Incentive-Based Regulation: Theory. Introduction Basic Ideas: Make polluting an expensive activity...
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Transcript of Incentive-Based Regulation: Theory. Introduction Basic Ideas: Make polluting an expensive activity...
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Incentive-Based Regulation:
Theory
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Introduction
Basic Ideas: Make polluting an expensive activityLower 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)
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Advantages over CACPromotes more cost-effective regulation in the
short runProvides 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
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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
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IB Solutions in Grimeville
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Cost Effective Reduction for a 20 ton Cap
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IB Systems are Cost-Effective
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IB Regulation and Cost-Effectiveness
Both tax systems and marketable permit systems will achieve cost-effective pollution control automatically, at least on the chalkboardIn either case, government regulators do not need
to know anything about control costs at different sources
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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)
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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 costsUnder 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!!!
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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!
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Windfall Profits from Rising Prices
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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…)
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Using tax or auction revenues: Idea 2: “SkyTrust”?
Rebate the revenues directly back on an equal basis to all citizensSimilar to the Alaska Permanent FundNo “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)
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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.
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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
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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
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Taxes and Permits Compared
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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 taxesPermits: 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
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Incentives for New Technology Under IB and CAC
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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.
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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
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Nonuniformly mixed Pollutants in Grimeville
Taxes would have to be higher (or the emissions value of a permit lower) in already polluted areas
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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
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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.
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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!
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Imperfect Regulation in an
Uncertain World
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Perfect Information
The theory in IB systems is based upon the assumption of perfect informationRegulators 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
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IB Regulation, Two Special Cases
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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
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Case 1: Permits Preferred
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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 lowFor 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 cleanupPollution reduction to a level of C’’ can be
pursued relatively cheaplyBeyond C’’, costs mount rapidly
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Case 2: Taxes Preferred
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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
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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
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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
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Cost Uncertainty and the Hybrid Proposal
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Incentive-Compatible Regulation
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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
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Imperfect Information and Permits
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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)
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Determining Pollution Costs
Let:p = industry pollution levelL = number of permits made availablez = price of permitse = subsidy level for emission reductions
The industry’s total pollution control costs are thusCleanup 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
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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
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Incentive-Compatible Regulation, Case 1
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Telling the Truth
If firms understate their costsThe 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
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Incentive-Compatible Regulation, Case 2