Pollution Policy with Imperfect Information (Ch. 8)

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, …).

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.

dM

dB

Maximised net benefits

M*

*

M

D(M)B(M)

D(M)

B(M)

M

Figure 6.4 Total and marginal damage and benefit functions, and the efficient level of flow pollution emissions.

dM

dD

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

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)

Control instruments

Four criteria for judging instruments under uncertainty:

• Dependability

• Flexibility

• Costs of use

• Information requirements

• (Implementation costs)

Control instruments

1. 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

Figure 8.1 A comparison of emissions taxes and marketable emissions permits when abatement costs are uncertain.

Taxes Permits

t* P*

MC MC

MCMC

MCHMCH

MCL MCL

M MM* L*(= M*)

M M

P*

L*(= M*)

PH

PL

t*

M* MHML

Control instruments

1. 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

Control instruments

1. Dependability

Hence:

Only emission quotas, licenses and tradable permits can achieve emission targets under conditions of uncertainty.

Control instruments

2. 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.

Control instruments

2. 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

Control instruments

3. 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

Control instruments

3. Costs of use: Uncertainty about abatement costsIf abatement costs are overestimated, then:

A. 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)

M*

Figure 8.3A Uncertainty about abatement costs – costs overestimated: license system

Emissions, M

MD

MC (true)

MC (assumed)

LH

Loss when licenses used

Control instruments

3. Costs of use: Uncertainty about abatement costsIf abatement costs are overestimated, then:

B. 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)

t*

M*

Figure 8.3 Uncertainty about abatement costs – costs overestimated.

Emissions, M

MD

MC (true)

MC (assumed)

tH

Mt

Loss when taxes used

Control instruments

3. Costs of use: Uncertainty about abatement costsIf abatement costs are understimated, then:

A. 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)

B. 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)

t*

M*

Figure 8.4 Uncertainty about abatement costs – costs underestimated.

Emissions, M

MD

MC (true)

MC (assumed)

tL

LL Mt

Control instruments

3. 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)

t*

M*

Figure 8.5 Uncertainty about abatement costs – costs overestimated.

Emissions, M

MD

MC (true)

MC (assumed)

tH

LHMt

MD

t*

M*

Figure 8.6 Uncertainty about abatement costs – costs underestimated.

Emissions, M

MD

MC (true)

MC (assumed)

tL

LL Mt

MD

Control instruments

3. 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

M*

Figure 8.7 Uncertainty about damage costs – damages underestimated.

Emissions, M

MD (estimated)

MC (true)

t

L

MD (true)

Control instruments

3. Costs of use

Conclusion:

The presence of uncertainty substantially weakens the preference for incentive-based instruments over command and control instruments

Control instruments

4. Information requirements

To reduce uncertainty, EPA’s have a strong incentive to acquire better information. Three ways:

a. Research:• Is costly

• Incremental costs may exceed its benefits

b. Building institutional relationships with polluting businesses:

• Gives access to private-company information

• Danger: Undermines independence of the EPA

Control instruments

4. Information requirements

c. 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

*

M*

=L*

Figure 8.9(a) Incentive effects with permit systems.

Emissions, M

MD

MC (true)

MC (reported)

MP

=LP

P1

P2

*

MT2

Figure 8.9(b) Incentive effects with an emissions tax.

Emissions, M

MD

MC (reported)

MC (true)

M*

T

MT1

Control instruments

5. Implementation costsPollution control instruments have additional costs:

a) Transaction costsCosts of acquiring information, contracting, monitoring performance, and so on. Will be higher when uncertainty is greater.

b) Induced indirect costsUnemployment, loss of international competitiveness, and so on.

Control instruments

5. 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