PROBLEMS WITH IB IN GENERAL

Turning our attention first to potential problems associated with both marketable permits and pollution taxes, Grimeville can be used to illustrate the hot-spot issue. Hot spots are high local concentrations of pollutants. The IB system would, indeed, keep total pollution in Grimeville at 20 tons per day. However, residents living near plant A, which would pollute 13 tons per day under either a tax or a marketable permit scheme, would view the IB system as unacceptable if the higher level of emissions translated into a higher health risk.

Different pollutants display a different relationship between the sites at which emissions and damages occur. To illustrate this principle, suppose that Grimeville was divided into two air-quality regions: one containing plant A, the other plant B. If gunk were a uniformly mixed pollutant, 1 ton of emissions from either plant would translate into an even concentration of gunk, and its associated health risk, across the two areas. By contrast, if gunk were a concentrated pollutant, all the damage caused by emissions from plant A would occur in the area adjacent to A. The more general case is that of a nonuniformly mixed pollutant, where the bulk of the damage is caused locally, but effects do drift into other areas.

IB approaches work best for uniformly mixed pollutants, those evenly dispersed over fairly broad areas. Two examples are chlorofluorocarbons (CFCs), which deplete the ozone layer, and carbon dioxide, which contributes to global warming. An IB approach would clearly not work for a concentrated pollutant such as nuclear waste, for which uniform safety standards are demanded on equity grounds. To deal with the hot-spot problem in the intermediate case of nonuniformly mixed pollutants, economists have recommended trades (or taxes) based on the contribution of emissions to ambient air or water quality. (Recall from Chapter 13 that ambient air quality is the concentration of pollutants actually in the air.)

Implementing such a scheme requires a means of estimating the impact of emissions from specific plants on regional air or water quality. Consider the hypothetical situation in Grimeville, illustrated in Figure 15.3. Suppose that due to prevailing wind patterns, 1 ton of gunk emissions from plant A pollutes 70 percent in area A and 30 percent in area B. On the other hand, emissions from plant B are split 50/50 between the two areas. At the (13, 7) solution, a hot spot will indeed emerge in area A. In numerical terms, residents in A will face ambient pollution of $13*0.7+7*0.5=12.6$ tons, while residents in area B will face ambient pollution of $13*0.3+7*.05=7.4$ tons.

In this case, the Grimeville authorities would need to impose an ambient air-quality standard (similarly to the NAAQS discussed in Chapter 13) of 10 tons for each region and then control emissions in the two regions to meet the ambient standards. To do so using a tax approach would require higher pollution taxes in area A than in area B. Alternatively, if marketable permits were to be used, a given permit would allow lower emissions in area A than in area B.

Carrying this idea beyond Grimeville, taxes would also have to be higher (or the emission value of a permit lower) in already polluted areas, where new sources are more likely to result in a violation of ambient standards. The exact tax levels, or terms of trade for permits between areas, can be determined as long as the relationship between emissions and ambient standards is known.

As we will see in Chapter 16, trades of this type have occurred under the EPA’s “bubble” policy for air pollution control. However, if hot-spot problems proliferate, tax or permit systems can quickly become quite complex and, thus, lose their primary advantage to regulators—simplicity. In addition, the transaction costs for firms are raised if they need to employ complicated air-quality models to demonstrate that emission trades will not violate ambient standards.

Beyond hot spots, the next, and potentially quite serious, problem with IB regulation arises in the area of monitoring and compliance. One of the primary monitoring techniques used under the CAC system is simply to ensure that firms have actually installed the required abatement technology. For example, in about 20 states, cars are required to have catalytic converters yet are not required to pass emissions tests. This monitoring system is clearly imperfect as the control equipment may break down, and actual emissions are not checked. It does, however, provide regulators with a relatively straightforward tool for ensuring at least initial compliance.

Unlike the CAC case, however, IB regulation does not specify particular pollution-control technologies with known abatement impacts. Thus, regulators must rely even more heavily on (currently inadequate) monitoring of emissions to ensure compliance with permits or to collect taxes. As illustrated in Chapter 14, monitoring budgets are a soft political target for regulated industries. Thus, for an IB system of regulation to achieve its potential of reducing pollution at lower cost, a commitment to strict monitoring and stiff enforcement that is insulated from the budgetary axe must be made.

From the enforcement perspective, taxes have an advantage over permit systems because they generate a revenue stream for the government based on emissions. Thus, regulators have an economic incentive to monitor emissions closely to ensure maximum government revenues. The introduction of taxes on water pollutants in Germany has led government to require better monitoring technologies and to become more aggressive in enforcement.⁶

PROBLEMS WITH PERMIT SYSTEMS

Both cap-and-trade and pollution tax systems share problems of hot spots and a need for strict enforcement. A major problem unique to the marketable permits approach is that many proposed users face thin markets—markets with only a few buyers and sellers. The thin market problem is essentially this: why go to the trouble of “going to the market” when due to the small number of traders, there is a low probability of getting a good deal? In the Grimeville case, in order to trade permits, plants A and B would have to go to considerable trouble and expense to calculate with some precision their respective marginal cost of reduction curves and then employ brokers to engage in a face-to-face bargaining process. Is it worth the bother if there is only one other plant in town, which may well not have anything to offer?

As the Grimeville case illustrated, CAC regulation is seldom cost-effective because regulators do not have access to the control cost information necessary to impose least-cost regulation. In thin markets where trades are infrequent and prices not easily defined, IB systems are also hampered by imperfect information. Under such conditions, private firms know little about potential permit trades and face large transaction costs in completing such deals. As we will see in the next chapter, many of the small-scale experiments with permit systems in the United States have foundered on the thin market problem. By contrast, acid rain pollution permits are traded on the futures markets in Chicago. Plant managers can read in the newspaper the going price for an ${\text{SO}}_2$ credit, greatly reducing the informational barriers to trade.

A second problem with permits is the potential for the development of market power. Concerns here typically focus on access to permits as a barrier to entry. What if existing firms refuse to sell to new entrants in the market as a way to limit competition? This may be a problem when both of the following circumstances hold: (1) new firms are forced to buy permits from direct competitors and (2) a single dominant firm faces new entrants with higher pollution-control costs.⁷

Condition (1) does not generally hold. Under the acid rain program, for example, ${\text{SO}}_2$ trades are nationwide; thus, a utility in Massachusetts would have a hard time blocking the entry of a new power producer that could purchase credits from a noncompetitor in Ohio. Why is condition (2) necessary? If there are several existing large firms in the industry, the benefits of excluding new rivals to any given firm are lower. Moreover, the existing firms must maintain an informal agreement of not to sell. As the price new entrants are willing to pay for permits rises, each firm will have an incentive to cheat on this agreement.

Economists disagree on how significant this market power problem is. However, few would argue that the problem is big enough to seriously undermine the appeal of IB regulation. Indeed, the CAC approach has its own entry barriers associated with high cost of compliance for new sources. Nevertheless, concern should be focused on designing IB systems to minimize these problems. In particular, permit giveaways that endow large firms with a substantial share of the permits should be avoided.

A third and, in real life, more serious problem with cap-and-trade systems relates to price volatility. The annual stock of permits is in fixed supply: in the absence of banking (discussed later), it is perfectly inelastic. Thus, any changes in demand can lead to large swings in permit prices. As we will see in Chapter 16, a rapid run-up in demand by fossil-fuel electricity generators during the West Coast electricity shortages in the early 2000s sent $\text{NO}x$ permit prices skyrocketing and led to the temporary cancellation of the program. In Europe, prices for carbon permits have also been fairly volatile, though in the opposite direction, and have undergone repeated periods of collapse.

Volatility is a problem for two reasons. When price goes unexpectedly high, it makes it difficult for firms to rely on market purchases to cover unexpected compliance needs. As a result, in volatile markets, firms will hang on to all their permits to make sure that they have enough for compliance. At the high end, volatility thus discourages market participation and the cost savings that might arise from permit sales. On the other side, when prices unexpectedly collapse, firms’ incentives to invest in long-term pollution-reduction measures are undercut. Rather than the costly investments, firms might reckon that they will be better off just buying permits.

One way to dampen volatility is to allow banking: if firms can carry over unused permits from year to year, then during periods of low prices, firms are likely to hold onto permits (helping firm up the market price), for use or sale during high-price periods (helping to moderate those price increases). On the downside, banking does raise the possibility of temporal hot spots. If all the banked permits were used in a short time, pollution rates during that period would skyrocket. Bearing this in mind, banking can be a very useful tool to reduce price volatility.

A second tool is a “price collar,” or in other words, a government-set price floor combined with a government-set price ceiling. Under this scenario, government buys permits when the price falls below the floor and then bids prices back up to the minimum. If the government then banks these permits, they can hold them to periods when the price rises above the ceiling. By selling their excess stock, they can drive the price down below the ceiling. For more on these so-called hybrid approaches, see Appendix 15B.

A final objection to cap-and-trade systems generally has been raised by some environmentalists: Granting pollution permits “legalizes” pollution and thus takes the social stigma away from pollution as an activity. (An analogy here could be made to the legalization of recreational drugs.) This, it is argued, will lead to a long-run increase in pollution as individual moral codes against polluting weaken. One might counter that existing regulations already mandate some level of pollution as acceptable. Perhaps, more importantly, the formal legal status of pollution is probably not one of the primary determinants of social attitudes toward pollution.

PROBLEMS WITH TAXES

Although taxes and tradeable permit systems are quite similar in many respects, there are also important differences, again, summarized in Table 15.3. First, when permit systems are initiated through permit giveaways, they are much less costly compared to pollution taxes for the affected firms. For this reason, at least until recently, pollution taxes (and auctioned permit systems) have largely been off the real-world policy table in the United States. Because permit giveaways can actually increase the profitability of some firms, this is the type of IB regulation that we have generally seen being implemented.

Firms profit from receiving permits free of charge in two ways. First, if they face low-cost reduction opportunities, they can sell permits and make money. Second, because IB regulation raises the marginal cost of pollution produced, these increased marginal costs get passed on to consumers in the form of higher prices. As a result of these price increases, with permit giveaways, firms can make windfall profits. This is an important point. Even when the permits are given away for free, in unregulated competitive markets, the opportunity cost of those permits gets passed on to consumers.

How does this work? Consider the effect of a permit giveaway in the electricity market. Any new firm entering that market will not get any permits, so it will have to buy permits from existing firms. Because this new firm will enter the market only if there is sufficient demand for it to make a profit and cover its marginal costs, the market price of electricity will ultimately rise to cover the marginal costs of the permit.

This process is illustrated in Figure 15.4. Recall that in a competitive market, the supply curve reflects the sum of the marginal costs of production of the firms in the industry. The supply curve in the figure has a curious kink in it at ${\mathrm{Q}}_1$; all the firms to the left of ${\mathrm{Q}}_1$ receive permits for free, and all the new entrants into the market to the right of ${\mathrm{Q}}_1$ must purchase permits for a price equal to the vertical line segment at the kink: $\left({\mathrm{P}}_2-{\mathrm{P}}_1\right)$. This increases the marginal costs for new entrants and pushes the supply curve up for these producers. As demand rises to ${\mathrm{D}}_2$, the new entrant supplying the very first additional power now must cover this extra marginal cost in order to operate profitability, so price jumps to ${\mathrm{P}}_2$. Note that at the new higher price, the producer surplus (or profits) flowing to the existing firms has increased. They got the permits for free, so their costs have not gone up, and yet, they benefit from the induced increase in price. When firms earn money through no additional effort on their part, the extra revenues are referred to as windfall profits.

Of course, these profits come at the expense of electricity consumers. Recently, as economists have become aware of the costs of permit giveaways to consumers in the form of higher prices for dirty goods, and as citizens have begun to notice the large wealth transfers that giveaways create, pressure has been building for “Sky Trust” type systems of auctioned permits (sometimes called “cap and dividend,” discussed further in Chapter 1), and the auction revenues are rebated to consumers.⁸ Recent U.S. legislation covering global warming pollutants was a hybrid that included initial permit giveaways to get buy-in from industry, but converted to auction over time. More on this in Chapter 16. The bottom line, however, is that industry will always choose permit giveaways over pollution taxes, even if the giveaways eventually morph into permit auctions that function very much as pollution taxes.

Regardless of whether permits are auctioned or grandfathered, there are two fundamental differences between pollution taxes and cap-and-trade systems. First, permits are “quantity instruments”: they set a specified level of pollution, and a price emerges through trading. By contrast, taxes are “price instruments”: they put a price on pollution, and that price initiates a reduction in the quantity of pollution as firms clean up in response to the price incentive. But, with taxes, regulators do not know ahead of time how much pollution will result. They can only guess. In principle, they could raise the taxes after observing the pollution level and finding it still too high, but altering tax rates isn’t easy, to say the least. A final, related problem with pollution taxes as opposed to permits is that, to be effective over time, taxes have to be periodically raised to account for inflation or population increases and economic growth.

Given these problems, why use taxes instead of permits? One answer is to avoid the transaction costs associated with monitoring trades. As trading systems grow large and complex, there is a fear that loopholes and lax enforcement will provide opportunities for fraudulent reductions and counterproductive speculation, although both problems can be addressed with good system design. A second reason to prefer taxes is to provide insurance against price volatility and to guard against high costs from an overly ambitious pollution cap. (More on that issue in Appendix 15A.) In addition, the existence of tax revenues provides government a strong incentive for marketing and enforcement, and tax revenues, if used to cut existing labor taxes, can both increase labor market efficiency and make environmental policy less regressive by cushioning the impact of price increases for dirty goods on low-income workers.

Of course, both rebates and stronger enforcement incentives are possible if cap-and-trade relies on 100 percent auction of the permits. In fact, with 100 percent auction, the major difference between cap-and-trade and taxes is that with the former, the government sets a quantity target for allowable pollution, and the market determines the price of pollution. In the latter case of pollution taxes, the government sets a price target for pollution, and the market responds by reducing the quantity. If the final prices work out to be the same, then the two policies should generate identical impacts in terms of both pollution reduction and government revenues.

IB VERSUS CAC

To conclude this section, it is useful to point out that although economic theory is very useful in thinking through environmental problems, the real world is always messier than our theory. Indeed, CAC and IB systems are seldom found in their pure forms, and their advantages and disadvantages must be weighed in the context of each specific situation. For example, a close look at CAC regulation of particulate air pollution in Baltimore revealed that the CAC approach is often not as clumsy as it is made out to be by the economist’s stereotype.

In Baltimore, regulators specified different uniform standards for different categories of sources—“industrial coal-fired boilers, grain shipping facilities, etc.”—so that all areas in the city achieved a standard of at least 100 parts per million (ppm). Thus, while CAC regulators did impose uniform standards across categories of sources and mandated the use of specific abatement technologies, they also cast “at least one eye on cost savings.” This was reflected in their decision to regulate low-cost categories of sources more stringently compared to high-cost source categories.

This attention to cost greatly reduced any possible benefits from moving away from CAC and toward an IB system. The conclusion: “A carefully designed and implemented CAC system may stack up reasonably well relative to a feasible IB counterpart.”⁹

In our 30-year struggle to influence the pollution-control debate, economists originally concentrated on singing the praises of a chalkboard form of IB regulation, as against an equally theoretical enemy characterized as CAC. In the process, we have somewhat oversold our product. This section has focused on problems that real-world IB regulation either has faced or is likely to face in its implementation.

The existence of these problems, however, does not mean that the shift to IB regulation is a bad idea. On the contrary, pollution taxes and marketable permit systems have a very important role to play in reducing short-run compliance costs and especially in encouraging long-run innovation in pollution control and waste reduction. The policy challenge is to capture this potential in the face of real-world constraints.

The discussion in the previous chapter, comparing permits and taxes, was based on the assumption of perfect information: that is, regulators were assumed to know everything about both the benefits and cost of pollution control. However, we know from our discussion of the real-world practice of regulation in Chapter 12 that this assumption is far from the truth. In this appendix, we introduce uncertainty into the analysis to highlight an important difference between taxes and permits, based on the costs of regulatory mistakes. Mistakes on the cost side may loom large in controlling greenhouse gas emissions. For that reason, some economists have recommended a hybrid tax/permit system as an alternative to the international cap-and-trade approach negotiated under the Kyoto Protocol.

15A.0: Minimizing the Costs of Being Wrong

We noted earlier that permits have the advantage of providing a more certain level of pollution control than do emission taxes. This is because taxes have to be adjusted if regulators find pollutant levels resulting from a given tax are lower or higher than those expected. Let us explore this issue a bit more fully, with the aid of Figure 15A.1.

Figure 15A.1 illustrates the marginal costs and marginal benefits of pollution reduction for two particular cases. This diagram differs from the ones used previously in the book because the horizontal axis is flipped around. Instead of measuring pollution reduction (cleanup) as we have done before, it now measures pollution emitted. As a result, the MC of reduction curve now slopes downward, reflecting that, at high pollution levels, per unit cleanup is cheaper. Similarly, the MB of reduction curve now slopes upward: at high pollution levels, the per-unit benefits of cleanup are also high.

The first panel, with a steep marginal benefit curve, illustrates a pollutant with a safety threshold. Cleanup need not be pursued above $C\prime$, even on safety grounds, because the additional benefits are low. But, for cleanup levels below $C\prime$, damages from additional pollution begin to mount steeply. An example of a pollutant with a safety threshold is the ozone-depleting CFC, discussed in Chapter 21. Because the ozone layer has already been saturated with long-lived CFCs released in the past, any additional CFC production generates high marginal damages in the form of skin cancers and eye disease.

The second panel of Figure 15A.1, by contrast, illustrates a situation where costs are quite sensitive to the level of cleanup. Pollution reduction to a level of $C″$ can be pursued relatively cheaply, but beyond $C″$, costs begin to mount rapidly. Global warming probably fits this picture: carbon dioxide emissions can be reduced at fairly low cost by pursuing energy efficiency and switching to natural gas, but once these opportunities are exhausted, more expensive options have to be exercised.

If regulators knew with certainty the location of the curves in Figure 15A.1, then they could achieve efficient pollution reduction to $C$* using either form of incentive-based regulation. They might issue just enough marketable permits to achieve the desired cleanup or, alternatively, charge a pollution tax of $T$*. However, in the real world, regulators seldom, if ever, have such perfect information. The point of this appendix is to determine, following Weitzman (1974), the approach regulators should use when they are uncertain about the location of the curves and are pursuing efficiency as their goal. We will see that when the marginal benefit curve is steep, regulators should use a marketable permit system. By contrast, when the marginal cost curve is steep, a pollution tax system is preferred.

When the marginal benefit curve is steep, regulators will want to keep tight control over the actual quantity of pollutant released into the environment to ensure that the threshold is not far exceeded. Under these circumstances, a marketable permit system is preferred to a pollution tax because of the costs of being wrong. We can see this graphically in Figure 15A.2.

In Figure 15A.2, the efficient level of cleanup is $C$*. However, suppose that regulators miss the mark and issue 20 percent more permits than they should, so that firms clean up only to $\widehat{C}$. Then the monetary loss to society is represented by the gray area—the difference between the forgone benefits and increased costs of cleaning up to $C$*. By contrast, suppose that regulators opted for a pollution tax. Efficiency requires a tax of $T$*, but if the regulators set a target that is too low by 20 percent, we get a tax of $T\prime$. Facing this tax, firms clean up only to $C\prime$, and society loses net benefits equal to the gray area plus the hatched area as a result. The basic idea here is that a permit approach, because it allows for greater control over actual cleanup levels, keeps pollution relatively close to the safety threshold.

By contrast, when the social costs of being wrong arise more from increased compliance costs and less from the benefits of reduction, a tax policy will be preferred. We can see this in Figure 15A.3.

If regulators undershoot the efficient tax by 20 percent and set it at $T\prime$, firms will decrease cleanup only a little, to $C\prime$. Because the marginal cost of reduction curve is so steep, firm’s behavior will not be very responsive to the lower tax. As a result, monetary losses to society will be restricted to the gray area—the difference between lower control costs and higher forgone benefits from cleanup to only $C\prime$. By contrast, if regulators mandate a cleanup level that is 20 percent too low, then firms are forced to make bigger changes in their behavior, thus reducing pollution to $\widehat{C}$.

In this case, overall monetary losses to society become the gray area plus the hatched area. The intuition here is that, with a steep marginal cost curve, firms will not change their pollution behavior much with decreased (or increased) pollution taxes. As a result, losses to society from either underregulation or overregulation using taxes will be minimized.

What if both the marginal benefit and marginal cost curves are steep? Then a clear-cut advantage for either method, based on the costs of being wrong, disappears.

15A.1 An Application to Greenhouse Gas Emissions

As we will discuss in Chapter 21, in 1997, the industrial nations of the world signed the Kyoto global warming treaty. The treaty required developed nations to reduce emissions of global warming gases; for the United States, the target was 7 percent below the levels in 1990 by about 2010. The U.S. Senate refused to ratify the treaty, arguing that it was potentially too costly to achieve the targets.

To deal with this cost uncertainty, two economists, McKibbin and Wilcoxen, had an idea.¹ They offered a hybrid scheme: the United States should issue annual permits to greenhouse gas polluters that are tradeable within the country up to, say, Kyoto-level emissions. The country should then sell additional annual permits for, say, $25 per ton.

We saw in the previous chapter that permit sales are in fact equivalent to pollution taxes. So, the McKibben and Wilcoxen (1997) approach can be thought of as a hybrid system, with a cap-and-trade base and pollution taxes on the top. The advantage of the government permit sales program is to put a ceiling on permit prices of $25, as no one would buy permits at a higher price from their neighbors if they are available from the government for $25.

In defending their proposal, McKibben and Wilcoxen argue: “There is tremendous uncertainty about what the price of an international carbon permit would be, but $100 per ton is well within the range of estimates and some studies have projected prices of $200 or more” (1997). (Other credible studies put project carbon permit prices to meet the Kyoto targets as low as $25 per ton.) Figure 15A.4 illustrates this situation.

Under the hybrid proposal, permit giveaways would allow firms to pollute up to the Kyoto target, 7 percent below the levels in 1990. If the marginal costs of reduction are low, then permit prices would settle in at $25 per ton, and the Kyoto target would in fact be achieved. If, on the other hand, marginal costs turn out to be high, firms would turn to the government to buy excess allowances. In this hypothetical diagram, the $25 per ton sale program leads to more greenhouse gas pollution than that allowed under the Kyoto treaty: stabilization of carbon emissions at 10 percent above the levels in 1990.

Why go with the hybrid approach? If the cost optimists were correct, the Kyoto targets would have been achieved. If, on the other hand, the pessimists were right, and marginal reduction costs were high, the economy would have avoided an expensive crash reduction in greenhouse gas emissions. Avoiding this kind of socially disruptive outcome will be politically important in the deeper cuts that will be needed in the future if we seek to stabilize the climate.

15A.2 Summary

This appendix has considered an important distinction between marketable permits and pollution taxes when regulators are uncertain about the precise location of the marginal benefit and cost of pollution reduction curves. (Virtually always!) In such a case, regulators will not be able to correctly specify either the efficient tax or number of permits. If efficiency is the regulatory goal, then regulators should be concerned about minimizing the costs of any mistakes.

When the marginal benefit curve for cleanup is steep, regulators should opt for a tradeable permit system to keep the actual quantity of pollution close to the threshold. When the marginal cost of reduction curve is steep, a tax system is preferred as a firm’s pollution behavior will not be particularly responsive to a tax set too high or too low. If these rules are followed, the efficiency costs arising from imperfect regulation in an uncertain world will be minimized.

REFERENCES

1. Barnes, Peter. 2001. Who owns the sky? Washington, DC: Island Press.
2. McKibben, Warwick, and Peter Wilcoxen. 1997. A better way to slow global climate change. Brookings Policy Brief 17. Washington, DC: Brookings Institution.
3. Weitzman, M. L. 1974. Prices versus quantities. Review of Economic Studies 41: 447–91.

In Chapter 12, we identified imperfect information as one of the primary obstacles to effective government regulation of the environment. We noted that, due to budget limitations, the Environmental Protection Agency gathers or generates less than full information about most problems before acting. In particular, the agency can sponsor only limited research of its own; as a result, it must often turn to industry for data about the expected compliance costs of regulation. Yet, asking for information about costs from the very industry one is regulating has elements of asking the fox to guard the henhouse. The incentives for cheating are rather high.

In Chapter 12, we also discussed two potential solutions to this problem. One was to build up the EPA’s institutional capability so as to increase its ability to detect inaccurate reports of compliance costs. The second was to design regulatory policy so as to minimize any gains from lying. The so-called incentive-compatible regulation ensures that the incentives faced by the regulated parties are compatible with the regulator’s goal. This appendix illustrates how incentive-compatible regulation can work.

15B.0 Incentives to Lie

To motivate the discussion in this section, consider the EPA’s efforts to regulate sulfur dioxide (${\text{SO}}_2$) emissions from power plants. Suppose that the agency seeks to regulate ${\text{SO}}_2$ at the efficient level, where the marginal benefits of reduction just equal marginal costs. If the EPA knew the costs and benefits, it might then achieve the efficient pollution level in one of two ways. First, it could issue or auction off marketable permits up to the ${\text{SO}}_2$ target. Or, it could set an emission tax to achieve the same goal. However, as we show next, if firms are expecting a marketable permit system, they have an incentive to overstate compliance costs. By the same token, if they expect a tax, an incentive exists to understate compliance costs.

Figure 15B.1 illustrates a marginal cost–marginal benefit diagram for analyzing pollution control. The true marginal benefits and costs of ${\text{SO}}_2$ reduction are reflected by the curves labeled MB and MC. If the EPA had access to this information, efficiency would require a pollution level of $P$*. This, in turn, could be achieved by either auctioning off $P$* marketable permits (at a market-clearing price of $T$*) or setting a pollution tax at $T$*.

However, suppose that the EPA must rely on power companies for information about how much it will cost firms to switch to less-polluting production methods. If faced with a marketable permit system, industry has a clear incentive to lie and overstate the cost ($\text{MC}\prime$). If the industry does so and the EPA uses the industry estimates, the agency will increase the number of permits it sells to $P\prime$. This will drive down the price of permits to $T\prime$ and allow an inefficiently high level of pollution, thus reducing the firm’s cleanup costs.

By contrast, suppose the agency is planning to use a pollution tax to control ${\text{SO}}_2$ emissions, and firms know this. Then, as illustrated in Figure 15B.2, companies have the incentive to understate their costs, for example, claiming $\text{MC}″$. The EPA will then consider the efficient pollution level to be $P″$ and set what it thinks is the appropriate tax at $T″$. This will reduce the emission tax (from $T$*). However, with a low tax of $T″$, actual pollution will rise to $P\prime \prime \prime$. Again, pollution levels will be inefficiently high, and a firm’s cleanup costs will be reduced.

Now, after the fact, regulators will be able to tell that they have been lied to. How? In the marketable permits case, permit prices will be only $T\prime$, reflecting real control costs, when the agency expects them to rise to $T″$. In the tax case, the pollution level will be $P\prime \prime \prime$, again reflecting real control costs, when the agency expects it to be $P″$. Thus, one approach to solving the problem of imperfect information would be to adjust either the number of permits or the tax level based on the observed outcomes. For example, if the observed pollution level is higher than that the regulator predicted, he can raise the pollution tax.

Through such a process, called iteration, the regulator might be able to arrive at the efficient tax level or number of permits. However, in practice, it is not easy to adjust either the number of permits or the tax level once they have been established. As detailed in Chapter 12, setting regulatory policy is a cumbersome and politically charged process not amenable to trial and error. Are we then stuck with a recognition that firms will tend to overstate costs if facing a marketable permit system and understate them if facing pollution taxes? Fortunately, no.

15B.1 Incentives to Tell the Truth

An incentive-compatible approach developed by Kwerel (1977) can be used to encourage truthful behavior.¹ This approach mixes a marketable permit system with a tax system to precisely balance the different incentives firms have to lie about compliance costs. It works in the following way. Regulators tell firms that they will combine an auction of marketable permits with a subsidy payment for any pollution reduced over and above the number of permits the firm holds (an excess emission reduction subsidy). To see this clearly, we need to use a little mathematical notation. So, let

The industry’s total pollution-control costs are thus

The trick here is that regulators set the subsidy level, $e$, at the intersection of the MB curve and the reported MC curve. Thus, by the costs they report, firms directly affect not only the number of permits issued but also the subsidy they will receive for any excess emission reductions.

With this setup, we can see how the incentive-compatible mechanism works to encourage truth telling. First, let us consider what happens if firms overstate their costs. At first glance, this seems like a good strategy. Figure 15B.3 illustrates the situation. By overstating their costs, the firms know that regulators will provide a large number of permits ($\overline{L}$) and set a high emission reduction subsidy at $\overline{e}$. Both of these seem favorable. The catch is that, unlike the case of a straight marketable permit system, the large supply of permits will not cause their price to fall. Instead, the high emission subsidy will cause the permit price that firms have to pay to be driven up. As long as $e$ is greater than the price of permits, $z$, each firm would do better buying another permit, holding emissions constant, and collecting the subsidy for the extra “reduction.” But, this high demand for permits will cause permit prices to get bid up to $\overline{e}$.

As a result, in equilibrium, the permit price $z$ must just equal $\overline{e}$. Because the price of an additional permit just equals the emission subsidy, firms will not come out ahead financially from the subsidy policy and, thus, do not benefit from a high $\overline{e}$. However, as long as the true MC of reduction is less than the subsidy, firms would lose money if they did not reduce pollution and receive the subsidy. As a result, they will cut back pollution to $\overline{P}$ even though they hold $\overline{L}$ permits.

Thus, the final equilibrium will look like this: $L$ permits auctioned off at a price just equal to the emission subsidy $\overline{e}$, with firms polluting at a level of $\overline{P}$. But, $\overline{P}$ is a lower level of pollution and one more costly to achieve than $P$*. Thus, overstating compliance costs will lead firms to bear higher pollution reduction costs than they would if they told the truth.

Is there an incentive to understate costs? Figure 15B.4 illustrates this possibility. If firms underreport costs, then $\widehat{L}$ permits will be available, and firms will receive a subsidy for emission reductions below $\widehat{L}$ of $ê$. However, because the true marginal costs of reduction exceed the subsidy for excess emission reductions, firms will pollute up to the limit of $\widehat{L}$ and not take any subsidies. But, again, this is a stricter and more costly standard than they would have faced if they had told the truth. Understating costs is clearly not a good strategy for firms.

We have just demonstrated that both overstating and understating compliance costs ultimately lead to higher costs for firms than telling the truth. Thus, under this hybrid regulatory mechanism, firms have no incentive to lie. In a nutshell, the advantages to inflating costs that accrue under a straight marketable permit system are here negated by the emission reduction subsidy, which forces up permit prices.

15B.2 Summary

This appendix has provided an introduction to incentive-compatible regulation. We first established that firms have an incentive to overstate compliance costs when faced with marketable permit regulation and to understate costs when faced with pollution taxes. A mechanism that precisely balanced these offsetting tendencies by combining a tax-based subsidy policy with a marketable permit system was then suggested. This hybrid regulatory structure is incentive compatible, because firms are provided an incentive to tell the truth, which is compatible with the regulatory goal of efficient regulation.

REFERENCES

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2. Kwerel, Evan. 1977. To tell the truth: Imperfect information and optimal pollution control. Review of Economic Studies 44(3): 595–601.
3. Mason, Keith. 1991. The economic impact. EPA Journal, January/February, 45–48.