CHAPTER 15
Incentive-Based Regulation: Theory

15.0 Introduction

In the late 1960s, when major new environmental legislation was being contemplated, economists had a bit of advice to offer: why not harness market incentives to control pollution? The basic idea was twofold. First, make polluting an expensive activity. This would both directly reduce pollution and induce a search for less-polluting substitutes. Second, lower the costs of pollution control by leaving decisions about how specifically to reduce pollution up to firms and individuals.

Two schemes were widely discussed. The first was a pollution tax (also known as an effluent or emission charge or a Pigovian tax).1 For example, to reduce the acid rain caused by sulfur dioxide emissions from power plants, one could impose a tax on emissions of, say, $200 per ton of SO2. Alternatively, one might achieve a rollback through a cap-and-trade system (also known as tradeable permit or marketable permit systems). Here, permits would be issued only up to a certain target level of emissions. These permits could then be bought and sold, again putting a price tag on pollution. These two regulatory approaches—pollution taxes and cap-and-trade systems—are referred to as incentive-based (IB) regulation, because they rely on market incentives to both reduce pollution and minimize control costs.

As we saw in Chapter 13, the recommendations of economists were largely ignored in the drafting of the major environmental legislation of the early 1970s. Instead, the nation opted for what we have called the command-and-control (CAC) approach to regulation, requiring uniform emissions across sources and mandating the adoption of particular pollution-control technologies. Since that time, economists have maintained a steady drumbeat of support for the more flexible IB approach. The mid-1990s saw the first large-scale test of this type of regulation in air pollution control. Since 1995, sulfur dioxide emission credits have been traded among coal-burning electric facilities nationwide. At the same time, tradeable permit systems have been introduced in the Los Angeles basin and the Northeastern United States, covering two urban air pollutants, sulfur oxide and nitrogen oxide, and also Northeast utilities are trading under a carbon dioxide cap. Meanwhile, California is moving ahead with the first statewide trading system for CO2, and across the globe, from China to Canada to the EU, pollution taxes and cap-and-trade systems are increasingly taking hold.

From a theoretical perspective, IB systems offer several advantages over a CAC approach. First, IB systems will promote more cost-effective regulation in the short run. (Recall that cost-effectiveness is defined as achieving a given pollution target at the lowest possible cost.) More importantly, over the long run, IB systems provide incentives for firms to seek out new technologies to lower pollution-control costs. Finally, in theory, an IB approach reduces the costly burden of information gathering for regulatory bureaucrats—rather than having to choose which technology is to be deemed BACT or BAT or LAER, regulators need only to specify the tax level or the number of permits and then let private incentives take over. Because control over information is a primary means of political influence, as we saw in Chapter 12, IB approaches can reduce such influence in the regulatory process.

However, IB approaches are not without their theoretical drawbacks, including problems of monitoring and enforcement, hot spots (high local concentrations of pollutants), thin markets, price volatility, and the possible exercise of market power, among others. Overcoming these obstacles to realize the potential of IB regulation is one challenge facing policymakers today. In addition, especially in the United States, these market-based approaches that were once championed by conservatives have recently lost favor on the right, due to the increasingly partisan dialog over climate change in particular.

This chapter examines in some detail the theoretical advantages and disadvantages of IB regulation. Chapter 16 then takes a closer look at the lessons to be learned from our practical experience with IB systems and the way that potential problems with the IB approach are being dealt with in the ongoing cap-and-trade and pollution-tax experiments.

15.1 The Cost-Effectiveness Rule

One defining aspect of the stereotypical CAC regulatory approach is its prescription of uniform standards for all pollution sources. Economists have widely criticized this requirement, as it essentially blocks any effort to achieve cost-effective pollution control.2 To see why, we need to understand the following rule:

Cost-effectiveness rule. Cost-effectiveness is achieved if, and only if, the marginal cost of reduction is equal for each pollution source.

It is easy to show that this is true. Consider a town called Grimeville, which hosts an oil refinery, A, and a coal plant, B. The Grimeville City Council wants to control the total emissions of harmful gunk at 20 tons per day and is considering a uniform standard of 10 tons per day for each plant. Suppose that when refinery A emits 10 tons of gunk, it has marginal reduction costs of $10 per ton, while at an emission level of 10 tons, coal plant B has marginal reduction costs of only $2 per ton. Here’s the question.

Whenever the marginal cost of pollution reduction at one source is greater than that at another, the overall costs can be reduced without changing the pollution level by decreasing pollution at the low-cost site and increasing it at the high-cost site. Thus, cost-effectiveness is achieved only when the marginal costs of reduction are equal at all sites.

Let us expand the Grimeville example to illustrate how the city council might identify the cost-effective method of reducing pollution to 20 tons. Table 15.1 lists the complete marginal reduction cost schedules for the two plants, assuming that MCa=20xa and MCb=202xb, and xa and xb are the respective levels of pollution.

TABLE 15.1 Marginal Cost of Gunk Reduction in Grimeville

Pollution at Each Plant (tons/day) MC of Reduction ($/ton)
Plant A Plant B
20 >−−−−−−  1 −−−−−−  0
19 >−−−−−−  2 −−−−−−  0
18 >−−−−−−  3 −−−−−−  0
17 >−−−−−−  4 −−−−−−  0
16 >−−−−−−  5 −−−−−−  0
15 >−−−−−−  6 −−−−−−  0
14 >−−−−−−  7 −−−−−−  0
13 >−−−−−−  8 −−−−−−  0
12 >−−−−−−  9 −−−−−−  0
11 >−−−−−− 10 −−−−−−  0
10 >−−−−−− 11 −−−−−−  2
9 >−−−−−− 12 −−−−−−  4
8 >−−−−−− 13 −−−−−−  6
7 >−−−−−− 14 −−−−−−  8
6 >−−−−−− 15 −−−−−− 10
5 >−−−−−− 16 −−−−−− 12
4 >−−−−−− 17 −−−−−− 14
3 >−−−−−− 18 −−−−−− 16
2 >−−−−−− 19 −−−−−− 18
1 >−−−−−− 20 20
0

Table 15.1 reveals that it will cost $1 for plant A to reduce pollution from 20 tons to 19 tons per day, $2 to move from 19 to 18, and so on. Marginal reduction costs thus rise as pollution reduces. Plant B, on the other hand, faces zero marginal reduction costs all the way back to 10 units of gunk. Below 10 units, however, pollution reduction becomes increasingly costly for plant B as well. Of the two, plant B clearly has lower overall emission reduction costs.

The council has a two-part problem to solve: choose pollution levels at the two plants so that (1) total pollution equals 20 tons and (2) marginal reduction costs are (roughly) equal. We already know that cost-effectiveness will require plant A to pollute more than 10 tons, while plant B pollutes less. The simple way to identify the cheapest solution is to try a few combinations. Table 15.2 rearranges the information in Table 15.1 to examine pollutant combinations that add up to a total of 20 tons per day.

TABLE 15.2 Identifying the Cost-Effective Option

Plant A Plant B
Pollution (tons of gunk/day) Marginal Savings ($) as Pollution Rises Pollution (tons of gunk/day) Marginal Cost ($) as Pollution Reduces
10 10
11 >−−−−−− 10 9 >−−−−−− 2
12 >−−−−−− 9 8 >−−−−−− 4
13 >−−−−−− 8 7 >−−−−−− 6
14 >−−−−−− 7 6 >−−−−−− 8
15 >−−−−−− 6 5 >−−−−−− 10

We can use the table to find the cost-effective regulatory option. We have already discovered that moving from (10, 10) to (11, 9) lowers the total costs by $8. Similarly, moving on to (12, 8) generates savings of $9 at a cost of only $4. Finally, moving to (13, 7) saves an additional $2 (86). However, the (14, 6) option increases the net costs by $1, because the additional savings ($7) are less than the additional costs ($8). Moving on to (15, 5) is an even worse idea, as the savings are only $6 for an additional expense of $12. Thus, the cheapest regulatory option that achieves total pollution of 20 is plant A: 13 and plant B: 7. Note, as our rule predicts, that at this point, marginal reduction costs are roughly equal.

We can confirm this guess-and-check result using a more general algebraic approach. Recall that the data in Table 15.1 relating pollution levels to the marginal costs of reduction at the two plants are based on these MC relationships: MCa=20xa and MCb=202xb. Thus, the marginal cost of reduction at plant A, assuming that it is polluting 11 units, would be 2011, or $9. We also have the constraint that total pollution must equal 20: xa+xb=20, all of which, of course, suggests another question.

This exercise ratifies our eyeballed result for the cost-effective allocation of pollution at 13 tons and 7 tons. As a final bonus, the MC equations allow us to confirm that the marginal cost of reductions are indeed exactly equal at both plants: 202*6.666=2013.333=6.66 per ton.

We can compare total costs at the uniform standard option (10, 10) and the cost-effective option (13, 7) to see how much money we save from the latter choice. Total costs can be calculated as just the sum of all the marginal costs, so total costs at (10, 10) are 1+2+3+4+5+6+7+8+9+10=55. Total costs at (13, 7) are 1+2+3+4+5+6+7+2+4+6=40, for a net savings of 5540=15.

This example illustrates a principal reason why, in general, CAC systems that require uniform standards do not achieve cost-effectiveness. Because both high- and low-cost plants must meet the same standard, in our example, 10 tons per day, opportunities for reducing the overall costs are ignored. But, why are uniform standards set in the first place? Couldn’t the Grimeville City Council achieve a cost-effective solution by going through the earlier exercise and choosing (13, 7) in the first place?

In general, the answer is no. In the real world, the council might well founder on a lack of information—what economists refer to as imperfect information.3 Only the firms have access to the pollution-control cost information in Table 15.1, and they would be unwilling to share these data with the public. Of course, the regulators might still recognize in a qualitative way that refinery A has higher reduction costs compared to coal plant B and thus incorporate some concern for cost savings into their regulatory design. As we shall see, some CAC systems do just this.

Yet, such a rough approach would not capture all cost savings. In addition, in the political arena, plant B’s owners and residents around plant A might argue against such a move on the grounds of equity or safety. The next section illustrates that, in theory, IB regulation will achieve cost-effectiveness “automatically” through a market mechanism.

15.2 IB Regulation and Cost-Effectiveness

Back in the Grimeville City Council offices, the village economist proposes a tax system for controlling pollution and claims that the tax will deliver cost-effective pollution control. To prove her point, she draws graphs of the two marginal cost of reduction curves, reproduced in Figure 15.1. (Note that she has switched the direction of the horizontal axis—it now shows increasing pollution rather than pollution reduction. The reason for this is that, as we will see, it is easier to illustrate cleanup costs and tax revenues when the marginal cost of reduction curve is drawn sloping downward.) She then proclaims, “Consider, if you will, the effect of a tax on gunk emissions of $7.50 per ton on the pollution situation in our fair city. Faced with such a tax, plant A will reduce its pollution level from 20 to 13 units. It won’t go below 13 tons because for these units it is cheaper for it to pollute and pay the tax than it is to reduce pollution. By a similar logic, plant B will reduce pollution down to 7 tons per day. Because at the final pollution levels (13, 7) the marginal cost of reduction for both firms will be just less than the tax and thus equal to each other, my plan will be cost-effective.”

Graphical illustration of cost-effective Pollution Taxes.

FIGURE 15.1 Pollution Taxes Are Cost-Effective

“Moreover,” the economist continues, “because pollution now has a ‘price,’ every day they pollute the firms will pay for the privilege, 20 * $7.50, or $150 in all (areas w and x in the figure). This will provide them with a tremendous long-run incentive to search out new, less polluting ways of doing business. But best of all, Grimeville will be rich! We’ll earn tax revenue from the 20 units of pollution equal to $150 per day!”

For a moment, the audience is awed by the overwhelming clarity and logic of the economist’s argument. But only for a moment. “Wait a minute,” objects the oil refinery lobbyist. “Grimeville won’t earn a dime. Those steep taxes will drive both plants out of business. Not only are you making industry pay to reduce pollution from current levels back to 20 units (areas y and z), but now you’re imposing additional taxes as well!”

“Hmmmm,” mumbles the village economist. “We can solve this problem. You’ll still have to pay the pollution tax, but we’ll give the industry an income tax rebate based on the average pollution tax to make the whole thing ‘revenue neutral.’ (So much for Grimeville’s tax windfall!) As long as the size of the rebate is not connected to your individual firm’s efforts to reduce pollution, the pollution tax will still give you an incentive for further reductions.”

“But, how will we know where to set the tax?” the village environmentalist demands. “If we set it too low, gunk pollution will be more than 20 tons per day. Then we’ll have to adjust the tax upward, and he,” pointing at the refinery lobbyist, “is bound to complain about taxes being raised again. Besides, inflation will erode the value of the tax. And even if the tax is inflation adjusted, pollution levels will keep going up as population and production levels grow.”

“Valid points,” the economist concedes. “But here’s another idea. Suppose, instead of the pollution tax, we institute a cap-and-trade system.”

“A what?” asks the mayor.

“A cap-and-trade system. Let me explain. We’re interested in reducing total pollution to 20 tons per day, correct? Suppose we give each firm ten 1-ton permits allowing them to pollute, but we also allow the firms to buy or sell these permits. What will be the outcome?”

“I’m all ears,” says the mayor.

Plant A, facing high marginal reduction costs, would dearly love to have an 11th permit. In fact, from Table 15.2 we know it would be willing to pay up to $10 per day to get its hands on one. Plant B, on the other hand, would be willing to sell one permit, reducing to 9, for anything over $2 per day. Thus, a deal will be made. By a similar logic, A would be willing to pay up to $9 for a 12th permit, and B would sell another for anything over $4. Finally, A would buy the 13th for a price of up to $8, while B would part with an additional permit for a price greater than $6. However, the firms would stop there. Plant A would be willing to pay only $7 for the 14th permit, while B would have to be paid $8 to reduce down to six permits. So, voila! Market incentives will generate trade in permits until a cost-effective solution (13, 7) is reached.

“Note that the final price for a permit in this bargaining scenario is between $6 and $8 per day, which is very close to our $7.50 tax. As in the tax case, pollution now has a ‘price,’ giving firms long-run incentives to develop new, less pollution-intensive techniques so that they can sell their excess permits. Moreover, if new firms enter the area, they can do so only by buying existing permits. Total pollution will be fixed at 20 units.”

“Wait a minute,” objects the environmentalist. “Why should we give away the ‘right to pollute’?”

“Well,” says the economist, “we do that already whenever we set legal pollution standards. But one alternative would be for the government to sell the permits, instead of giving them away. A price of $7.50 or so would clear the market—because at that price plant A would demand 13, and plant B would demand 7. (Take a minute to check this.) Certain types of auctions would in fact generate such a price. But if you think about it, government sale of permits is really identical to a tax system! Selling permits to pollute one unit at $7.50 per day is the same thing as charging a tax of $7.50 per day for any units of gunk emitted.”

“Which is exactly why we oppose permit sales by the government,” pipes in the oil refinery lobbyist. “Once again you’re asking industry to cough up areas w and x in taxes, in addition to paying areas y and z in cleanup costs. But this permit giveaway idea sounds interesting…”

Now the conversation in Grimeville went on well into the night, but at this point, we would like to interrupt and summarize the main points. First, both tax systems and marketable permit systems will achieve cost-effective pollution control “automatically,” at least on the chalkboard. In either case, government regulators do not need to know anything about control costs at different sources. In the case of a tax, regulators merely specify a tax level, observe the market response, and if the induced pollution reduction is too little (or too great), adjust the tax upward (or downward). In the permit case, the government merely specifies the number of permits desired and distributes them by either sale or giveaway.

The discussion also highlights one of the political drawbacks of taxes (and permit sale systems). Polluters, whether firms or consumers, strenuously object to having to pay the government for the right to pollute up to the legal limit, in addition to the cleanup costs they face. For example, if the government were to impose a CAC standard of 13 units for plant A, the firm would have to pay area y shown in Figure 15.1 to clean up from 20 tons back to 13 tons. Under a $7.50 per ton tax (or permit-sale system), the firm would have to pay, in addition to these cleanup costs, 13*7.50=97.50, or area w. Such additional costs might in fact drive a firm out of business, and thus, they impose a bankruptcy constraint on the imposition of tax or permit policies.

In principle, pollution taxes or permit sales can be made revenue neutral by rebating the revenues to the affected firms or individuals in the form of income tax cuts. Parties paying the tax would not receive a rebate exactly equal to their pollution tax, as that would negate its effect. Instead, each polluter would receive an average rebate. In this way, average incomes remain the same, but the price of pollution still rises. Such tax rebates have been widely discussed as a way to reduce both the political opposition to and the regressive impact from any substantial carbon tax imposed to combat global warming. (Recall the Sky Trust idea from Chapter 1.)

Substituting pollution tax revenues for a tax on labor (the income tax) would enhance labor market efficiency, because in this particular case, people would work harder if they faced lower income taxes. This is the “double dividend” hypothesis discussed in Chapter 6.

In the case of a cap-and-trade system, rather than permit sales by government, permit giveaways substantially reduce the cost to, and political opposition from, industry. In the example provided earlier, where each firm was endowed with 10 permits, plant A ultimately had to pay for only 3 of its 13 permits, while plant B actually reaped a windfall from the giveaway policy.

The Grimeville discussion of the permit system also demonstrates that, in theory, the final outcome doesn’t depend on whether the permits are sold or distributed free of charge; in either case, a cost-effective solution will be achieved, though who pays how much to whom will vary. This is an important application of the Coase theorem discussed in Chapter 4. A Coase theorem corollary can be stated as follows:

If there is a well-functioning permit market, a cost-effective outcome will be achieved by a marketable permit system regardless of the initial ownership of the permits.

Take a minute to convince yourself that even if all 20 permits are initially given to plant A, the cost-effective solution (13, 7) will ultimately result. (Because we have only two firms, market power may be present. You have to assume that plant A isn’t interested in driving plant B out of business by refusing to sell any permits!)

Having convinced the Grimeville City Council that, at least in theory, incentive-based systems achieve short-run cost-effectiveness, a final question to the village economist might be, “So what?” How much could we, as a society, really save from a shift to an IB approach? At least a dozen studies have compared the compliance costs of CAC regulation with the costs of a hypothetical cost-effective approach. These studies provide a median CAC cost that is four times as high as the least-cost approach. Does this mean that we should expect overall savings of about 300 percent from a shift to IB regulation?

The answer is no. In practice, IB systems have not performed as well as they do on paper. For a variety of reasons discussed later, real-world pollution tax or tradeable permit approaches do not achieve truly cost-effective regulation. What the studies cited earlier suggest is that in some markets, it is technically feasible to reduce pollution-control costs to a quarter of their current level and substantially further in other markets. Thus, there is clearly room for doing better. While an IB approach is likely to reduce compliance costs, it will not operate perfectly or capture 100 percent of the potential cost savings.4

15.3 IB Regulation and Technological Progress

The magnitude of short-run cost savings from IB regulation, while uncertain, is probably substantial. However, potentially more important are the cost savings from long-run technological improvements in pollution control and waste reduction induced by the IB approach.

Taxes and permits generate important incentives for long-run technological progress in pollution control. Both systems put a “price” on pollution, so that every unit of pollution emitted represents a cost to the firm or individual. In the tax case, the cost is direct: less pollution would mean lower taxes. In the permit case, pollution bears an opportunity cost as less pollution would free up permits for sale. In both cases, because pollution is now costly to firms, they are provided with the motivation to continuously seek out new ways of reducing pollution.

Figure 15.2 illustrates the benefits of introducing a new pollution-control technology for a firm under an IB approach. The improved pollution-control system lowers the MC of reduction curve to MC, generating savings in two areas. First, the firm pays less for the units it was already cleaning up, area a. Second, the firm also pays less in taxes (or earns money from the sale of permits) by reducing pollution from P1 down to P2, area b.

Graphical illustration of Incentives for New Technology under IB and CAC.

FIGURE 15.2 Incentives for New Technology under IB and CAC

Compare these savings with those achievable under our stereotypical CAC system. First, the CAC systems are standard based. Once the firm has achieved the delegated emission standard P1, it gains relatively little by improving the pollution-control technology. Introducing an improved system gains only area a for the firm, as there is no incentive to reduce pollution below P1.

In addition, because the CAC approach specifies individual technologies as BACT, LAER, and the like, firms face regulatory obstacles in experimenting with new processes. To do so, they must convince the regulators that the new process will be superior to the industry standard, something the firm may not be able to demonstrate before installing the technology. In addition, firms may be reluctant to raise the industry standard by introducing new technologies that may then become the new BACT. This would force them to adopt the new technology in any new construction.

Finally, the CAC system dampens the incentives for innovation due to the new source bias discussed in Chapter 14. By regulating new sources more stringently than compared to old ones, the CAC system encourages firms and individuals to concentrate their energies on making old, high-pollution technologies last longer, rather than developing new, less-pollution-intensive substitutes. For example, one study found that the average age of electrical generating capacity in the states with nine of the highest environmental enforcement budgets was 16.5 years to 15 years, compared to 11.5 years for the rest of the states. It is difficult to sort out how much of the age increase was in fact due to higher regulation, because most of the nine were also “rust-belt” states, hit with declining demand for electricity generation in the same period. Yet, some of the increase was undoubtedly due to a heightened new source bias.5

By putting a price on every unit of pollution, by reducing specific technology requirements, and by leveling the playing field between new and old sources, IB regulation on paper appears to do a better job of promoting long-run investment in new pollution-control technologies and waste reduction than does the CAC system. How important are these potential cost savings? This would depend on how fast the pace of technological innovation was accelerated by a switch to IB, and it is a difficult effect to forecast. However, as we saw in Chapter 6, small changes in productivity have large long-run effects on costs, due to the cumulative nature of economic growth. Thus, it is safe to say that heightened incentives for technological progress in pollution control generated by IB regulations are probably more important than the short-run savings available from achieving cost-effectiveness.

15.4 Potential Problems with IB Regulation

There are several potential problems with implementing IB regulation. The first two—hot spots and monitoring and enforcement—apply to both tax and permit systems. Cap-and-trade systems have their own peculiar problems: the potential for thin markets, market power, and price volatility. Finally, pollution taxes have the special drawback that they are taxes—and thus are generally fiercely opposed by industries liable to be regulated. In addition, and unlike cap-and-trade systems, taxes do not ensure a particular amount of pollution control, and they must be raised over time to account for both economic growth and inflation. These advantages and disadvantages are summarized in Table 15.3 and discussed further later.

TABLE 15.3 Taxes and Marketable Permits Compared

Advantages of Permits Advantages of Taxes
If permits are given away, lower cost to firms If revenues are used to cut income taxes, labor market efficiency will be improved
More certain pollutant level If revenues are partially retained by enforcement agencies, enforcement incentives are strengthened
No need for adjustment to account for economic growth or inflation Issues of thin markets, market power, and price volatility are avoided

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.

Illustration of Nonuniformly Mixed Pollutants in Grimeville.

FIGURE 15.3 Nonuniformly Mixed Pollutants in Grimeville

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 SO2 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, SO2 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 NOx 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 Q1; all the firms to the left of Q1 receive permits for free, and all the new entrants into the market to the right of Q1 must purchase permits for a price equal to the vertical line segment at the kink: P2P1. This increases the marginal costs for new entrants and pushes the supply curve up for these producers. As demand rises to D2, 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 P2. 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.

Illustration of Permit Prices Passed on to Consumers in Competitive Markets.

FIGURE 15.4 Permit Prices Are Passed on to Consumers in Competitive Markets

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.

15.5 Summary

As a partial answer to the question “How can we do better?”, this chapter has focused on the theoretical arguments in favor of shifting to an IB system of pollution regulation. The economic advantages are twofold: (1) a reduction in the short-run costs of complying with regulations and (2) greater incentives for long-run cost savings and pollution reduction through technological progress. There is also a political-economic argument to be made in favor of IB schemes. By reducing the information necessary for regulators to make intelligent decisions, IB approaches reduce the influence that political actors can wield in the process.

IB approaches work by putting a price on every unit of pollution produced by a firm. Short-run cost-effectiveness (equality of marginal reduction costs across all sources) is then achieved “automatically,” as firms cut back (or increase) pollution levels until marginal reduction costs are just less than the tax or price of a permit. Because all firms do this, marginal costs of reduction equalize across the economy. Moreover, because any level of pollution costs the firm money, the pollution price also generates a long-run incentive for further pollution reduction through technological innovation.

Although taxes and tradeable permit systems are quite similar in many respects, there are also important differences.10 When permit systems are initiated through permit giveaways, they are much less costly than pollution taxes for the affected firms. Permits also generate a much more certain level of pollution control than taxes and do not need to be adjusted for inflation or population increases and economic growth. However, permit systems have the drawbacks associated with market power, thin markets, and price volatility. In addition, taxes generate strong incentives for monitoring and enforcement and, if used to replace income taxes, can increase labor market efficiency. Of course, revenues from government permit sales could serve these same two functions.

Potential problems with both types of IB systems include the generation of hot spots and greater reliance on direct performance monitoring to ensure compliance. In addition, liberal critics of cap-and-trade have been concerned about the potential to “game the system.” However, as long as monitoring and enforcement systems are strong, this criticism holds little weight. Conservatives, by contrast, don’t like new taxes. The way to address this issue is to design incentive-based systems to be revenue neutral, by cutting other taxes or rebating tax or permit revenues directly back to the citizens. Despite these potential problems, IB approaches deserve, and are receiving, broader attention as mechanisms for reducing pollution-control costs and pollution at the same time. The next chapter reviews the record on IB systems to date and discusses some of the challenges in implementation faced in the ongoing experiments.

KEY IDEAS IN EACH SECTION

  1. 15.0 Economists have argued that incentive-based (IB) regulation can both lower the short-run costs of pollution control and provide better incentives for long-run technological improvements compared to the current CAC approach. The two types of IB regulation are pollution taxes and cap-and-trade systems.
  2. 15.1 This section illustrates that cost-effective pollution control can be achieved only when the marginal costs of reduction at each source are equal. Due to imperfect information, regulators have a hard time mandating cost-effectiveness.
  3. 15.2 The Grimeville City Council meeting is used to illustrate how IB regulation can help achieve cost-effective pollution control “automatically.” Three additional points are stressed. (1) Pollution taxes, if used to replace taxes on labor, would increase labor market efficiency. (2) Although pollution taxes can be made revenue neutral (and non regressive) in theory, in practice, they seldom are, so firms prefer permit giveaways. (3) The Coase theorem corollary indicates that, in a well-functioning market, cost-effective pollution control can be achieved regardless of the initial distribution of permits.
  4. 15.3 More important than short-run cost-effectiveness, IB regulation provides better incentives than CAC does for long-run technological progress in pollution control.
  5. 15.4 This section discusses some of the disadvantages of IB regulation. Disadvantages of both systems include hot spots for the case of nonuniformly mixed and concentrated pollutants and monitoring and compliance problems. Disadvantages specific to permits include thin markets, market power, and price volatility. Price volatility can be addressed via banking and the imposition of price floors and price ceilings. Disadvantages specific to taxes include higher costs for firms as well as the need to increase taxes over time to account for inflation and economic growth.

REFERENCES

  1. Brown, Gardener W. Jr., and Ralph W. Johnson. 1984. Pollution control by effluent charges: It works in the Federal Republic of Germany, why not in the U.S.? Natural Resources Journal 24: 929–66.
  2. Burtraw, D., D. Kahn, and K. Palmer. 2005. CO2 allowance allocation in the regional greenhouse gas initiative and the effect on electricity investors. Electricity Journal 19(2): 79–90.
  3. Maloney, Michael T., and Gordon L. Brady. 1988. Capital turnover and marketable pollution rights. Journal of Law and Economics 31(1): 203–26.
  4. Misiolek, W. S., and H. W. Elder. 1989. Exclusionary manipulation of markets for pollution rights. Journal of Environmental Economics and Management 16: 156–66.
  5. Oates, Wallace E., Paul R. Portney, and Albert M. McGartland. 1989. The net benefits of environmental regulation. American Economic Review 79(5): 1233–42.
  6. Tietenberg, T. H. (1990). Economic instruments for environmental regulation. Oxford Review of Economic Policy 6(1): 17–33.

APPENDIX 15A: Imperfect Regulation in an Uncertain World

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.

Graphical illustration of IB Regulation, two cases: Steep Marginal Benefits and Steep Marginal Costs.

FIGURE 15A.1 IB Regulation, Two Special Cases

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, even on safety grounds, because the additional benefits are low. But, for cleanup levels below C, 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.

Graphical illustration of Case 1: Permits Preferred.

FIGURE 15A.2 Case 1: Permits Preferred

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 Ĉ. 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. Facing this tax, firms clean up only to C, 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.

Graphical illustration of Case 2: Taxes Preferred.

FIGURE 15A.3 Case 2: Taxes Preferred

If regulators undershoot the efficient tax by 20 percent and set it at T, firms will decrease cleanup only a little, to C. 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. 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 Ĉ.

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.

Graphical illustration of Cost Uncertainty and the Hybrid Proposal.

FIGURE 15A.4 Cost Uncertainty and the Hybrid Proposal

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.

APPENDIX 15B: Incentive-Compatible Regulation

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 (SO2) emissions from power plants. Suppose that the agency seeks to regulate SO2 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 SO2 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 SO2 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*.

Graphical illustration of Imperfect Information and Permits.

FIGURE 15B.1 Imperfect Information and Permits

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 (MC). If the industry does so and the EPA uses the industry estimates, the agency will increase the number of permits it sells to P. This will drive down the price of permits to T 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 SO2 emissions, and firms know this. Then, as illustrated in Figure 15B.2, companies have the incentive to understate their costs, for example, claiming 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. Again, pollution levels will be inefficiently high, and a firm’s cleanup costs will be reduced.

Graphical illustration of Imperfect Information and Taxes.

FIGURE 15B.2 Imperfect Information and Taxes

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, reflecting real control costs, when the agency expects them to rise to T. In the tax case, the pollution level will be P, 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

p=industry pollution levelL=number of permits made availablez=price of permitse=subsidy level for emission reductions

The industry’s total pollution-control costs are thus

cleanup costs+permit costsexcess emission reduction subsidy(area underzLe(Lp)MC curve)

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 (L¯) and set a high emission reduction subsidy at 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 e¯.

Graphical illustration of Incentive-Compatible Regulation, Case 1.

FIGURE 15B.3 Incentive-Compatible Regulation, Case 1

As a result, in equilibrium, the permit price z must just equal 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 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 P¯ even though they hold L¯ permits.

Thus, the final equilibrium will look like this: L permits auctioned off at a price just equal to the emission subsidy e¯, with firms polluting at a level of P¯. But, 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 L̂ permits will be available, and firms will receive a subsidy for emission reductions below L̂ 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 L̂ 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.

Graphical illustration of Incentive-Compatible Regulation, Case 2.

FIGURE 15B.4 Incentive-Compatible Regulation, Case 2

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

  1. Gruenspecht, A., and L. Lave. 1989. The economics of health, safety and environmental regulation. In Handbook of industrial organization, Vol. II, ed. R. Schmalansee and R. Willig. New York: North Holland.
  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.

Notes

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