1. Pollution Policy with Imperfect Information (Ch. 8)

2. Pollution policy with imperfect information
Welfare analysis in Ch. 5 & theory on pollution control targets and instruments (Ch. 6 & 7) assumes full information is available on total/marginal damage and benefits of pollution.
Real world is characterised by many risks and uncertainties. This has implications for pollution target setting (pollution levels) as well as pollution instrument choice (taxes, tradable permits, licenses, technology requirements, …).

3. Target setting
Derivation of economic efficient pollution level assumes the government has perfect information on:
D= D(M) is pollution damage function
B= B(M) is pollution benefits function
(benefits = avoided pollution abatement costs)
Then efficient pollution level M* and pollution shadow price * can be determined.

4. Figure 6.4 Total and marginal damage and benefit functions, and the efficient level of flow pollution emissions.
D(M)
B(M)
D(M)
B(M)
Maximised net
benefits M * M* M

5. Target setting Required information:
Scientific knowledge about pollution impact (but functioning of ecosystem is complex and stochastic)
Valuation of environmental services (has many theoretical and practical problems)
Information on the costs of abatement (possessed by pollution generators; have incentives to provide incorrect information)
Needed for the whole range of possible pollution levels

6. Target setting
Moreover, economic efficiency is not sufficient to guarantee survival of a renewable resource stock or an ecosystem
Alternative:
Use of precautionary principle to play safe, or a combination of economic efficiency and conservation criteria (e.g.: use of efficiency criterion subject to an overriding sustainability constraint)

7. Control instruments
Four criteria for judging instruments under uncertainty:
Dependability
Flexibility
Costs of use
Information requirements
(Implementation costs)

8. Control instruments Dependability
To what extent can an instrument be relied upon to achieve its target?
Under full information, both emission quantity controls (licenses & tradable permits) and price controls (emission taxes and abatement subsidies) have known outcomes and can achieve target.
See top-level figures in Fig. 8.1

9. Taxes Permits t* P* t* P* MC MC PH MCH MCH PL MC MC MCL MCLML M* MH M M
L*(= M*)
Figure 8.1 A comparison of emissions taxes and marketable emissions permits when abatement costs are uncertain.

10. Control instruments Dependability When abatement costs are uncertain:
Price-based instruments lead to uncertainty in the quantity of abatement
Quantity-control instruments (emission quotas, licenses) lead to uncertainty in prices, but not in targets
Tradable permits also lead to uncertainty in prices, but not in targets
Emission outcomes of technology requirements cannot be known a priori

11. Control instruments Dependability Hence:
Only emission quotas, licenses and tradable permits can achieve emission targets under conditions of uncertainty.

12. Control instruments Flexibility
Can the instruments quickly and cheaply be adjusted as new information arises, conditions change or targets are adjusted?
Difficult to draw general conclusions, depends on specific circumstances.

13. Control instruments
Flexibility
Some general hypotheses emerge from the literature:
Price-based instruments are inflexible, because there is often strong resistance against changes in their rates (interest groups)
Changes in emission licenses and permits generally meet less resistance
Technology regulations impose large capital costs. Changes in these regulations can imply large new investment costs
Validity and practical usefulness of these assertions is unclear

14. Control instruments Costs of use
How large are the efficiency losses when the instrument is used with incorrect information?
What are the welfare costs of target misspecification caused by:
Uncertainty about abatement costs
Uncertainty about pollution damage

15. Control instruments Costs of use: Uncertainty about abatement costs
If abatement costs are overestimated, then:
Too many licenses will be issued (LH). Hence:
The marginal and total damage to the environment will be higher
The abatement costs will be lower
Welfare loss is triangle below the MD curve (Fig. 8.3A)

16. Figure 8.3A Uncertainty about abatement costs – costs overestimated: license systemMD
Loss when
licenses used
MC (assumed)
MC (true) M* LH
Emissions, M

17. Control instruments Costs of use: Uncertainty about abatement costs
If abatement costs are overestimated, then:
Emission fee will be set too high (tH). Hence:
The level of emissions will be lower
The marginal and total damage to the environment will be lower
The abatement costs will be higher
Welfare loss is triangle below the MC curve (Fig. 8.3B)

18. Figure 8.3 Uncertainty about abatement costs – costs overestimated.MD tH t*
MC (assumed)
Loss when
taxes used
MC (true) Mt M*
Emissions, M

19. Control instruments Costs of use: Uncertainty about abatement costs
If abatement costs are understimated, then:
Too few licenses will be issued (LL). Hence:
Damage to the environment will be lower
The abatement costs will be higher
Welfare loss is triangle below the MC curve (Fig. 8.4)
Emission fee will be set too low (tL). Hence:
The damage to the environment will be higher
The abatement costs will be lower
Welfare loss is triangle below the MD curve (Fig. 8.4)

20. t* tL LL M* Mt Emissions, M
Figure 8.4 Uncertainty about abatement costs – costs underestimated. MD t* tL
MC (true)
MC (assumed) LL M* Mt
Emissions, M

21. Control instruments Costs of use: Uncertainty about abatement costs
The size of the welfare effects depends on the slopes of the MD and MC curves:
If the MD curve is steeper than the MC curve, licenses are preferred to taxes (Fig. 8.3 and 8.4)
If the MD curve is flatter than the MC curve, taxes are preferred to licenses (Fig. 8.5 and 8.6)

22. tH t* Mt M* LH Emissions, M
Figure 8.5 Uncertainty about abatement costs – costs overestimated. MD MD tH t*
MC (assumed)
MC (true) Mt M* LH
Emissions, M

23. t* tL M* LL Mt Emissions, M
Figure 8.6 Uncertainty about abatement costs – costs underestimated. MD MD t* tL
MC (true)
MC (assumed) M* LL Mt
Emissions, M

24. Control instruments Costs of use: Uncertainty about damage costs
If damage costs are underestimated, then:
Too many licenses will be issued (L).
Tax rate will be set too low (t).
Hence: Welfare loss is the same for both instruments (Fig. 8.7)
If damage costs are overestimated, then welfare loss will also be the same for both instruments

25. Figure 8.7 Uncertainty about damage costs – damages underestimated.
MD (true)
MD (estimated) t
MC (true) M* L
Emissions, M

26. Control instruments Costs of use Conclusion:
The presence of uncertainty substantially weakens the preference for incentive-based instruments over command and control instruments

27. Control instruments Information requirements
To reduce uncertainty, EPA’s have a strong incentive to acquire better information. Three ways:
Research:
Is costly
Incremental costs may exceed its benefits
Building institutional relationships with polluting businesses:
Gives access to private-company information
Danger: Undermines independence of the EPA

28. Control instruments Information requirements
Incentive-based instruments for revealing information:
Firms have an incentive to lie about abatement costs, if they expect that the reported costs influence the severity of regulation
None of the pollution control instruments will induce firms to report the true costs (Fig. 8.9)
A mixture of instruments, however, may reduce such misreporting

29. Figure 8.9(a) Incentive effects with permit systems.MD
P1 *
MC (reported)
P2
MC (true) M*
=L* MP
=LP
Emissions, M

30. Figure 8.9(b) Incentive effects with an emissions tax.MD * T
MC (true)
MC (reported)
MT1
MT2 M*
Emissions, M

31. Control instruments Implementation costs
Pollution control instruments have additional costs:
Transaction costs
Costs of acquiring information, contracting, monitoring performance, and so on. Will be higher when uncertainty is greater.
Induced indirect costs
Unemployment, loss of international competitiveness, and so on.

32. Control instruments Implementation costs
May differ greatly between different instruments
Technology controls have relatively low transaction costs
Cost-efficiency rankings of instruments may change when transaction costs are taken into account
Transaction costs advantage may outweigh the efficiency disadvantage, and make technology control a superior instrument for pollution control