1. Incentive-Based Regulation: Theory

2. Introduction  Basic Ideas: Make polluting an expensive activity Lower 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)

3. Advantages over CAC Promotes more cost-effective regulation in the short run Provides 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

4. 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

5. IB Solutions in Grimeville

6. Cost Effective Reduction for a 20 ton Cap

7. IB Systems are Cost-Effective

8. IB Regulation and Cost-Effectiveness  Both tax systems and marketable permit systems will achieve cost-effective pollution control automatically, at least on the chalkboard In either case, government regulators do not need to know anything about control costs at different sources

9. 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)

10. 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 costs Under 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!!!

11. 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!

12. Windfall Profits from Rising Prices

13. 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…)

14. Using tax or auction revenues: Idea 2: “SkyTrust”?  Rebate the revenues directly back on an equal basis to all citizens Similar to the Alaska Permanent Fund No “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)

15. 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.

16. 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

17. 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

18. Taxes and Permits Compared

19. 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 taxes Permits: 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

20. Incentives for New Technology Under IB and CAC

21. 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.

22. 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

23. Nonuniformly mixed Pollutants in Grimeville Taxes would have to be higher (or the emissions value of a permit lower) in already polluted areas

24. 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

25. 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.

26. 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!

27. Imperfect Regulation in an Uncertain World

28. Perfect Information  The theory in IB systems is based upon the assumption of perfect information Regulators 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

29. IB Regulation, Two Special Cases

30. 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

31. Case 1: Permits Preferred

32. 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 low For 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 cleanup Pollution reduction to a level of C’’ can be pursued relatively cheaply Beyond C’’, costs mount rapidly

33. Case 2: Taxes Preferred

34. 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

35. 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

36. 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

37. Cost Uncertainty and the Hybrid Proposal

38. Incentive-Compatible Regulation

39. 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

40. Imperfect Information and Permits

41. 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)

42. Determining Pollution Costs  Let: p = industry pollution level L = number of permits made available z = price of permits e = subsidy level for emission reductions  The industry’s total pollution control costs are thus Cleanup 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

43. 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

44. Incentive-Compatible Regulation, Case 1

45. Telling the Truth  If firms understate their costs The 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

46. Incentive-Compatible Regulation, Case 2