Escolar Documentos
Profissional Documentos
Cultura Documentos
Assignment B
Question 3
1
Economics of Environmental Policy
Cost
Marginal
Damage
P*
Marginal
Abatement
Cost
e* e1
Emissions
Chart 1
2
Economics of Environmental Policy
Cost
Actual
Marginal
Marginal Damage
Abatement
Cost
P*
Suggested
Marginal
Damage
P2
e* e2 e1
Emissions
Chart 2
Since a policy is created to internalize an externality, the polluter will be made worse
off as a result: its costs will increase and, if it can't pass on all the increase in cost to its
costumers, it will face diminishing profits as a result of the policy – and the cost is only
passed on integrally in case the consumer's price elasticity of demand for the product is 1,
otherwise consumption will be reduced as a result of the price increase. Because of this,
profit-maximizing polluters try to raise doubts about the cost of their activity to society – for
instance, by raising doubts about the real marginal costs from emissions to society (the
“Suggested Marginal Damage” in Chart 2). So, even under the policy, the polluter's objective
is to keep its activity (and emissions) as high as possible – reducing less of its emissions, to
e2 but not to e*, will bring it a cost of P2, smaller than P*.
In case such efforts are unsuccessful, and policymakers put forward environmental
policies costly for them, polluters have an incentive not to comply with these rules. This can
be done thanks to the information asymmetry in the system – the policymaker does not
know as much about the polluter's activity as the polluter itself, and can only access this
information at a cost (Blandford, 2007).
3
Economics of Environmental Policy
4
Economics of Environmental Policy
Cost
Marginal
P3 Abatement
Marginal
Damage
Cost
P2
Marginal Abatement
P* Cost
+
Transaction Costs
e* e2 e1
Emissions
Chart 3
Monitoring costs depend on several factors, the most important being the target
chosen: when the target of the policy is an emission, for example CO2, SO2 or NOx from
smokestacks, the most widely chosen form of accounting for emissions is self-reporting, via
a monitoring device at the point where the pollution comes from. This device is
complemented with an analysis of the values reported by the agent, and also by eventual in-
site inspections that certify the system is working according to the rules. In the case these
emissions measurements are part of an emissions trading scheme, it is also pertinent to
keep a permanent record of all the transactions, assuring that at no point track of the permits
is lost, or that permits might be added or subtracted to the system by participants (Peterson,
2003). On the other hand, if the target is an input (as for instance, a tax on petrol and diesel
fuel, or a tax on fertilizer), all economic transitions of that input must be accounted for and
the tax must be collected on time. A third example might be a ban on exploitation of a
renewable resource (like fisheries or forest products) for a certain amount of time in a certain
location, which could either require the physical presence of law enforcers and/or satellite
and radar surveillance of the area in question (Diamond, 2005).
Either way, it is clear that monitoring costs vary widely with the specific target of a
5
Economics of Environmental Policy
policy, and failure to account for the differing costs of the various policies might contribute to
the failure of the policy. As a rule-of-thumb, it can be said that the more specific the policy is
(targeting a specific emission, in a specific location, with a specific instrument), the more
efficient it will be in reducing the emissions to the optimal level, but also the greater the
transaction costs involved. This results in an effective trade-off between efficiency and cost-
effectiveness so that, for a given emission, an equilibrium between the efficiency in reduction
of the emissions and the transaction costs must be reached.
Another, less important, source of difference in transaction costs is the kind of
instrument selected. For instruments that don't respect the equi-marginal principle – taxes
or standards – the incentive towards non-compliance is different for different companies
with different marginal abatement costs. Chart 3 illustrates this situation (H-MAC has high
abatement costs, L-MAC has low abatement costs). For each of them, reducing emissions is
an opportunity cost, equal to its own Marginal Abatement Cost at e* - P L-MAC for the L-
MAC polluter is significantly smaller than P-HMAC, for the H-MAC polluter. If the probability
of getting caught is equal among all firms producing the same pollutant, H-MAC also faces
the highest opportunity cost of abiding the law, so it is the most motivated to break that law.
This means that, the least cost-effective and economically efficient the policy instrument, the
more these companies are motivated to break the law.
Cost
P
Marginal
H-MAC Damage
Marginal
Abatement Cost for
L-MAC
Marginal
Abatement Cost for
H-MAC
P
L-MAC
e* e1
Emissions
Chart 4
6
Economics of Environmental Policy
One way to reduce the uncertainty regarding this issue is to design and implement
auction-based schemes, that force the participants to reveal their willingness to pay or their
willingness to accept compensation, according to the instrument chosen. For instance,
farmers apply for financial support, offering in return an environmental management plan,
that effectively equals the marginal abatement cost curve (Fraser & Fraser, 2005). The
same happens in policies concerning tradeable permits, like the ETS in phase II, after 2012
(Pew Center, n.d.).
C=p*f (Equation 1)
where C is the cost of non-compliance, p in the probability of being caught while cheating
and f is the penalty incurred for cheating. The monitoring and enforcement efforts can be
adjusted to the compliance needs: either increase the probability of detection of moral
hazard or the penalty of the non-compliance once detected (Becker, 1968; Fraser & Fraser,
2005; Fraser & Fraser, 2006).
For a cost minimizing polluter, the choice whether to comply or not with the
environmental policy depends if the costs of compliance are smaller, equal or higher than
the costs of non-compliance (C in Equation 1). The policymaker must, therefore, increase C
to a level where it, at least, equates the opportunity cost of complying.
The first possible way to increase the cost of non-compliance is to increase the
probability of detection in case of non-compliance. This implies an increase in monitoring
effort, which in turn brings substantial increases to the policy. These increases only result in
an increase of gains to society up to the point where the cost on increasing monitoring
7
Economics of Environmental Policy
5. Final notes
Compliance monitoring and enforcement are crucial to the success of a policy, but
should be accounted for since the creation of the instrument, through its implementation and
at the moment of evaluation of the results. Failure to do so will compromise the objectives of
8
Economics of Environmental Policy
the policy, resulting in a larger than desirable level of pollution, an increased cost, or both.
Careful targeting of polluters and a correct level of enforcement of punishments for non-
compliance will go a long way into avoiding these less-than-ideal outcomes.
9
Economics of Environmental Policy
References
Diamond, J. (2005) Collapse: How Societies Choose to Fail or Succeed (in Portuguese).
Rio de Janeiro: Editora Record.
Fraser, R. & Fraser, I. (2006) The Implications of Information Asymmetries for Agri-
Environmental Policies. Paper presented at the OECD Workshop on “Information
Deficiencies in Agri-Environmental Policies”, Paris, 6 June 2006
Pew Center on Global Climate Change (n.d.) The European Union Emissions Trading
Scheme (EU-ETS): Insights and Opportunities [Internet]. Available from:
<http://www.pewclimate.org/docUploads/EU-ETS%20White%20Paper.pdf> [Accessed 10
November 2008].
10