Bas-reg-instru-kolst - Ham auvtfioflmtadt‘h Elommxgli cam—L2 ll tea-owns “has” Loco lo arena—n Utmth NEH.m BASIC REGULATORY INSTRUMENTS

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Unformatted text preview: Ham: auvtfioflmtadt‘h. Elommxgli cam—L2; ll. tea-owns “has” Loco lo] arena—n Utmth NEH . .m'. BASIC REGULATORY INSTRUMENTS , M l - Having just discussed the prevalence of conflicting incentives and private information, - _‘ this is an appropriate time to introduce the two major types of environmental regulation: e I j I economic incentives and command and control. [3’ A. Command and Control 15 Command-and—control regulation is the dominant form of environmental regulation in the 1. . ,' world today.” Although it can take many forms, thebasic concept of command and con- it " - trol is for the regulator to Specify the steps individual polluters must take to solve a pol- “ ' 1:: lution problem. The essence of command and control is that the regulator collects the in- g’ formation neceSsary to decide the physical actions to control pollution; the regulator then _ ‘ commands the polluter to take specific physical steps to control the pollution. The regu- Lr. later is generally quite specific as to what steps-must be taken. 3k Command—and—control regulations can take many forms. One way of conveying the Be - _ . '5: _ nature of command and control is by example. For instance, the Clean Air Act in the 140 ’ REGU LATING POLLUTION United States requires the EPA to determine the minimum pollution control “performance” of new sources of pollution. The EPA is required to specify for each new category of source (e.g., new power plants or new tire factories) what pollution controls and emission rates are deemed acceptable. This means that the EPA must investigate the production procass for literally every type of plant or factory in the United States, at least if signifi- cant pollution is involved. For instance, in tire manufacture, the EPA has hired engineers to examine the process of tire manufacture, generating a “Control Technology Guideline,” which indicates what kinds of pollution control are appropriate for new tire manufactur- ing plants. In industries that apply surface coatings (e. g., finniture manufacture), regula- tions may impose limits on the types of coatings that may be used or firms may he re- quired to use a certain type of vent system to recapture vapors that are emitted during painting. Furthermore, products may be banned altogether as is the case with many oil- based paints in urban areas of the United States most severely affected by photochemical smog. Power plants (producing electricity) may be required to use certain technologies to reduce emissions of sulfur dioxide. At one time in the United States, flue-gas desulfur- ization was required on all new coal-fired power plants, regardless of the uncontrolled emission rate of the plant. Command-and—control regulations take many specific forms. Specific. pollution- control equipment requirements can be specified as in the above example. Alternatively, the regulation may specify an emission limit for particular types of plants and particular pollutants. An example might be the us. standards for new automobiles: every new car may emit no more than it grams of carbon monoxide per mile driven.8 Furthermore, all new cars are required to have a specifically defined system for capturing vapor that might escape from the gasoline tank during refueling. (1n the case of automobiles, a major fac-' tor that bears on pollution is how much the car is used. There are virtually no regulations in the United States addressing distance driven except for modest taxes on gasoline.) In the case of power plants, fuel quality may be limited (e.g., sulfur content cannot exceed 1%) or emissions per unit of fuel use may be limited (e.g., no more that 1.2 pounds of sulfur dioxide may be emitted per million Btu of fuel used). Command and control may in fact be combined with significant fines and penalties associated with noncompliance. Such incentives to comply with a command-and-control regulation should not be confused with an economic incentive to abate pollution. Though command and control may take many forms, there are two key features that distinguish command and control from economic incentives: (1) restricted choice for the polluter as to what means will be used to achieve an appropriate environmental target; and (2) a lack of mechanisms for equalizing marginal control costs among several different polluters. For example, if a polluter is told by a regulator that it must use a particular type of equip- ment, the polluter has little choice in determining emissions. If there is a cheaper way to attain the same level of emissions, such cost savings cannot be pursued. Some command- and—control regulations may afford some discretion to the polluter. Polluters may, for in- stance, be told that they can emit up to a certain amount per unit of goods output (e.g., grams of 302138]? kwh sold). This gives more discretion to the polluter, although the pol- luter is not free to adjust emissions among sources that have different pollution control costs. The one thing that characterizes all command-and—control regulation is a central- ization of some of the pollution control decisions that could be made by the polluter. The best analogy for command and control is the system of central planning that .- i . BASIC REGULATORY INSTRUMENTS 141 existed in the former Sofiet Union to manage its economy. Rather than let prices signal relative scarcity and thus direct goods around the economy, nearly all decisions on pro- duction, investment, and even interplant trade were made centrally, by central planners. In theory this can work as well as any system. The problem is that the informational re- quirements are enormous. In actuality, planners operate with very incomplete informa- tion, which leads to serious inefficiencies. Despite these problems, this is more or less how pollution generation is managed in most countries. Although this approach to run- ning an economy proved too burdensome for the Soviet Union, environmental regulation in most market economies is unlikely to have such a dramatic effect since pollution con- trol is only a modest part of modem economies. On the other hand, one might expect it to be possible to significantly improve on the current system, What are the pros and cons of command and control? Command-and-control regu- lations have one major advantage: more flexibility in regulating complex environmental processes and thus much greater certainty in how much pollution will result from regu- lations. In an urban area with factories at different locations contributing differently to overall levels of urban pollution, it can be difficult to fashion a workable set of emission taxes or other incentives to ensure a certain level of pollution. Furthermore, in an atmos- phere of uncertainty, where it is unclear how a polluter might re5pond to an economic in- centive, command and control gives greater certainty on how much pollution will actu~ ally be emitted? Another advantage of command and control is in simplifying monitoring of compliance with a regulation. If a regulation states that a particular piece of pollution control equipment must be used, monitoring simply involves seeing whether that equip- ment has been installed. This is easier than measuring pollution emissions. There are of course disadvantages to command and control. Because the informa- tional costs are high for command and control, such a regulatory system can be very costly to administer. Each plant, or at least each industry, must be analyzed in detail to deter- mine the appropriate level of emission control. This is very costly, not to mention fraught with errors. There is also the potential for fundamental information problems. The regu- lator often needs to rely on information from the polluter, either in terms of emissions or costs of control. Because of this, the pollute: has an incentive to distort information pro- vided to the regulator. (Though this problem often applies to other forms of regulation as well.) A very significant problem with conunand and control is reduced incentives to find better ways to control pollution. This may be purely a static issue, finding process changes or other means to reduce pollution. Or it might involve investing in research into better ways of controlling pollution. In either case, many types of command and control pro- vide weak incentives for innovation (see I affe and Stavins, 1995). . Perhaps one of the biggest problems with command and control is difficulty in sat- isfying the equimarginal principle. It is almost impossible for command-and—control reg- ulations to ensure that the marginal costs of pollution control are equalized among dif- ferent polluters generating the same pollution. This could occur only if regulators are completely correct in their assessment of each firm’s control costs. If the marginal costs of pollution are not equalized, costs of pollution control will be unnecessarily high. This failure of the equimarginal principle is illustrated in Table 8.1, which shows the marginal cost of controlling biological oxygen demand (BOD), a measure of water pollution in rivers and lakes. Table 8.1 is drawn from an analysis (Magat et al.. 1986) of 142 REGULATING POLLUTION TABLE 8.1 Marginal Treatment Costs of BOD Removal, US. Regulations Industry Subcategory Marginal cost“ Poultry Duck—small plants 3.15 Meat pacldng Simple slaughterhouse 2.19 Low processing paclcinghouse 1.65 Cane sugar Crystalline refining 1.40 Leather tanning Hair previously removed/chromium 1.40 Poultry Duck—large plants 1.04 Leather Save hair/vegetable 1.02 Hair previously removed 1.02 ‘Meat packing processing packinghouse 0.92 Complex slaughterhouse 0.90 Paper . Unbleached kraft 0.36 Leather tanning Save hairlchromium 0.75 Pulp hair/chromium 0.63 Poultry Turkey 0.60 Cane sugar Liquid refining 0.51 Paper Paperboard 0.50 Kraft-NSSC 0.42 Leather Pulp or save hair/no finish 0.39 Poultry Further processing only—large plants 0.35 Chicken—small plants 0.25 Paper NSSC—ammonia process 0.22 Raw sugar processing Iouisiana 0.21 Poultry Fowl—email plants 0.20 Chicken—medium plants 0.16 Raw sugar processing Puerto Rico 0.16 Paper NSSC—sodiurn process 0.12 Poultry Fowl—large plants 0.10 Chicken—large plants 0.10 “Units: DES. dollars per kilogram ofBOD removed. ' Source: Magat et a1. (1986), p. 136. I how the USEPA translates legislative mandates regarding water quality into regulations to apply to individual firms. Clearly, the equimarginal principle is violated. 'It would be much more cost effective, without hurting the environment, to relax regulations on some of the high cost industries and tighten regulations on some of the lower cost industries.” As another example, Table 8.2 is a listing of a number of US. command—and- control regulations that are designed to protect health and save lives. Interpreting lives saved as the only goal of the regulation, the equimatginal principle also fails to hold. Some regulations save lives at very low cost, whereas some are extremely costly (e.g., formaldehyde in the workplace, at $72 billion per life saved). A final problem is that with command-and—control, the pollute: pays only for pol- lution control, not residual damage from the pollution that is still emitted even after con- trols are in place. This effectively provides a subsidy to the polluter, which may create a variety of distortions. As an example of this consider paper manufacture with pulp (the raw material) either coming from recycled paper (assumed pollution free) or virgin wood DDS me 10 1nd- ives old. a .4. ., pol— con- do a (the reed BASIC REGULATORY lNSTRUMENTS 143 TABLE 8.2 Average Cost of US Regulations to Reduce Risk of Death —-—-—-—-—.________________ Expected Cost per expected Initial annual life saved Regulation annual risk lives saved (millions of 1984 $) ———.______________—__ Unvented space heaters 2.7 in 105 63.000 0.10 Airplane cabin fire protection 6.5 in 10B 15.000 0.20 Auto passive resuaints/belts 9.1 in 105 1,850.000 0.30 Underground construction 1.6 in 103 8.100 0.30 ‘ Servicing wheel rims 1.4 in 105 2.300 0.50 Aircraft seat cushion flammability 1.6 in 107 37.000 0.60 Aircraft floor emergency lighting 22 in 105 5.000 0.70 Crane suspended personnel platform 1.8 in 103 5.000 1.20 Concrete and masonry construction 1.4 in 105 6.500 1.40 Benzenelfugifive emissions 2.1 in 105 0.310 2.80 Grain dust 2.1 in 104 4.000 5.30 Radionuclidesluranium mines 1.4 in 104 1.100 6.90 Benzene in workplace 8.8 in 104 3.800 17.10 Ethylene oxide in workplace 4.4 in 105 2.800 25.60 Arsenic/copper smelter 9.0 in 104 0.060 26.50 Uranium mill tailings. active 4.3 in 104 2.100 ' 53.00 Asbestos in workplace 6.7 in 105 74.700 . 89.30 Arsenic/glass manufacturing 3.8 in 105 0.250 142.00 Radionuclides/DOE facilities 4.3 in 106 0.001 210.00 Benzene/ethylbenzenol styrene 2.0 in 106 0.006 483.00 Formaldehyde in workplace 6.8 in 107 0.010 72,000.00 -—-———~——-——._—_____,_______—_ Source: Viscusl (1996), pp. 124—125. (with associated pollution). Efficiently regulating the manufacture of virgin wood pulp in- volves seeing that the proper pollution control is achieved and that the damage from any remaining pollution is included in the price of pulp. This way the price of pulp reflects pollution control costs and residual damage. However, if command-and-control regula- tions require only pollution control and not the payment of residual damage, the result— ing price of virgin pulp will be lower. Why is this undesirable? It is- easy to see that with a lower price of virgin pulp, paper manufacturers are more likely to choose pulp over recycled pulp, because it is cheaper. As a result, there will be more pollution than is efficient. B. Economic Incentives Economic incentives, in contrast to command-and-control regulation, provide rewards for polluters to do what is perceived to be in the public interest. We are all familiar with in- centives. Instead of closely monitoring a child’s homework activity, a parent may provide a substantial reward for good grades (or a disincentive for bad grades). The idea is to align public and private incentives. In the context of pollution, there are three basic types of economic incentives: fees, marketable permits, and liability. 3 144 REGULATING POLLUTION Pollution fees involve the payment of a charge per unit of pollution emitted. If the fee is at the right level, this would be an example of a Pigovian fee. When a polluter must pay for every unit of pollution emitted, it becomes in the polluter’s interest to reduce emis- srons. . A marketable permit allows polluters to buy and sell the right to pollute. Thus what starts as something akin to command and control (a permit to pollute) turns into an eco- nomic incentive by allowing trading. Trading induces a price or value on a permit to pol- lute, thus causing firms to see polluting as an expensive activity; less pollution means fewer permits need be bought. There is an opportunity cost of emitting; by not emitting, the firm can sell more permits. . This is illustrated in Figure 8.2, which corresponds to the situation in which there are two polluters. We are interested in allowing 100 units of pollution in total. We start by giving each firm 50 permits. The marginal savings from polluting functions are shown in Figure 8.2 for the two firms. They have been drawn so that any point along the hori- zontal axis gives the number of permits each firm holds: read from the left for firm 1 and from the right for firm 2. Note that trading will occur until firm 1 holds e* and firm 2 holds 100 - 3*. The equilibrium price of a permit is p*. It is important to note that an emission fee of p* would achieve exactly the same outcome. Suppose there is a little uncertainty. With an emission'fee, we know preciser what the marginal cost of control will be; we are less sure about the quantity of pollu— tion. With a marketable permit, we know exactly how much pollution there will be; we are less sure of the marginal cost of control. ‘ Liability is a third type of economic incentive. The basic idea is that if you harm someone, you must compensate that person for damage. In theory, this means that when you undertake a risky activity (such as polluting or storing hazardous wastes), you will take all potential damage from your activity into account when deciding how carefully to perform your activity. The important issue is that the government is not telling you what to do, just that you will be responsible for any consequences. This creates an incentive to 'be careful when undertaking risky activity and, in fact, to take the socially desirable amount of precaution in undertaking such risky activity. To illustrate liability, suppose we have a hazardous waste storage facility (a “dump”). The dump can do things to minimize the risk of hazardous wastes leaking into the envi- Figure 8.2 Marginal savings from Firmt Firm2 polluting functions for two firms. M81, Marginal savings from emit- ting, firm 1; M32, marginal savings M52 from emitting, firm 2; 9*, equilib- . rium holding of permits; p", equi- p. ad librium price of permits. I 1 A o 50 e“ 100 100 so 100 — e* " o --+ Firm 1 T Firm 2 .4— holdlngs Staan holdings point "SEES ngs lib- tui- BASIC REGULATORY INSTRUMENTS 145 moment. We can lump all of those risk-reducing activities into one term, “precaution.” If the dump takes a great deal of precaution, the risk of a leak will below. If the dump takes little precaution, the risk will be high. Precaution is of course expensive for the dump to undertake. All other things being equal, the dump would prefer to take little precaution. Damage to society also depends on the level of precaution. This is illustrated in Figure 8.3, which shows both costs to the dump and damage to society as functions of the level of precaution. There is some socially desirable level of precaution, x*, at which the mar— ginal costs of tain'ng more precaution are just offset by the reduction in marginal damage from taking more pmcaution. liability works by saying to the dump: “Do whatever you wish but should an accident occur, we will find the socially desirable level of precaution; if you were not taking that level of precaution, you will be responsible for all of the en- . vironmental damage from the accident.” This is how negligence liability works, although other types of liability work in a similar fashion. This threat of being held responsible for accident damages is often a sufficient incentive for firms to take the socially desirable amount of precaution. One of the dominant questions in environmental economics and regulation over the past three decades is why command and control dominates environmental regulation worldwide when most economists believe economic incentives are much better. Clearly, economic incentives have a number of advantages over command and con- trol. First, informational requirements are less significant. It is not necessary to know what it going on within a firm to usc an emission fee. Furthermore, economic incentives will provide an incentive for a polluter to innovate, finding cheaper ways of controlling pol- lution.11 Also, in contrast to command and control, economic incentives involve the pol- luter paying for control costs as well as pollution damage. Thus there is no implicit sub- sidy to the industry. As we will see, the fee payments approximate the damage associated with the pollution. Consequently the cost (and thus the price) of the product manufactured in association with pollution will reflect control costs as well as residual pollution darn- age. In the previous section, in the example of paper manufacture, we saw the importance of reflecting environmental damage in product price, something that command and con— trol fails to achieve. Figure 8.3 An illustration of precau- . d . . . ' Firm non an liability costs of precaution C(X) Expected accident cost from precaution Dot) x“ Precaution (X) L MC(X*) = —-MD(x") 146 REGULATING POLLUTION Probably the biggest advantage of economic incentives is that the equimarginal prin— ciple will automatically hold for most types of economic incentives. For instance, with an emission fee, all firms set their marginal cost of pollution control equal to the fee. The equimarginal principle is trivially satisfied. When firms trade pollution permits, the price of the permit that will be determined by the permit market sends the same signal to all polluters regarding the opportunity cost of emitting. The equimarginal principle will hold. As We will see in Chapter 12, liability effectively has the polluter setting its marginal ' abatement cost equal to marginal damage. Thus the equimarginal principle will also hold. Why is meeting the equimarginal principle so important? Basically beoause the costs of I regulation will be higher if the equimarginal principle does not hold, perhaps much higher. ._ t, Thus economic incentives have this cost-saving advantage. I ' There are disadvantages to economic incentives. One problem is forging a set of economic incentives that can accommodate the complexities of environmental transfor- mation without being excessively complex and impractical. Just think of urban air pollu- tion in which the damage from a unit of emissions can vary considerably in both space and time. Developing an economic incentive that efficiently and perfectly takes these com- plexities into account can be very difficult. A second problem with economic incen ves is largely political. If there is a great deal of uncertainty associated with the environmental problem being controlled, it may be necessary to adjust the level of the incentive (level of the fee, number of marketable permits issued) over time, as information becomes available. This may be Very difficult in many practical situations. For instance such an adjustment in the United States might require Congressional action. It took over 10 years of debate in Congress before the U.S. Clean Air Act was amended in 1990 to include acid rain control. A third problem, also political, is that many economic incentives involve massive transfers from firms to the government. An emissions tax generates a tremendous amount of revenue for the government administering the tax. This may be good for the govern- ment, but instituting such a tax may be very difficult politically, precisely because of these wealth transfers. This explains in large part why substantial emission fees have gone nowhere in most market economies. In contrast, emission fees have been widely used in the former Soviet Union and Eastern Europe because of the traditional dedication of the fee revenue to investment in pollution control in state enterprises.12 IV. COMPLICATIONS FOR ENVIRONMENTAL REGULATION ____//—————- A. Space and Time In contrast to most types of regulation, pollution regulation is complicated by the physical environment that interposes itself between polluters and consumers. This is illustrated in Figure 8.4. A polluter generates emissions. These emissions are transformed, possibly in a complex fashion, to ambient concentrations of pollution. Emissions cause no damage; it a. is ambient concentrations that cause damage. This is an important distinction. The word ambient refers to the world around us. That is its use here. Ambient concentrations are the concentrations of pollution in the air around us or in the water We drink It is ambient con- ...
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This note was uploaded on 06/09/2011 for the course ECON 330 taught by Professor Marble during the Spring '11 term at University of Texas at Austin.

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Bas-reg-instru-kolst - Ham auvtfioflmtadt‘h Elommxgli cam—L2 ll tea-owns “has” Loco lo arena—n Utmth NEH.m BASIC REGULATORY INSTRUMENTS

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