Pollution control:

instruments

Cost efficiency and cost-effective pollution abatement instruments

• Suppose a list is available of all instruments which are capable of achieving some

predetermined pollution abatement target.

• If one particular instrument can attain that target at lower real cost than any other can

then that instrument is cost-effective.

• Cost-effectiveness is clearly a desirable attribute of an instrument.

– Using a cost-effective instrument involves allocating the smallest amount of

resources to pollution control, conditional on a given target being achieved.

– It has the minimum opportunity cost.

– Hence, the use of cost-effective instruments is a prerequisite for achieving an

economically efficient allocation of resources.

Least-Cost Principle

• A necessary condition for abatement at least cost is that the marginal cost of abatement

be equalised over all abaters - known as the least-cost theorem of pollution control -

illustrated in Figure 6.1.

• A least-cost control regime implies that the marginal cost of abatement is equalised over

all firms undertaking pollution control.

• A least-cost solution will in general not involve equal abatement effort by all polluters.

• Where abatement costs differ, cost efficiency implies that relatively low-cost abaters

will undertake most of the total abatement effort, but not usually all of it.

5 10 15 35 40302520

Pollution abatement, Z

Z

MCA = 3ZA

MC

MCB = 3ZB

75

100

200

Figure 6.1 Marginal abatement cost functions for the two firms

Instrument category

Institutional approaches to

facilitate internalisation of

externalities

Command and control

instruments

Economic incentive (market-

based) instruments

Classification of pollution control instruments

Instrument category Description

Institutional approaches to facilitate internalisation of externalities

Facilitation of bargaining Cost of, or impediments to, bargaining are

reduced

Specification of liability Codification of liability for environmental

damage

Development of social responsibility Education and socialisation programmes

promoting ‘citizenship’

Command and control instruments

Input controls over quantity and/or mix of

inputs

Requirements to use particular inputs, or

prohibitions/restrictions on use of others

Technology controls Requirements to use particular methods or

standards

Output quotas or prohibitions Non-transferable ceilings on product

outputs

Emissions licences Non-transferable ceilings on emission

quantities

Location controls (zoning, planning

controls, relocation)

Regulations relating to admissible location

of activities

Instrument category Description

Economic incentive (market-based) instruments

Emissions charges/taxes Direct charges based on quantity and/or

quality of a pollutant

User charges/fees/natural resource taxes Payment for cost of collective services

(charges), or for use of a natural resource

(fees or resource taxes)

Product charges/taxes Applied to polluting products

Emissions abatement and resource

management subsidies

Financial payments designed to reduce

damaging emissions or conserve scarce

resources

Marketable (transferable, marketable)

emissions permits

Two systems: those based on emissions

reduction credits (ERCs) or cap-and-trade

Deposit-refund systems A fully or partially reimbursable payment

incurred at purchase of a product

Non-compliance fees Payments made by polluters or resource

users for non-compliance, usually

proportional to damage or to profit gains

Performance bonds A deposit paid, repayable on achieving

compliance

Liability payments Payments in compensation for damage

Approaches which facilitate voluntary, decentralised internalisation of

externalities : Bargaining

• One approach to achieving emissions, or other environmental policy, targets is to

improve existing social or institutional arrangements that facilitate environmental

damage-reducing voluntary decentralised behaviour.

• Two variants of this approach:

– Improve the effectiveness of property rights regimes in bringing about socially efficient

allocations of resources;

– Encourage greater social responsibility in making choices and taking decisions.

• Each of these two variants shares the characteristic of potentially preventing the

emergence of externalities, or internalising externalities which have arisen.

– In doing so, it is possible that decentralised behaviour by consumers and producers may

generate efficient outcomes and so obviate the need for regulatory intervention.

• In a classic paper, Ronald Coase (1960) explored the connection between property rights

and the likelihood of efficient bargaining solutions to inefficient allocations of

resources.

• Coase proposed that a necessary condition for bargaining between agents to bring about

efficient resource allocation is the existence of a well defined and enforceable allocation

of property rights.

• Coase also showed that efficient bargaining may be hindered by the presence of non-

trivial transactions costs.

Bargaining – The Coasian Solution

Noise

MBZ

MCZ

c

b d

a

Z1Z2 Z3

Limitations to the Bargaining Solution to Pollution Problems

1. Transactions Costs

a) Large numbers of generators and/or sufferers

b) Linkage identification

2. The effect is Public

a) non-excludable

b) non-rival

Difficulties/limitations of bargaining as a solution to externalities problems

1. The likelihood of bargaining taking place is at best low unless well-defined and

enforceable property rights exist.

– For many environmental resources, well-defined and enforceable property rights do not exist.

– An important example is that in which the environmental resource is an open access resource in which

exclusion is impossible except at very high, and possibly prohibitive, cost.

2. Second, bargaining solutions require that the expected gains from bargaining are larger

than the expected costs of carrying out that bargaining.

– Thus, bargaining is facilitated by the existence of a relatively small number of affected parties, and by all such

parties being easily identifiable.

– Again, many environmental problems fail to satisfy either of those properties. Typically, environmental

degradation affects many people and in many cases, as with vehicle pollution, is attributable to a large number

of sources.

– It is often difficult to identify all affected parties, and the transactions costs associated with undertaking a

bargaining exercise can be enormous. Hence where the number of affected individuals is large, the scope for

efficient bargaining behaviour is restricted.

3. Difficulty (or impossibility) of intertemporal bargaining, including bargaining between

current and future generations.

– Often, environmental externalities cut across generations – our behaviour today imposes externalities on future

persons.

– While bargaining between affected individuals at one point in time seems feasible, it is difficult to imagine that

this could happen between representatives of the present generation and those not yet living.

– One would not, therefore, expect that bargaining between directly affected individuals and firms would offer

much prospect of bringing about an efficient response to global climate change, involving as it does many

generations.

Role of government

• If bargaining does offer the prospect of substantial efficiency gains, then government

should facilitate it wherever that is cost-effective.

• It could do so by clearly defining and explicitly allocating property rights where that is

practicable (and ethically acceptable).

• Where environmental problems spill over national boundaries, as in the case of

biodiversity decline or greenhouse gas emissions, further complications arise.

• Government might seek to develop and sustain an institutional structure that maximises

the scope for bargaining behaviour.

• Gains may also derive from government’s taking some responsibility for environmental

monitoring so as to identify pollution producers and recipients, and disclosing

information from this to affected parties.

• Access to the judicial system should be easy and cheap, and also equitable as between

different classes of parties. This will facilitate use of the liability principle.

• in many societies bargaining solutions to resolve disputes are often embedded in long

standing cultural traditions and social norms, and collective choice mechanism operating

within these frameworks.

• the limitations to bargaining do appear to be very substantial, and it would be

inappropriate to place too much reliance on such a mechanism as far as environmental

pollution problems are concerned.

Liability

• The role that may be played by the judicial system in helping to bring about efficient

outcomes has been implicit in our discussion of bargaining.

• That role can be taken a step further. Liability can be used as a means of dealing with

environmental hazards.

• Suppose that a general legal principle is established which makes any person or

organisation liable for the adverse external effects of their actions.

• In effect, property rights are then vested in the party adversely affected by the action

which generates the harm.

• Liability for damage is one mechanism that induces the potential injurer to undertake

the socially efficient level of precaution, Q*, where NMB (MB – MC) I smaximised.

• Two possible versions of the liability principle (there are many others): we investigate

whether they generate the appropriate incentive.

Strict Liability If an accident occurs, the injurer pays

full compensation to the victim

Negligence Liability If an accident occurs, the injurer pays

full compensation to the victim only if

the injurer were not, prior to the

accident, undertaking the efficient level

of precaution. If it were, then the injurer

is not required to pay any compensation

Development of social responsibility

• Pollution problems happen, in the final analysis, because of self-interested but

uncoordinated behaviour.

• Encouraging people – either as individuals or in their roles within organisations - to

behave as socially responsible citizens can help to attain environmental goals.

• Government has limited influence over the cultural context of human behaviour.

• But it would be wrong to ignore the opportunities that exist for using educational

institutions and the mass communications media to help achieve specific targets and to

promote ethical behaviour.

• The evidence that individuals do not exclusively act in a narrowly utilitarian way

suggests that this objective may be more than just wishful thinking.

• Perhaps the strongest evidence is to be found in our family and social lives, where much

of what we think and do has a social – rather than purely self-interested – basis.

• Given this, ‘cultural’ instruments that promote ‘social responsibility’ may be powerful

ways of achieving general environmental goals.

Command and control instruments• The dominant method of reducing pollution in most countries has been the use of direct

controls over polluters.

• This set of controls is commonly known as command and control instruments.

• Figure provides a schema by which these instruments can be classified.

Location of

emissions

Ambient pollution

levels

Emissions output

Production technique

Inputs used

Quantity of goods produced

The pollution process

Zoning

Ambient pollution

requirements

Emissions

licenses

Technology controls

Input restrictions

Output quotas

Command and control instruments

Non-transferable emissions licences

• Suppose that the EPA is committed to attaining some overall emissions target

for a particular pollutant. It creates licences (also known as permits or quotas)

for that total allowable quantity.

– After adopting some criterion for apportioning licences among the individual sources, the EPA

distributes licences to emissions sources.

– These licenses are non-transferable; that is, the licences cannot be transferred (exchanged)

between firms.

– Therefore, each firm’s initial allocation of pollution licences sets the maximum amount of

emissions that it is allowed.

• Successful operation of licence schemes is unlikely if polluters believe their

actions are not observed, or if the penalties on polluters not meeting licence

restrictions are low relative to the cost of abatement.

– Licence schemes will have to be supported, therefore, by monitoring systems and by

sufficiently harsh penalties for non-compliance.

Non-transferable emissions licences

• Under special conditions, the use of such emissions licences will achieve an overall

target at least cost (that is, be cost-efficient).

• But it is highly unlikely that these conditions would be satisfied.

– Cost-efficiency requires the marginal cost of emissions abatement to be equal over all abaters.

– If the EPA knew each polluter’s abatement cost function, it could calculate which level of emissions of each

firm (and so which number of licences for each firm) would generate this equality and meet the overall target.

– It is very unlikely that the EPA would possess, or could acquire, sufficient information to set standards for each

polluter in this way.

– The costs of collecting that information could be prohibitive, and may outweigh the potential efficiency gains

arising from intervention.

– Problem of information asymmetries; those who possess the necessary information about abatement costs at the

firm level (the polluters) do not have incentives to provide it in unbiased form to those who do not have it (the

regulator).

– A system of long-term relationships between regulator and regulated may partially overcome these

asymmetries, but might bring other problems (such as regulatory capture.

• Given all this, it seems likely that arbitrary methods will be used to allocate licences,

and so the controls will not be cost-efficient.

Instruments which impose minimum technology requirements

• Command and control instrument that consist of regulations which specify

required characteristics of production processes or capital equipment used.

• In other words, minimum technology requirements are imposed upon potential

polluters.

• Examples of this approach have been variously known as best practicable

means (BPM), best available technology (BAT) and best available technology

not entailing excessive cost (BATNEEC).

• In some variants of this approach, specific techniques are mandated, such as

requirements to use flue-gas desulphurisation equipment in power generation

or minimum stack heights.

• Sometimes the specific technique adopted is sometimes negotiated between

the EPA and the regulated parties on an individual basis.

Location• Pollution control objectives , in so far as they are concerned only with reducing human

exposure to pollutants, could be met by separating the locations of people and pollution

sources.

• This is only relevant where the pollutant is not uniformly mixing, so that its effects are

spatially differentiated.

• Separation can be done ex ante or ex post.

• Separation ex ante, by zoning or planning control, is relatively common.

– Planning controls and other forms of direct regulation directed at location have a large role to play in the

control of pollution with localised impacts and for mobile source pollution. They are also used to prevent

harmful spatial clustering of emission sources.

• Ex post relocation decisions are rarer because of their draconian nature; examples

include people being removed from heavily contaminated areas, such as Chernobyl.

• Location decisions of this kind will not be appropriate where we are concerned about

wider ecosystem impacts or where pollution is uniformly mixing

Command and Control: assessment

Attractive Properties

• Certainty of outcome

• Ability to get desired results very quickly.

Unattractive Properties

• Likely to be cost-inefficient, as CAC techniques contain no mechanisms to

bring about two desired results:

– equalization of marginal abatement costs over the controlled firms in that programme.

– equalization of marginal abatement costs across different programmes (e.g. Magat et al. (1986)

estimated that the marginal treatment cost of biological oxygen demand (BOD) from US rivers

and lakes varied from as little as $0.10 per kilogram of BOD removal to as much as $3.15).

• Lack good dynamic incentives

Economic incentive (quasi-market) instruments :

Basic Principle

• Incentive-based instruments work by altering the structure of pay-offs that

agents face, thereby creating incentives for individuals or firms to voluntarily

change their behaviour.

• The pay-off structures are altered by changing relative prices. This can be

done in many ways. We focus on two of them:

1. By the imposition of taxes on polluting emissions (or on outputs or activities deemed to be

environmentally harmful), or by the payment of subsidies for emissions abatement (or

reduction of outputs or activities deemed to be environmentally harmful).

2. By the use of tradable emission permit (or allowance) systems in which permits command a

market price. Those prices are, in effect, the cost of emitting pollutants.

• More generally, any instrument which manipulates the price system in such a

way as to alter relative prices could also be regarded as an incentive-based

instrument.

With uniform taxation across discharge sources, the overall reduction is achieved at least cost

MNPB is Marginal Net Private Benefit = MPB – MPC

No tax - Profit maximised where MNPB = 0

With tax – Profit maximised where MNPB = t

Total Cost of pollution reduction = aM1*M1t + bM2*M2

t

There is no re-allocation of pollution reduction as between the two firms that

can reduce the total cost

P2M1

t t

M2t M2*M1

t M1*

a b

MNPB1

MNPB2

Key results• The tax instrument - at rate t - brings about a socially efficient aggregate level of

pollution

• It will also achieve that aggregate target in a cost-effective way.

– Cost-efficiency requires that the marginal abatement cost be equal over all abaters.

– Under the tax regime all firms adjust their firm-specific abatement levels to equate their marginal abatement

cost with the tax rate.

– But as the tax rate is identical for all firms, so are their marginal costs.

• Knowledge of both the aggregate marginal pollution damage function and the

aggregate emissions abatement cost function are necessary for achieving a socially-

efficient emissions target at least real resource cost to the economy as a whole. But it is

not necessary to know each firm’s marginal abatement cost function.

• There is a problem with emissions taxation – if the firms’ MNPB(P) functions are not

known, it is not possible to calculate the tax rate that will bring about the desired overall

reduction in pollution. Whatever reduction is achieved will be brought about at least

cost, but it could be too big or too small.

• Tradeable permits avoid this problem. Since the quantity of permits issued is equal to

the desired level of total emissions, assuming compliance, the achieved reduction is that

intended. Tradeable permits are dependable, as well as least cost. They have the least

cost property because with a single market price per permit, all firms move to where

their MNPB = permit price, and the situation is as in the previous slide.

• If the permits are initially issued free, there is no revenue arising, as there is with

taxation.

Marketable emissions permits

Marketable permit systems are based on the

principle than any increase in emissions must be

offset by an equivalent decrease elsewhere.

There is a limit set on the total quantity of emissions

allowed, but the regulator does not attempt to

determine how that total allowed quantity is

allocated among individual sources.

A tradeable permit system can attain the

socially efficient level of pollution emissions (M)

Emissions, M

MNPBM

Total supply of

permits

0 M*

Equilibrium permit priceP*

An emissions tax can attain the socially efficient

level of pollution abatement (Z)

Pollution

abatement, Z

SMBZ

MCZ

0 Z2

tax ratet*

An abatement subsidy can attain the socially

efficient level of pollution abatement (Z)

Pollution

abatement, Z

SMBZ

MCZ

0 Z2

S* Subsidy rate

The initial allocation of permits and the determination

of the equilibrium market price of permits

Two general methods of initial allocation:

• Case 1: the EPA sells all permits by auction

• Case 2: the EPA allocates all permits at no charge (which in turn requires that

a distribution rule be chosen)

Figure 6.9 The determination of the market price of emissions permits

Auctioned permits case

Marginal abatement cost

(aggregate)

*

M̂M* Emissions,

M

0

Fixed supply of

permits

A firm will bid to

purchase an

additional emissions

permit whenever the

marginal cost of

abating emissions

exceeds the permit

price. The market

equilibrium permit

price is determined

by the value of the

aggregate marginal

abatement cost at the

level of abatement

implied by the total

number of issued

permits.

Demand for permits

*

EP* Emission permits

(EP)

0

Figure 6.10 The determination of the market price of emissions permits: free initial

allocation case

Supply of permits

Figure 6.11: Efficient abatement with two firms and marketable permits

0

20

40

60

80

100

120

140

160

180

200

0 5 10 15 20 25 30 35 40 45 50

Emissions abatement, Z

Marg

ina

l ab

ate

men

t co

st

MC(B)

MC(A)

MC(INDUSTRY)

Required industry wide abatement

Equilibrium permit price =

Marginal abatement cost for

each firm = 75

Under tradable permit schemes, in equilibrium marginal abatement costs will be equal over all firms. Hence

marketable permits, like taxes and subsidies, achieve any given target at least cost. Moreover, if the total

quantity of permits issued is M* and that quantity is identical to the level of emissions which would emerge

from an emissions tax (or an abatement subsidy) at the rate * then a marketable permit scheme will generate

an equilibrium permit price *.