositions MM II change. The second exercise is to understand how large should the penalty be as a function of the cost of implementing the required changes. Climate Finance | João Amaro de Matos 23 Penalty and cost of implementation In fact, both alternatives, penalty or costs of implementing changes, will decrease the payoff to the shareholders, but not to the credit holders. For the case of costs 𝑐, if 𝑋 is generated per period, the cash flows are : To the debt holders: 𝑅𝑏 𝐵 To the shareholders: 𝑋 − 𝑐 − 𝑅𝑏 𝐵 1 − 𝑇𝐶 In perpetuity, the value of equity is obtained discounting at 𝑅𝑠 , 𝑋 − 𝑐 − 𝑅𝑏 𝐵 1 − 𝑇𝐶 𝑐 1 − 𝑇𝐶 𝑆𝐿,𝑐 = = 𝑆𝐿 − 𝑅𝑠 𝑅𝑠 Where 𝑆𝐿 is the value of equity under no cost of implementation. Climate Finance | João Amaro de Matos 24 Penalty and cost of implementation For the case of penalties τ, if 𝑋 is generated per period, the cash flows are : To the debt holders: 𝑅𝑏 𝐵 To the shareholders: 𝑋 − 𝑅𝑏 𝐵 1 − 𝑇𝐶 − τ In perpetuity, the value of equity is obtained discounting at 𝑅𝑠 , 𝑋 − 𝑅𝑏 𝐵 1 − 𝑇𝐶 − τ τ 𝑆𝐿,τ = = 𝑆𝐿 − 𝑅𝑠 𝑅𝑠 Where 𝑆𝐿 is the value of equity under no penalty. Climate Finance | João Amaro de Matos 25 Penalty and cost of implementation Exercise 1: just replicate the proof above a) For the case of penalty τ ⇒ 𝑋 1 − 𝑇𝐶 = 𝑆𝐿 + 𝐵 1 − 𝑇𝐶 𝑅0 + τ ⇒ 𝑋 1 − 𝑇𝐶 = 𝑆𝐿 𝑅𝑠 + 𝑅𝑏 𝐵 1 − 𝑇𝐶 + τ b) For the case of costs 𝑐 ⇒ 𝑋 1 − 𝑇𝐶 = 𝑆𝐿 + 𝐵 1 − 𝑇𝐶 𝑅0 + 𝑐 1 − 𝑇𝐶 ⇒ 𝑋 1 − 𝑇𝐶 = 𝑆𝐿 𝑅𝑠 + 𝑅𝑏 𝐵 1 − 𝑇𝐶 + 𝑐 1 − 𝑇𝐶 Equalizing in both cases cancel the last terms and lead to the traditional Climate Finance | João Amaro de Matos 26 Penalty and cost of implementation Exercise 1: Equalizing both equations in (a) cancels the term τ, and doing the same thing in (b) cancels the term 𝑐 1 − 𝑇𝐶 , leading to the traditional 𝐵 𝑅𝑠 = 𝑅0 + 𝑅0 − 𝑅𝑏 1 − 𝑇𝐶 𝑆𝐿 Note that this does not mean however, that the rates 𝑅𝑠 , 𝑅𝑏 and 𝑅0 may not change – what we are saying is that the interrelation between them are kept constant. These costs of capital may indeed change, as a function of the factors enumerated above. Climate Finance | João Amaro de Matos 27 Penalty and cost of implementation Exercise 2: how large should the penalty be as a function of the cost of implementing the required changes? For the case of penalties τ, there is a decrease in value for the shareholders of τ/𝑅𝑠. For the case of costs 𝑐, there is a decrease in value for the shareholders of 𝑐 1 − 𝑇𝐶 /𝑅𝑠. Thus, in this simple setting, the penalty will only be effective if τ > 𝑐 1 − 𝑇𝐶 Climate Finance | João Amaro de Matos 28 Penalty and cost of implementation Determining the appropriate penalty for non-conforming to climate change regulations in relation to the costs of implementing the measures is a complex and context-specific issue. There is no one-size-fits-all answer as it depends on various factors, including the severity of the non-compliance, the specific regulatory framework, the industry, and the broader societal and environmental considerations. Here are some key points to consider: Climate Finance | João Amaro de Matos 29 Penalty and cost of implementation 1. Deterrence and Enforcement: The penalty for non-conformance should be designed to deter non- compliance and ensure enforcement of climate change regulations. The penalty should be substantial enough to discourage companies from violating the regulations, but not excessively punitive to the point of causing disproportionate harm to the company or stifling innovation and economic growth. Climate Finance | João Amaro de Matos 30 Penalty and cost of implementation 2. Cost-Benefit Analysis: Assessing the penalty in relation to the costs of implementing measures involves conducting a cost-benefit analysis. It requires evaluating the potential economic, environmental, and social benefits of compliance with climate change regulations against the costs incurred by the company to implement the necessary measures. The penalty should align with the goal of incentivizing companies to adopt sustainable practices while taking into account the economic feasibility and competitiveness of the affected industries. Climate Finance | João Amaro de Matos 31 Penalty and cost of implementation 3. Proportional Approach: A proportional approach suggests that the penalty should be proportionate to the severity and impact of the non-conformance. The magnitude of the penalty should reflect the extent of harm caused by non-compliance and the potential benefits lost to society from the company's failure to adopt sustainable practices. It should be balanced and commensurate with the violation to ensure fairness and equity. Climate Finance | João Amaro de Matos 32 Penalty and cost of implementation 4. Graduated Approach: Regulatory frameworks often employ a graduated approach to penalties, with escalating consequences for repeated or more severe non-compliance. Graduated penalties provide companies with an opportunity to rectify their non-compliance, learn from their mistakes, and gradually improve their adherence to climate change regulations. It also encourages companies to proactively implement measures and avoid larger penalties in the future. Climate Finance | João Amaro de Matos 33 Penalty and cost of implementation 5. Contextual Considerations: Different industries and sectors may face varying challenges and costs associated with implementing climate change measures. Regulatory bodies should consider the specific circumstances and capabilities of companies when determining penalties. Small and medium-sized enterprises (SMEs) or industries with limited financial resources may require flexibility or support mechanisms to ensure compliance without disproportionate burdens. Climate Finance | João Amaro de Matos 34 Penalty and cost of implementation 6. Externalities and Societal Costs: When setting penalties, it's important to consider the broader societal costs of non-compliance with climate change regulations. Climate change poses significant risks to the environment, public health, and social well-being. The penalty should account for the externalities associated with non- conformance, reflecting the potential damages and costs imposed on society as a whole. Climate Finance | João Amaro de Matos 35 Penalty and cost of implementation Ultimately, finding the right balance between penalties and the costs of implementing climate change measures requires careful analysis and stakeholder engagement. Regulatory bodies, policymakers, industry representatives, and environmental experts should collaborate to develop regulations and penalties that strike a reasonable balance between promoting compliance, encouraging innovation, and addressing the urgent need to mitigate climate change. Climate Finance | João Amaro de Matos 36 Externalities Climate Finance | João Amaro de Matos 37 Externalities and Market Failure The economics of Pollution From 1970 to 2012, the population of the United States increased by one- third and the size of the US economy more than doubled. Despite this growth, the United States, using a variety of anti-pollution policies, has made genuine progress against a number of pollutants. According to the US Energy Information Administration, the emissions of certain key air pollutants declined substantially from 2007 to 2012; in fact, they dropped 730 million metric tons a year—a 12% reduction. This seems to indicate that progress has been made in the United States in reducing overall carbon dioxide emissions, which cause greenhouse gases. Climate Finance | João Amaro de Matos 38 Externalities and Market Failure Despite the gradual reduction in emissions from fossil fuels, many important environmental issues remain. Along with the still-high levels of air and water pollution, other issues include hazardous waste disposal, destruction of wetlands and other wildlife habitats, and the impact of pollution on human health. Climate Finance | João Amaro de Matos 39 Externalities and Market Failure Private markets offer an efficient way to put buyers and sellers together and determine what goods are produced, how they are produced, and who gets them. The principle that voluntary exchange benefits both buyers and sellers is a fundamental building block of the economic way of thinking. But what happens when a voluntary exchange affects a third party who is neither the buyer nor the seller? Climate Finance | João Amaro de Matos 40 Externalities and Market Failure Consider, for example, a concert producer who wants to build an outdoor arena that will host country music concerts a half-mile from your neighbourhood. You will be able to hear these outdoor concerts while sitting on your back porch—or perhaps even in your dining room. In this case, the sellers and buyers of concert tickets may both be quite satisfied with their voluntary exchange, but you have no voice in their market transaction. The effect of a market exchange on a third party who is outside, or external, to the exchange is called an externality. Climate Finance | João Amaro de Matos 41 Externalities and Market Failure Because externalities that occur in market transactions affect other parties beyond those involved, they are sometimes called spill overs. Externalities can be negative or positive. If you hate country music, then having it waft into your house every night would be a negative externality. If you love country music, then what amounts to a series of free concerts would be a positive externality. Climate Finance | João Amaro de Matos 42 Externalities and Market Failure Back to the case of Pollution as a negative externality Pollution is a negative externality. Economists illustrate the social costs of production with a demand and supply diagram. The social costs include the private costs of production incurred by the company and the external costs of pollution that are passed on to society. The diagram below shows the demand and supply for manufacturing refrigerators. Climate Finance | João Amaro de Matos 43 Externalities and Market Failure The demand curve, D, shows the quantity demanded at each price. The supply curve, 𝑆𝑝𝑟𝑖𝑣𝑎𝑡𝑒 , shows the quantity of refrigerators supplied by all the firms at each price if they are taking only their private costs into account and they are allowed to emit pollution at zero cost. The market equilibrium, 𝐸0 , where quantity supplied and quantity demanded are equal, is at a price of $650 and a quantity of 45,000. Climate Finance | João Amaro de Matos 44 Externalities and Market Failure Pollution as a negative externality The situation is not actually that simple, however. Pollution is created as a by-product of the metals, plastics, chemicals, and energy that are used in manufacturing refrigerators. Lets us say that, if these pollutants were emitted into the air and water, they would create costs of $100 per refrigerator produced. These costs might occur because of injuries to human health, impact on property values, destruction of wildlife habitat, reduction of recreation possibilities, or because of other negative impacts. Climate Finance | João Amaro de Matos 45 Externalities and Market Failure In a market with no anti-pollution restrictions, firms can dispose of certain wastes at no cost. Now imagine that firms that produce refrigerators must factor in these external costs of pollution—that is, the firms have to consider not only the costs of labour and materials needed to make a refrigerator but also the broader costs to society from pollution. If the firm is required to pay $100 for the additional external costs of pollution each time it produces a refrigerator, production becomes more costly and the entire supply curve shifts up by $100. Climate Finance | João Amaro de Matos 46 Externalities and Market Failure A supply shift caused by pollution costs Quantity supplied before Quantity supplied after Price Quantity demanded considering pollution cost considering pollution cost $600 50,000 40,000 30,000 $650 45,000 45,000 35,000 $700 40,000 50,000 40,000 $750 35,000 55,000 45,000 $800 30,000 60,000 50,000 $850 25,000 65,000 55,000 $900 20,000 70,000 60,000 Climate Finance | João Amaro de Matos 47 Externalities and Market Failure Notice the fourth column of the table above. Taking external costs of pollution into account, the firm will need to receive a price of $700 per refrigerator and produce a quantity of 40,000. You can also see this shift on the graph by looking at supply curve 𝑆𝑠𝑜𝑐𝑖𝑎𝑙. The new equilibrium will occur at 𝐸1. Taking the additional external costs of pollution into account results in a higher price, a lower quantity of production, and a lower quantity of pollution. Climate Finance | João Amaro de Matos 48 Externalities and Market Failure Remember that supply curves are based on choices about production that firms make while looking at their marginal costs; Demand curves are based on the benefits that individuals perceive while maximizing utility. If no externalities existed, private costs would be the same as the costs to society as a whole, and private benefits would be the same as the benefits to society as a whole. Thus, if no externalities existed, the interaction of demand and supply would coordinate social costs and benefits. But the reality is that externalities do exist. Because of this, a supply curve showing private costs doesn't actually represent all social costs. Climate Finance | João Amaro de Matos 49 Externalities and Market Failure Because externalities represent a case where markets no longer consider all social costs but only some of them, economists commonly refer to externalities as an example of market failure. When there is market failure, the private market fails to achieve efficient output because either firms do not account for all costs incurred in the production of output and/or consumers do not account for all benefits obtained, in the case of a positive externality. In the case of pollution, at the market output, social costs of production exceed social benefits to consumers, and the market produces too much of the product. Climate Finance | João Amaro de Matos 50 Externalities and Market Failure There is a general concept here. If firms are required to pay the social costs of pollution, they create less pollution but produce less of the product and charge a higher price. Climate Finance | João Amaro de Matos 51 Command-and-control regulation When the United States started passing comprehensive environmental laws in the late 1960s and early 1970s, a typical law specified how much pollution could be emitted out of a smokestack or a drainpipe. These laws also imposed penalties if pollution limits were exceeded. Other laws required the installation of certain equipment—for example, on automobile tailpipes or on smokestacks—to reduce pollution. Both laws that specify allowable quantities of pollution and laws that detail which pollution-control technologies must be used fall under the category of command-and-control regulation. In effect, command-and-control regulation requires that firms increase their costs by installing anti-pollution equipment; firms are thus required to take the social costs of pollution into account. Climate Finance | João Amaro de Matos 52 Command-and-control regulation Command-and-control regulation has been highly successful in protecting and cleaning up the US environment. In 1970, the Environmental Protection Agency was created to oversee all environmental laws. In the same year, the Clean Air Act was enacted to address air pollution. Just two years later, in 1972, Congress passed and the president signed the far-reaching Clean Water Act. These command-and-control environmental laws, and their amendments and updates, have been largely responsible for cleaner air and water in the United States in recent decades. However, economists have pointed out three difficulties with command- and-control environmental regulation. Climate Finance | João Amaro de Matos 53 Command-and-control regulation First, command-and-control regulation offers no incentive to improve the quality of the environment beyond the standard set by a particular law. Once the command-and-control regulation has been satisfied, polluters have zero incentive to do better. Second, command-and-control regulation is inflexible. It usually requires the same standard for all polluters, and often the same pollution-control technology as well. This means that command-and-control regulation draws no distinctions between firms that would find it easy and inexpensive to meet the pollution standard—or to reduce pollution even further—and firms that might find it difficult and costly to meet the standard. Firms have no reason to rethink their production methods in fundamental ways that might reduce pollution even more and at lower cost. Climate Finance | João Amaro de Matos 54 Command-and-control regulation Third, command-and-control regulations are written by legislators and the Environmental Protection Agency, so they are subject to compromises in the political process. Existing firms often argue—and lobby—that stricter environmental standards should not apply to them, only to new firms that wish to start production. Consequently, real-world environmental laws are full of fine print, loopholes, and exceptions. Critics of command-and-control regulation understand the goal of reducing pollution, but they question whether this type of regulation is the best way to design policy tools for accomplishing that goal. Climate Finance | João Amaro de Matos 55 Market-oriented environmental tools Market-oriented environmental policies create incentives to allow firms some flexibility in reducing pollution. The three main categories of market-oriented approaches to pollution control are pollution charges, marketable permits, and better-defined property rights. Climate Finance | João Amaro de Matos 56 Market-oriented environmental tools A pollution charge is a tax imposed on the quantity of pollution that a firm emits. A pollution charge gives a profit-maximizing firm an incentive to figure out ways to reduce its emissions—as long as the marginal cost of reducing the emissions is less than the tax. Climate Finance | João Amaro de Matos 57 Market-oriented environmental tools A marketable permit program is a program in which a city or state government issues permits allowing only a certain quantity of pollution. These permits to pollute can be sold or given to firms free. Climate Finance | João Amaro de Matos 58 Market-oriented environmental tools A clarified and strengthened idea of property rights can also strike a balance between economic activity and pollution. For instance, a policy that provides private landowners with an incentive to protect endangered species on their land can be an effective environmental protection tool. Climate Finance | João Amaro de Matos 59 Types of Market-oriented tools Pollution charges A pollution charge is a tax imposed on the quantity of pollution that a firm emits. A pollution charge gives a profit-maximizing firm an incentive to figure out ways to reduce its emissions—as long as the marginal cost of reducing the emissions is less than the tax. For example, consider a small firm that emits 50 pounds per year of small particles, such as soot, into the air. Particulate matter, as it is called, causes respiratory illnesses and also imposes costs on firms and individuals. The graph below illustrates the marginal costs that a firm faces in reducing pollution. Climate Finance | João Amaro de Matos 60 Types of Market-oriented tools The marginal cost of pollution reduction, like most marginal cost curves increases with output, at least in the short run. Reducing the first 10 pounds of particulate emissions costs the firm $300. Reducing the second 10 pounds would cost $500. The third ten pounds would cost $900, the fourth 10 pounds $1,500, and the fifth 10 pounds $2,500. This pattern for the costs of reducing pollution is common—the firm can use the cheapest and easiest method to make initial reductions in pollution, but additional reductions in pollution become more expensive. Climate Finance | João Amaro de Matos 61 Types of Market-oriented tools Imagine the firm now faces a pollution tax of $1,000 for every 10 pounds of particulates emitted. The firm has the choice of either polluting and paying the tax, or reducing the amount of particulates they emit and paying the cost of abatement as shown in the graph above. How much will the firm pollute and how much will the firm abate? Climate Finance | João Amaro de Matos 62 Types of Market-oriented tools The first 10 pounds would cost the firm $300 to abate. This is substantially less than the $1,000 tax, so they will choose to abate. The second 10 pounds would cost $500 to abate, which is still less than the tax, so they will choose to abate. The third 10 pounds would cost $900 to abate, which is slightly less than the $1,000 tax. The fourth 10 pounds would cost $1,500, which is much more costly than paying the tax. As a result, the firm will decide to reduce pollutants by 30 pounds because the marginal cost of reducing pollution by this amount is less than the pollution tax. With a tax of $1,000, the firm has no incentive to reduce pollution more than 30 pounds. Climate Finance | João Amaro de Matos 63 Types of Market-oriented tools A firm that has to pay a pollution tax will have an incentive to figure out the least expensive technologies for reducing pollution. Firms that can reduce pollution cheaply and easily will do so to minimize their pollution taxes, whereas firms that will incur high costs for reducing pollution will end up paying the pollution tax instead. If the pollution tax applies to every source of pollution, then no special favouritism or loopholes are created for politically well- connected producers. Climate Finance | João Amaro de Matos 64 Types of Market-oriented tools For an example of a pollution charge at the household level, let's consider two ways of charging for garbage collection. One method is to have a flat fee per household, no matter how much garbage a household produces. An alternative approach is to have several levels of fees, depending on how much garbage the household produces and to offer lower or free charges for recyclable materials. As of 2006, the US Environmental Protection Agency had recorded over 7,000 communities that have implemented pay-as-you-throw programs. When people have a financial incentive to put out less garbage and to increase recycling, they find ways of doing so. Climate Finance | João Amaro de Matos 65 Types of Market-oriented tools A number of environmental policies are really pollution charges, although they often do not travel under that name. For example, the federal government and many state governments impose taxes on gasoline. We can view this tax as a charge on the air pollution that cars generate as well as a source of funding for maintaining roads. Climate Finance | João Amaro de Matos 66 Types of Market-oriented tools Similarly, the refundable charge of five or 10 cents that some states have for returning recyclable cans and bottles works like a pollution tax that provides an incentive to avoid littering or throwing bottles in the trash. Compared with command-and-control regulation, a pollution tax reduces pollution in a more flexible and cost-effective way. Climate Finance | João Amaro de Matos 67 Types of Market-oriented tools Marketable permits When a city or state government sets up a marketable permit program—for example, cap and trade—it must start by determining the overall quantity of pollution it will allow as it tries to meet national pollution standards. Then, a number of permits allowing only this quantity of pollution are divided among the firms that emit that pollutant. These permits to pollute can be sold or given to firms free. Climate Finance | João Amaro de Matos 68 Types of Market-oriented tools Now, add two more conditions. Imagine that these permits are designed to reduce total emissions over time. For example, a permit may allow emission of 10 units of pollution one year, but only 9 units the next year, then 8 units the year after that, and so on down to some lower level. In addition, imagine that these are marketable permits, meaning that firms can buy and sell them. Climate Finance | João Amaro de Matos 69 Types of Market-oriented tools To see how marketable permits can work to reduce pollution, consider the four firms listed in the table below. The table shows current emissions of lead from each firm. At the start of the marketable permit program, each firm receives permits to allow this level of pollution. However, these permits are shrinkable, and next year the permits allow the firms to emit only half as much pollution. Climate Finance | João Amaro de Matos 70 Types of Market-oriented tools How marketable permits work Firm Alpha Firm Beta Firm Gamma Firm Delta Current emissions— permits distributed 200 tons 400 tons 600 tons 0 tons free for this amount How much pollution will these permits 100 tons 200 tons 300 tons 0 tons allow in one year? Actual emissions one 150 tons 200 tons 200 tons 50 tons year in the future Buyer or seller of Buys permits for 50 Doesn’t buy or sell Sells permits for 100 Buys permits for 50 marketable permit? tons permits tons tons Climate Finance | João Amaro de Matos 71 Types of Market-oriented tools Let’s say that in a year, Firm Gamma finds it easy and cheap to reduce emissions from 600 tons of lead to 200 tons, which means that it has permits that it is not using that allow emitting 100 tons of lead. Firm Beta reduces its lead pollution from 400 tons to 200 tons, so it does not need to buy any permits, and it does not have any extra permits to sell. However, although Firm Alpha can easily reduce pollution from 200 tons to 150 tons, it finds that it is cheaper to purchase permits from Gamma rather than to reduce its own emissions to 100. Meanwhile, Firm Delta did not even exist in the first period, so the only way it can start production is to purchase permits to emit 50 tons of lead. Climate Finance | João Amaro de Matos 72 Types of Market-oriented tools The total quantity of pollution will decline. But the buying and selling of the marketable permits will determine exactly which firms reduce pollution and by how much. With a system of marketable permits, the firms that find it least expensive to do so will reduce pollution the most. Climate Finance | João Amaro de Matos 73 Types of Market-oriented tools Better-defined property rights A clarified and strengthened idea of property rights can also strike a balance between economic activity and pollution. Ronald Coase, who won the 1991 Nobel Prize in economics, offered a vivid illustration of an externality: a railroad track running beside a farmer’s field where the railroad locomotive sometimes gives off sparks and sets the field ablaze. Coase asked whose responsibility it was to address this spill over. Should the farmer be required to build a tall fence alongside the field to block the sparks? Or should the railroad be required to put some gadget on the locomotive’s smokestack to reduce the number of sparks? Climate Finance | João Amaro de Matos 74 Types of Market-oriented tools Coase pointed out that this issue cannot be resolved until property rights are clearly defined—that is, the legal rights of ownership on which others are not allowed to infringe without paying compensation. Does the farmer have a property right not to have a field burned? Does the railroad have a property right to run its own trains on its own tracks? If neither party has a property right, then the two sides may squabble endlessly, nothing will be done, and sparks will continue to set the field aflame. However, if either the farmer or the railroad has a well-defined legal responsibility, then that party will seek out and pay for the least costly method of reducing the risk that sparks will hit the field. The property right determines whether the farmer or the railroad pays the bills. Climate Finance | João Amaro de Matos 75 Types of Market-oriented tools The property rights approach is highly relevant in cases involving endangered species. The US government’s endangered species list includes about 1,000 plants and animals, and about 90% of these species live on privately owned land. The protection of these endangered species requires careful thinking about incentives and property rights. The discovery of an endangered species on private land has often triggered an automatic reaction from the government to prohibit the landowner from using that land for any purpose that might disturb the imperilled creatures. Climate Finance | João Amaro de Matos 76 Types of Market-oriented tools Consider the incentives of that policy: if you admit to the government that you have an endangered species, the government effectively prohibits you from using your land. As a result, rumours abound of landowners who follow a policy of “shoot, shovel, and shut up” when they find an endangered animal on their land. Other landowners have deliberately cut trees or managed land in a way that they knew would discourage endangered animals from locating there. Climate Finance | João Amaro de Matos 77 Types of Market-oriented tools A more productive policy would consider how to provide private landowners with an incentive to protect the endangered species that they find and to provide a habitat for additional endangered species. For example, the government might pay landowners who provide and maintain suitable habitats for endangered species or who restrict the use of their land to protect an endangered species. Again, an environmental law built on incentives and flexibility offers greater promise than a command-and-control approach, which tries to oversee millions of acres of privately owned land. Climate Finance | João Amaro de Matos 78 Benefits and costs of environmental laws Government economists have estimated that US firms may pay more than $200 billion per year to comply with federal environmental laws. That's big bucks. Is the money well spent? The benefits of a cleaner environment can be divided into four areas: People may stay healthier and live longer. Certain industries that rely on clean air and water—such as farming, fishing, and tourism—may benefit. Property values may be higher. People may simply enjoy a cleaner environment in a way that does not need to involve a market transaction. Climate Finance | João Amaro de Matos 79 Benefits and costs of environmental laws Some of these benefits, such as gains to tourism or farming, are relatively easy to value in economic terms. It is harder to assign a monetary value to others, such as the value of clean air for someone with asthma. It seems impossible to put a clear-cut monetary value on still others, such as the satisfaction you might feel from knowing that the air is clear over the Grand Canyon, even if you have never visited the Grand Canyon. Climate Finance | João Amaro de Matos 80 Benefits and costs of environmental laws Although estimates of environmental benefits are not precise, they can still be revealing. For example, a study by the US Environmental Protection Agency, or EPA, looked at the costs and benefits of the Clean Air Act from 1970 to 1990. It found that total costs over that time period were roughly $500 billion—a huge amount. However, it also found that a middle-range estimate of the health and other benefits from cleaner air was $22 trillion—about 44 times higher than the costs. Climate Finance | João Amaro de Matos 81 Benefits and costs of environmental laws A more recent study by the EPA estimated that the environmental benefits to Americans from the Clean Air Act will exceed their costs by a margin of four to one. The EPA estimated that “in 2010 the benefits of Clean Air Act programs will total about $110 billion. This estimate represents the value of avoiding increases in illness and premature death which would have prevailed.” Climate Finance | João Amaro de Matos 82 Benefits and costs of environmental laws Saying that overall benefits of environmental regulation have exceeded costs in the past, however, is very different from saying that every environmental regulation makes sense. For example, studies suggest that when breaking down emission reductions by type of contaminants, the benefits of air pollution control outweigh the costs primarily for particulates and lead. When looking at other air pollutants, the costs of reducing them may be comparable to or greater than the benefits. Climate Finance | João Amaro de Matos 83 Benefits and costs of environmental laws Ecotourism: making environmentalism pay The definition of ecotourism is a little vague. Does it mean sleeping on the ground, eating roots, and getting close to wild animals? Does it mean flying in a helicopter to shoot anaesthetic darts at African wildlife? Or a little of both? The definition may be fuzzy, but tourists who hope to appreciate the ecology of their destination—eco-tourists—are the impetus for a large and growing business. The International Ecotourism Society estimates that international tourists interested in seeing nature or wildlife will take 1.56 billion trips by 2020. Climate Finance | João Amaro de Matos 84 Benefits and costs of environmental laws Realizing the attraction of ecotourism, the residents of low-income countries may come to see that preserving wildlife habitats is more lucrative than, say, cutting down forests or grazing livestock to survive. In South Africa, Namibia, and Zimbabwe, for example, a substantial expansion of both rhinoceros and elephant populations is broadly credited to ecotourism, which has given local communities an economic interest in protecting them. Climate Finance | João Amaro de Matos 85 Benefits and costs of environmental laws Some of the leading ecotourism destinations include Costa Rica and Panama in Central America; the Caribbean; Malaysia, and other South Pacific destinations; New Zealand; the Serengeti in Tanzania; the Amazon rain forest; and the Galapagos Islands. In many of these countries and regions, governments have enacted policies whereby revenues from ecotourism are shared with local communities, giving people in those communities a kind of property right that encourages them to conserve their local environment. Climate Finance | João Amaro de Matos 86 Benefits and costs of environmental laws Ecotourism needs careful management so that the combination of eager tourists and local entrepreneurs does not destroy what the visitors are coming to see. But whatever one’s qualms are about certain kinds of ecotourism— such as the occasional practice of rich tourists shooting elderly lions with high-powered rifles—it is worth remembering that the alternative is often that people with low incomes living in poor countries will damage their local environment in their effort to survive. Climate Finance | João Amaro de Matos 87 Benefits and costs of environmental laws Marginal benefits and marginal costs We can use the tools of marginal analysis—like the diagram below— to illustrate the marginal costs and the marginal benefits of reducing pollution. Climate Finance | João Amaro de Matos 88 Benefits and costs of environmental laws When the quantity of environmental protection is low so that pollution is extensive—for example, at quantity 𝑄𝐴 —there are usually a lot of relatively cheap and easy ways to reduce pollution, and the marginal benefits of doing so are quite high. At 𝑄𝐴 , it makes sense to allocate more resources to fight pollution. However, as the extent of environmental protection increases, the cheap and easy ways of reducing pollution begin to decrease, and more costly methods must be used. The marginal cost curve rises. Also, as environmental protection increases, marginal benefits are reduced. Climate Finance | João Amaro de Matos 89 Benefits and costs of environmental laws As the quantity of environmental protection increases to 𝑄𝐵 , the gap between marginal benefits and marginal costs narrows. At point 𝑄𝐶 , the marginal costs exceed the marginal benefits. At this level of environmental protection, society is not allocating resources efficiently because too many resources are being given up to reduce pollution. As society draws closer to 𝑄𝐵 , some might argue that it becomes more important to use market-oriented environmental tools to hold down the costs of reducing pollution. These people's objective is to avoid environmental rules that would provide the quantity of environmental protection at 𝑄𝐶 , where marginal costs exceed marginal benefits. Climate Finance | João Amaro de Matos 90 International environmental issues An international perspective on environmental issues Many countries around the world have become more aware of the benefits of environmental protection. Unfortunately, even if most nations took steps individually to address their environmental issues, it would still not solve certain environmental problems which spill over national borders. Take global warming, for example—no one nation by itself can reduce carbon dioxide and other gas emissions enough to solve the problem. The problem is so big, that nations must cooperate to effectively address it. Climate Finance | João Amaro de Matos 91 International environmental issues An international perspective on environmental issues Another example is the challenge of preserving biodiversity—the spectrum of animal and plant genetic material. Although a single nation can protect biodiversity within its own borders, no nation acting alone can protect biodiversity around the world. Global warming and biodiversity both are examples of international externalities—externalities that cross national borders and cannot be resolved by a single nation acting alone. Climate Finance | João Amaro de Matos 92 International environmental issues What should international environmental regulations look like? Bringing the nations of the world together to address environmental issues requires a difficult set of negotiations between countries with different income levels and different sets of priorities. If nations such as China, India, Brazil, Mexico, and others are developing their economies by burning vast amounts of fossil fuels or by stripping their forest and wildlife habitats, then the world’s high- income countries acting alone will not be able to reduce greenhouse gases. Climate Finance | João Amaro de Matos 93 International environmental issues However, low-income countries, with some understandable exasperation, point out that high-income countries do not have much moral standing to lecture them on the necessities of putting environmental protection ahead of economic growth. After all, high-income countries historically have been—and are still today—the primary contributors to greenhouse warming through the burning of fossil fuels. It is hard to tell people who are living in a low-income country— where adequate diet, health care, and education are lacking—that they should sacrifice an improved quality of life for a cleaner environment. Climate Finance | João Amaro de Matos 94 International environmental issues If high-income countries want low-income countries to reduce their emissions of greenhouse gases, then the high-income countries may need to pay some of the costs. Perhaps some of these payments will happen through the private market—for example, some tourists from rich countries will pay handsomely to vacation near the natural treasures of low-income countries. Or perhaps some of the transfer of resources will happen through making modern pollution-control technology available to poorer countries. Climate Finance | João Amaro de Matos 95 International environmental issues The practical details of what such an international system might look like and how it would operate across international borders are forbiddingly complex. It seems highly unlikely that some form of world government will impose a detailed system of environmental command-and-control regulation around the world. As a result, a decentralized and market-oriented approach may be the only practical way to address international issues such as global warming and biodiversity. Climate Finance | João Amaro de Matos 96 The trade-off between economic output and environmental protection The trade-off between economic output and environmental protection Unfortunately, it's not possible for a country to maximize both its environmental protection and its economic output. Each country must make a decision about how the two goals should be balanced—and how to achieve that balance. Climate Finance | João Amaro de Matos 97 The trade-off between economic output and environmental protection Using a production possibility frontier to analyse economic output and environmental protection One of the tools we can use to analyse the trade-off between economic output and environmental protection is a production possibility frontier, or PPF, like the one below. Climate Finance | João Amaro de Matos 98 The trade-off between economic output and environmental protection The PPF shows the opportunity cost of choosing either more environmental protection or more economic output. Notice that at the far left of the graph—at point P, a country would be selecting a high level of economic output but very little environmental protection. At the other extreme—point T, — a country would be selecting a high level of environmental protection but little economic output. Climate Finance | João Amaro de Matos 99 The trade-off between economic output and environmental protection Countries with low per capita gross domestic product, or GDP—such as China—tend to place a greater emphasis on economic output. This will help them to produce nutrition, shelter, health, education, and desirable consumer goods. Countries with higher income levels, where a greater share of people have access to the basic necessities of life, may be willing to place a relatively greater emphasis on environmental protection. Climate Finance | João Amaro de Matos 100 The trade-off between economic output and environmental protection All choices represented by points on the PPF are productively efficient—they just represent different balances of environmental protection and economic output. A choice that is inside the PPF, however—like M — is productively inefficient. Economists tend to have milder opinions about the choice between P, Q, R, S, and T, than environmentalists, because all of these points lie along the production possibility frontier and thus are productively efficient. Climate Finance | João Amaro de Matos 101 The trade-off between economic output and environmental protection Economists are, however, united in their belief that an inefficient choice such as M, is undesirable. Rather than choosing M, a nation could achieve either greater economic output with the same environmental protection, as at point Q, or greater environmental protection with the same level of output, as at point S. Command-and-control environmental laws sometimes involve a choice like M, but market-oriented environmental tools offer a mechanism for providing either the same environmental protection at lower cost or providing a greater degree of environmental protection for the same cost. Climate Finance | João Amaro de Matos 102