Enforcement & Compliance in Pollution Permit Markets Jim Murphy John Stranlund This research is funded by USEPA STAR Program grant #R829608

2 Motivation Environmental regulations often involve fixed standards –Emissions standards –Technology standards Market-based mechanisms can meet environmental goals at lower cost –Programs must be enforced well

3 Enforcing markets different than standards Regulators have experience enforcing emissions standards –e.g., Target enforcement at firms with high abatement costs or low standards Enforcing market-based mechanisms fundamentally different –Permit price is key determinant of compliance –Require new types of enforcement strategies Policy implication : Enforcement strategies that were effective for standards might not be appropriate for markets

4 Implications for enforcement of permit markets Violations depend on: –Permit price and enforcement  violations independent of firm characteristics –e.g., abatement costs, initial permit allocation  no justification for targeted enforcement Compliance decisions are linked together through the permit market –Direct effects and indirect price effects

5 Direct and indirect price effects Effects of increased enforcement on… –Violations: a negative direct effect a countervailing positive price effect –“Two steps forward, one step back…” –Emissions: no direct effect only a negative price effect Policy implication : To improve environmental quality, enforcement must be broad enough to affect permit price. Policy implication : Changes in enforcement can induce changes in permit prices—which affect compliance decisions.

6 Nice story, but where’s the proof? Well-developed theory about compliance and enforcement of permit markets Theory has important implications for design of enforcement strategies –But…there are no direct empirical tests of the theory Lab experiments allow us to test theory in a controlled setting –“Wind tunnel”

7 Theoretical framework Theoretical model: –Firms maximize expected profits by choosing: Emissions Permits –Parameters Firm abatement costs Enforcement: Audit probability & Fine Aggregate standard Initial permit allocation  Violations

8 Experimental design Each cell repeated 3 times with 8 participants per group.

9 Experiment details Subjects –UMass students –2-hour training before “real” data sessions –Paid $7 for show-up, plus experiment earnings (avg $14). 8 subjects per group, 4 of each type –Type-A: High marginal abatement cost –Type-B: Low marginal abatement cost 12 identical 5-minute periods –Discarded first 2 periods

10 Experiment details Production (emissions) –Generates “Earnings from Production” –Each unit produced sequentially –Only during first 4 minutes of period Permit market –Continuous double auction –Trading allowed for full 5 minutes of period Random audits and penalties if necessary after period ends

11 Results: Targeted enforcement Violations –Independent of marginal abatement costs –NOT independent of initial permit allocation Permit buyers tend toward higher violations Responsiveness to enforcement –Independent of marginal abatement costs –Independent of initial permit allocation Policy implication : With markets, little support for targeted enforcement

12 Results: Contrast with emissions standards Violations –Depend upon firm characteristics High marginal abatement costs and/or low standard yield greater violations Responsiveness to enforcement –Greater for firms with high marginal abatement costs Policy implication : With standards, firm-level characteristics are important determinants of compliance and effectiveness of enforcement. Not true with markets.

13 Results: Direct and indirect price effects Strong support for hypotheses about indirect price effects of enforcement –Violations: Countervailing positive price effect –Emissions: No direct effect, only indirect price effect Policy implication : To improve environmental quality, enforcement must be broad enough to affect permit price. Policy implication : Impacts of increased enforcement could be overstated

14 Concluding remarks Enforcing permit programs is fundamentally different from emissions standards Experiment results largely consistent with theory –Targeted enforcement Little justification under emissions trading –Requires competitive trading by risk neutral firms. –Direct and indirect effects of enforcement Permit programs  permit price links compliance and emissions decisions. Standards  compliance decisions are independent.