Module 6:Taxes and Permits-I

Incentivize the future !

Command and Control versus Incentives

Part 1. Policy tools to realign private incentives with environmental goals are of three kinds
1.01    Legal Mandates and Technological Restrictions

1.02    Cooperative Institutions to share information between regulators, polluters, and victims

1.03    Economic incentive mechanism to increase the shirking costs on environmental protection

Part 2.    Economic Incentives –

2.01    Economic incentives offer cost effective alternatives to Command and Control systems. It helps in reducing shirking costs, increase flexibility to find least cost pollution control strategies. The three main types of economic incentives are; Price Rationing, Quantity Rationing, Liability Rules

Part 3.    Price Rationing

3.01    Emission Charges (taxes )
3.02    Ambient  Charges (standards)
3.03    Product Charges
3.04    Subsidies

Part 4.    Emission Charges


Effect of Pigouvian tax

4.01    Pigovian Taxes are set in such a way that it is more cost efficient for the firm to reduce pollution than to pay the taxes (taxes are set higher than the Marginal Social Cost)

4.02    Tax rate (t) is fixed at the point where MB=MC, which is the optimal level

4.03    Internalizing the Marginal Social Cost in decision making, leading a reduction in output Marginal Benefit equals the Private Costs plus the Social Costs

4.04    Not necessary to compensate victims

4.05    Equality of Coase theorem and Pigovian Solutions. Problems in applications of Coase theorem in allocation of public bads.

4.06    In controlling emissions from several polluters whose emissions all contribute to damage in the same way, equimarginal principle requires that MC of cost control be equalized across firms to achieve an emission reduction at the lowest cost possible.

4.07    Inability to measure MSC (Marginal Social Cost) leading to distortion

4.08    Information Asymmetry leads to the provision of wrong incentives to industry making Pigovian taxes inefficient in some scenarios. (Weitzman , 1974)

Part 5.    Ambient Charges

Ambient standards used around industrial units and hence are a very popular instrument

5.01    Ambient charges are an attempt to overcome the asymmetry of information which includes mainly the moral hazards and inability to perfectly monitor the emission from each producer. Ambient charges is a system where in the charges are based on the overall ambient concentration of a pollutant in a region. Ambient Charges consists of two parts;

5.02    A per unit charge or subsidy based on the deviation from the ambient standard.
A lump sum penalty for not achieving the standard (independent of the deviation)

5.03    The liability of each polluter in an ambient charge system depends on the aggregate emissions from the entire group of polluters. Since each producer has to pay the full marginal damage of the total level of ambient pollution, he has no incentive to free ride on the other’s actions .The system is not made for budget balancing and therefore allows for this. A disadvantage of Ambient Charges is the amount of information needed to set the appropriate levels of tax/subsidy is vast (like pollutant leeching, runoff, etc.) and is therefore more difficult to implement and monitor.

Part 6.    Product Charges

6.01    Product Charges is an indirect attempt to influence behavior by putting a charge directly on the product or input perceived to cause the problem. It gives attention to environmental cost at each at product cycle; production, use, and disposal. It has been criticized for lack of impact on producer behavior because of relatively low levels of product charges
Part 7.    Subsidies

Subsidy Break-up for Renewables vs Non-Renewables

7.01    Same MC principle applies as Pigouvian taxes. Same effect in the short run, reducing output of firms by offering a lump-sum subsidy based compensation for reduced output. However taxes preferred in the long run as they are less distortionary, by virtue of subsidies incentivizing market entry in the long run. Subsidies are used for modeling positive externality based interventions

7.02    HSW explores the relationship between environmental subsidies, the diffusion of a clean technology, and the degree of product differentiation in an imperfectly competitive market.
7.03    The subsidy succeeds in reducing environmental damage only when the substitution effect (the reduction in pollution associated with the clean technology) exceeds the output effect (the extent that the subsidy increases output). The model further adds product differentiation and diffusion dynamics.
7.04    When the substitution effect dominates, environmental damage decreases monotonically during the diffusion process. The extent of technology diffusion (the degree to which clean technology replaces dirty) is decreasing in the degree of product differentiation.

7.05    Further, as products become closer substitutes, it is more likely that the subsidy will reduce environmental damage. Finally, the subsidy for clean technology will spill over to the remaining dirty producers, increasing their profit as well. In a free-entry equilibrium, the subsidy decreases pollution when product differentiation is low compared to the relative pollution intensity of the clean technology.
Part 8.    Liability Rules
8.01    Liability rules are set so that the producer pays a bond up-front and is reimbursed if no environmental harm occurs, or he pays a compliance fee after the harm has been done. It is aimed at reducing shirking on environmental pollution control by raising expected cost of misbehavior.

8.02    Random Penalty Mechanism
8.03    If total ambient concentration exceeds a standard, regulator selects at least one producer at random and fines him. Regulator redistributes the portion of the fine minus the damages to the society to the other producers. Less information is needed to implement compared to taxes, subsidies. It is budget balanced, and does not require additional revenue beyond the welfare gain generated by abatement, but will work only if the firms were risk averse

8.04    Deposit-refund system:
8.05    The purchasers of potentially polluting products pay a surcharge, which is refunded to them when they return the product or container to an approved centre for recycling or proper disposal. It is cost-effective and efficient, as less administrative role is needed
Part 9.    Quantity Rationing

Efficiency of Permits

9.01    Tradable permits are a cost-efficient, market-driven approach to reducing greenhouse gas emissions. A government must start by deciding how many tons of a particular gas may be emitted each year. It then divides this quantity up into a number of tradable emissions entitlements – measured, perhaps, in CO2-equivalent tons – and allocates them to individual firms. This gives each firm a quota of greenhouse gases that it can emit over a specified interval of time. Then the market takes over.

9.02    Those polluters that can reduce their emissions relatively cheaply may find it profitable to do so and to sell their emissions permits to other firms. Those that find it expensive to cut emissions may find it attractive to buy extra permits. Trading would continue until all profitable trading opportunities had been exhausted.

9.03    Permits would ensure that emissions do not exceed a given level. They are not as good as carbon taxes, however, at guaranteeing that the costs of abatement will be neither too large nor too small. So, in choosing between the two main market-oriented approaches of tradable entitlements and carbon taxes, a government must decide whether it is more important to be certain of the quantity of reduced emissions or of the costs involved.

9.04    Tradable permits are already being used to address several other environmental problems. For example, the US regulates chlorofluorocarbons (CFCs) with tradable emissions entitlements, and it is introducing a similar system to limit emissions of pollutants that cause acid rain. The 1987 Montreal Protocol on Substances that Deplete the Ozone Layer also includes provisions for the international trading of emissions permits, although no such trades have yet taken place.

9.05    To be successful, a permit scheme would have to be carefully designed. If the rules governing trading are complex, or if the market for permits consists of only a few players, trading may not be efficient. This will also be true if trading involves substantial transaction costs. On the other hand, even an inefficient permits system may be a more cost-efficient way to reduce emissions than using most forms of regulatory control.  If implemented internationally, tradable permits could lead to resource transfers from rich countries to poor ones.  International trading could take place between governments as well as between firms. But before trading could begin, governments would have to agree on how to make the initial allocation of permits.

PCE for CO2 around the world

9.06    One proposal calls for allocating entitlements on an equal per-capita basis. Such an allocation would guarantee resource transfers from the North to the South because, having fewer greenhouse gas emissions per capita than do industrialized ones, developing countries would be net sellers of permits, while rich countries would be net buyers. However, it is highly unlikely that such an allocation would be acceptable to the rich countries. They would probably prefer to have no agreement at all than to make such large transfers.

9.07    To win broad acceptance, an international scheme for tradable permits could not allocate quotas on a simple per-capita basis. The problem is that developed countries have high per-capita emissions, the developing countries have low per-capita emissions, and the former Communist countries are somewhere in between.

9.08     An allocation based on population would be attractive to developing countries, but probably unacceptable to industrial countries because it would require them to make huge transfers to poor countries (assuming that the agreed goal was to reduce global emissions on a large scale). Allocating entitlements according to a slightly more complex formula could reduce these transfers and ensure that every party to the agreement is better off than it would be without the agreement.

9.09    Agreement would be far more likely if the entitlements were initially allocated according to a formula that reflected the different circumstances of these country groups. For example, the developed countries could receive somewhat fewer permits than would be required for current emissions levels, and the poor countries a slight surplus, with the total quantity of entitlements being somewhat below current global emission levels. One study estimates that such an allocation would lower resource transfers to a fraction of current overseas development assistance.

9.10    International tradable permits could be effective even if implemented on a small scale. Economists analyses schemes for emissions permits have usually focused on international agreements for making large-scale reductions in global greenhouse gas emissions. But trading may also be effective in more limited circumstances. For example, a country facing high abatement costs may meet its own national target for emissions reduction by providing incentives for other countries with low abatement costs to undertake abatement on its behalf. Such bilateral agreements (known as “offsets”) may involve relatively high transactions costs, but their small scale may make them easier to negotiate and implement, at least in the short run.

9.11    From a narrow economic perspective, individual countries do not have a strong incentive to reduce their net greenhouse gas emissions unilaterally. Few countries emit more than 1-2% of mankind’s current fossil fuel emissions of carbon dioxide (CO2). So if a country reduced its emissions, it would receive some benefit in the form of a small reduction in global climate change, but that benefit would be only a tiny fraction of the world-wide benefit. As a result, individual countries have very little economic incentive for incurring the costs of abating emissions or of enhancing forests or other “carbon sinks”.

9.12    To be truly effective, climate policies will have to be international. The industrial countries account for about one-half of mankind’s current CO2 emissions. However, even if all the developed countries work together to cut their emissions, they would have only a limited impact on future climate change because emissions are expected to increase rapidly in the developing countries. It must be remembered that, while the industrialized countries are largely responsible for the historical build-up of atmospheric concentrations, new policies can only impact current and future emissions.

9.13    Resource transfers will be required to make an internationally coordinated policy attractive to developing countries. Developing countries may be relatively more vulnerable to climate change than are industrialized countries. However, the total benefit they would receive from policies to reduce climate change damages is likely to be smaller than the benefit realized by industrial countries, since the latter have larger economies (this analysis considers only market goods and services).

9.14    Resources will therefore have to be transferred to developing countries to make it attractive for them to incur the costs of substantially reducing greenhouse gas emissions and enhancing carbon sinks.

9.15     Precedents for such transfers exist. For example, under the amended Montreal Protocol industrialized countries compensate developing countries for the “incremental costs” of substituting new chemicals for CFCs. In the case of climate change, rich countries would find transfers economically attractive because the total cost of abatement can be reduced if the abatement burden is distributed widely. While the UN Convention on Climate Change calls for such transfers, agreeing on their magnitude and distribution will not be easy.

9.16     Free rider incentives will be hard to overcome. The problem is that any country that decides not to participate in the global effort to reduce emissions saves substantially on abatement costs. At the same time, because this country’s emissions are small relative to the total, it would suffer only a minute loss in benefit as a consequence of its own decision not to participate. So this country would be better off economically if it did not participate.

9.17    It will be harder to reduce emissions of carbon dioxide than it has been to reduce emissions of gases that destroy the ozone layer. While it is true that the Montreal Protocol successfully harnessed international cooperation to phase out CFCs, climate change is a very different environmental problem. Reducing CFCs will be relatively cheap, and the economically measurable benefits quite high – largely because ozone depletion causes cancer, which people are willing to pay a lot to avoid. This gave countries strong unilateral incentives to agree to phasing out CFCs. Such is not the case with climate change.


CDM at work

Part 10.    Evaluative Criteria

10.01    Effectiveness
10.02    Effectiveness of a system depends on the success in achieving the regulator’s objective which is context specific. If risks associated with small increases in emissions are high, then practical strategy is to use permits (quantity rationing). If the objective is to maintain more certainty over the costs of pollution, emission charges should be used. (price rationing). The debates over effects are based on theory, no incentive systems have been used to make detailed statements on their use.
10.03     Efficiency

(a)    The aim of efficiency is to achieve regulator’s objectives at the lowest possible cost. Emission charges require constant monitoring, administrative capacity to use the data to set appropriate charges. On the other hand, tradable permit systems ask for a need to establish rules and organization rules of the permit market, monitoring trades between producers and to check if the producers selling permits have reduced their emissions appropriately.

10.04    Equity

(b)    Economic incentives can influence the distribution of costs and benefits among the members of society. Regulators can identify the winners who capture the benefits of cleaner environment and the losers who bear the financial cost of burden. Equity stresses on the need for a polluter pays principle, in the case of permits it is granting them the right to pollute. There is a need to also look at the feasibility of firm operating in the markets ( if the cost is too high, factories can relocate) – promotion of jobs, economic growth is important.

10.05    Flexibility to achieve objectives

10.06    A useful economic incentive system should adapt to the changes in markets, technology, and knowledge, social, political and environmental conditions. Fixed rates of charges can be problematic (for e.g.: when inflation rate is high). Tradable permits allows for more flexibility as the price for the permits are set by transactions among producers in the market

Part 11.    Practical Conditions for the use of Economic incentives

11.01    Informational base and administrative capacity
•    Information is needed on the cost and benefits of alternative incentive systems and recognition of winners and losers. Information needs to be collected, stored and disseminated to provide an adequate knowledge base to implement an economic incentive scheme. There is need to specify the chain of authority, the range and assignment of jurisdiction and the legal standing of the affected parties. In the case of the regulators, they need staff and funding to effectively implement, monitor and enforce the system. Regulators, therefore combine the efficiency gains of economic incentives with the strict standards of command and control to promote pollution control

11.02    Legal Structure
•    Legal system is needed to define property rights clearly, provide legal authority to issue incentives and specify who has legal standing and jurisdiction. It is more problematic when dealing common property or centralized property systems

11.03    Competitive Markets
•    Economic incentives are more efficient in a competitive environment. They are more advantageous, relative to direct regulations, in markets with many buyers and sellers

11.04    Political Feasibility
•    Something that makes economic rationale may not be politically feasible (like random penalty scheme where a well-behaved producer can be penalized due to the shirking of the others). Governments and institutions should also keep in mind jobs and economic growth as these have a political dimension

Part 12.    Regulations

Regulation - Pareto Superior but not Pareto Optimal

Part 13.    Political economy theory of regulation is based on two theories; 1)Public Interest Theory: purpose of regulation is to protect public interest (Normative), 2) Interest Group Theory:  purpose of regulation as promoting the narrow interests of particular groups in society, like individual industries (Positive) and it involves rent seeking. The reasons for regulation includes; imperfect competition, imperfect information, and the need to control the provision of public goods and bads.

Part 14.    The political economy of regulation deals with three main institutions that are imperative for regulation. The institutions are;
•    Legislature: Makes the new laws, define role of regulators
•    Judiciary: Tempering the regulator’s actions
•    Regulators:  Detailed Implementation of the legislature’s laws

14.02     Basic Regulatory Instruments

•    Command and Control
(i)    It is the dominant method for pollution control and regulation, and can be compared to the centrally planned economies. The regulator here specifies the individual steps the individual polluter must take. There is a restricted choice for polluter as to what means to achieve target and there is no means to ensure equi-marginal efficiency.
(ii)    Problems with command and control model include; information costs are high, reduced incentives for innovation. The Polluter only pays for pollution control, not the residual damages from pollution
(iii)   Economic Incentives

14.03    Complications for environmental regulation

•    Space and Time
•    Ambient levels of pollution cause more damage, but emission control do not take this into account since they are harder to measure. Space is a major factor for pollution like urban photochemical smog. Time is also important, like evening and night emissions are less dangerous than morning emissions, also seasonal variations

•   Effiency vs. Cost Effectiveness
(i)    Efficiency might not be always attainable because of the presence of imperfect information. If Efficiency is practically unattainable, next best solution is to establish targets and regulate polluters in such a way as to achieve the pollution target best way possible. A compromise that sacrifices efficiency in pollution control so that cost-effectiveness can be achieved, which is the second best solution.

14.04    Basic Debate

•    The basic debate is over whether to go for a Command-and-Control approach or a. Economic Incentives approach. Economic Incentives make more economic sense, but the former is more prevalent. Another important debate is over the public sources of pollution and the accountability over the control of pollution when it comes from a public source.


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