Incentive-Based Regulation:

Theory

Introduction

Basic Ideas: Make polluting an expensive activityLower the costs of pollution control by leaving

decisions about how to reduce pollution up to firms and individuals

Types of incentive-based (IB) regulations:Pollution taxes (pigovian taxes, emission or

effluent fees)Cap-and-Trade system (marketable or tradable

permit system)

Advantages over CACPromotes more cost-effective regulation in the

short runProvides better incentives for firms to seek out

new technologies to lower pollution control costs in the long run

Potential problems: Big 2: monitoring and enforcement, hot spots Others to be discussed

The Cost-Effectiveness Rule

“Cost-effectiveness is achieved if and only if the marginal cost of reduction is equal for each pollution source”

Why? Whenever the marginal cost of pollution reduction at one source is greater than that at another, 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

IB Solutions in Grimeville

Cost Effective Reduction for a 20 ton Cap

IB Systems are Cost-Effective

IB Regulation and Cost-Effectiveness

Both tax systems and marketable permit systems will achieve cost-effective pollution control automatically, at least on the chalkboardIn either case, government regulators do not need

to know anything about control costs at different sources

Pollution taxes and cap-&-trade w/ auction are equivalent:

If permits are auctioned by the government, then C&T= PT.

(Selling 20 permits at $7 is the same as taxing 20 units of emissions at $7)

Cap-&-trade: Give-aways versus auctions If permits are given away to firms free of

charge (permit-give-away), then C&T costs much less for firms than if the permits are auctioned (just like PT)—Under PT or C&T auction firms pay tax

revenues plus clean-up costsUnder C&T with a give-away, firms pay only

clean-up costs plus the costs of any additional permits.

And… with permit give-aways some firms MAKE MONEY!!!

How do firms profit from permit give-aways?

1. By selling excess permits

2. Prices rise the same amount regardless of whether permits are given away or auctioned– Firms without permits wind up paying the same

price in either case, so market prices have to rise to cover that cost.

Firms with low clean-up costs profit from higher energy prices!

Windfall Profits from Rising Prices

Using tax or auction revenues: Idea 1: “Double Dividend”?

Substituting PT or C&T auction revenues for a tax on labor (or capital) would discourage pollution and encourage work (or investment)! (more on this back in chapter 9…)

Using tax or auction revenues: Idea 2: “SkyTrust”?

Rebate the revenues directly back on an equal basis to all citizensSimilar to the Alaska Permanent FundNo “double-dividend” since you aren’t cutting

taxes on labor.

In general, rebating auction or tax revenue leads to net benefits for the majority of people (a “progressive” policy)

Conclusion on giveaways versus auctions Firms hate PT and/or Auctioned C&T. They

much prefer permit-give-aways under C&T. (CAC is much less expensive to firms as well.)

Both for “double-dividend” reasons, and to insure that incentive-based approaches are not regressive, economists increasingly favor C&T auctions (or PT) over permit-giveaways.

Relation between pollution taxes and cap-&-trade: 3 With C&T, directly control the quantity of

pollution emitted. With PT, regulators only indirectly

control the quantity of pollution, by guessing at industry response to a tax of a certain level.

More on this in Appendix 16A

Final theory point: Coase Theorem Corrolary

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

Taxes and Permits Compared

IB Regulation and Technological Progress

Taxes and permits generate better incentives for long-run technological progress in pollution control than CAC Taxes: less pollution means lower taxesPermits: pollution bears an opportunity costs since

less pollution frees up permits for sale In both cases, since pollution is now costly to

firms, they have a motivation to continuously seek out new ways of reducing pollution

Incentives for New Technology Under IB and CAC

Potential Problems with IB Regulation Two Problems w/ both PT and C&T:

Need for direct monitoring of emissions and enforcement of violations

Hot-spots: high local concentrations of pollutants Monitoring

Emissions monitoring is a GOOD thing, but it has to be built into the system up front. IB regulations cannot work without direct monitoring of emissions.

Hot Spots Uniformly mixed pollutant

Emissions concentrations are spread evenly over multiple areas

Concentrated pollutant All the damage done by emissions of a plant occur in the

plant’s area Nonuniformly mixed pollutant

The bulk of the damage is done locally, but effects do drift into other areas

IB systems create hot-spots for concentrated and nonuniformly mixed pollutants

Nonuniformly mixed Pollutants in Grimeville

Taxes would have to be higher (or the emissions value of a permit lower) in already polluted areas

Problems with Permit Systems Thin markets--markets with only a few buyers and

sellers Price Volatility! (RECLAIM– see next chapter) Potential for market power:

Most likely if new firms are forced to buy permits from direct competitors

Permit life Short permit lives quickly lose value and are not worth

trading Firms must be able to bank their permits--if a reduction is

made in one year, the permit can be saved for trade in a later year

Problems with Pollution Taxes

With taxes, regulators do not know in advance the actual level of pollution that will emerge. Tax must be raised if not enough pollution is reduced.

Taxes must be continually adjusted upward to hold pollution constant in the face of both economic growth and inflation.

Summary

Economists like IB regulations for what two reasons?

Over the last 20 years, we have been learning about the problems that come with these systems, but…

We still think they are great!

Imperfect Regulation in an

Uncertain World

Perfect Information

The theory in IB systems is based upon the assumption of perfect informationRegulators were assumed to know everything

about both the benefits and costs of pollution control

In the real world practice of regulation this assumption is far from the truth

This appendix will introduce uncertainty into the analysis

IB Regulation, Two Special Cases

Regulation with Imperfect Information When the marginal benefit benefit curve is

steep, regulators will want to keep tight control over the actual quantity of pollutant released to ensure 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

Case 1: Permits Preferred

Minimizing the Costs Of Being Wrong The previous slide illustrates a pollutant

with a safety threshold Cleanup need not be pursued beyond C’ since

the additional benefits are lowFor cleanup levels below C’, damages from

additional pollution begin to mount steeply The next slide illustrates a situation where

costs are quite sensitive to the level of cleanupPollution reduction to a level of C’’ can be

pursued relatively cheaplyBeyond C’’, costs mount rapidly

Case 2: Taxes Preferred

Regulation with Imperfect Information

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

An Application to Greenhouse Gas Emissions

Implementing Kyoto:On the national level, each country issues annual

permits to greenhouse gas polluters that are tradeable within the country up to Kyoto level emissions

If prices rise above a target level, governments government should then sell additional annual permits at that price

This puts a price ceiling on permit prices at the government selling price

Advantages to this System If the marginal costs of reduction are low

then the Kyoto targets will be achieved If the marginal reduction costs are high,

the economy avoids an expensive crash reduction in greenhouse emissions

Cost Uncertainty and the Hybrid Proposal

Incentive-Compatible Regulation

Incentives to Lie Incentive-based regulation ensures that the

incentives faced by the regulated parties are compatible with the goal of the regulator

If firms are expecting a marketable permit system, they have an incentive to overstate compliance costs

If firms expect a tax, an incentive exists to understate compliance costs

Imperfect Information and Permits

Incentives to Tell the Truth

An example of an incentive compatible approach 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 above the number of permits the firm holds (an excess emission reduction subsidy)

Determining Pollution Costs

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 thusCleanup costs + permit costs - excess emission

reduction subsidy Area under MC curve + z*L - e*(L-p)

The trick is to set the subsidy level e at the intersection of the MB curve and the reported MC curve

Telling the Truth If firms overstate their costs

The large supply of permits will not cause the price to fall, unlike in marketable permit systems

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”

Firms would lose money if they did not reduce pollution and receive the subsidy so they cut back pollution

Incentive-Compatible Regulation, Case 1

Telling the Truth

If firms understate their costsThe true marginal costs of reduction will

exceed the subsidy for excess emission reductions

Firms will pollute to the limit L and not take any subsidies

This is a stricter and more costly standard than they would have faced if they had told the truth

Incentive-Compatible Regulation, Case 2