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2.2. Greater Efficiency

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Savings from Economic Incentives


One means of controlling releases of pollution is to rely on private negotiations between those who bear the costs of pollution and sources of pollution. Under the assumptions of costless transactions and no strategic behavior, such negotiations can lead to an optimal level of pollution control in which the full costs of pollution are taken into account in the decision process of the source (Coase). While the assumption of no strategic behavior may be reasonable in many cases, costless transactions, which are necessary for the victims of pollution to negotiate successfully with sources, are unlikely to be a realistic assumption. The more victims there are, and the more geographically disperse are the victims, the higher transactions costs are likely to be.

Because negotiations between victims and sources of pollution cannot be relied upon as a means of control, environmental legislation dictates other mechanisms for internalizing pollution externalities. In one approach the pollution control authority specifies in considerable detail requirements for different source categories. The regulations may impose discharge limits or much more, such as the technology that must be used, the inputs that must be used, or characteristics of the outputs that are produced. This regulatory approach is termed "command and control." Market-based or incentive approaches, by contrast, provide rewards for reducing pollution (and conversely penalties for releasing pollution). The rewards may be of a financial nature, but need not be. In contrast to the command and control approach, an incentive-based regulatory strategy gives sources great flexibility in selecting both the type and magnitude of response.



The basic reference point is Figure 1, a stylized depiction of the incremental damage of increased levels of pollution and the incremental costs of controlling pollution. The economically efficient level of control limits pollution to E1. Up to that level of pollution the incremental damage from successive units of pollution are less than the incremental costs of control. Beyond E1, incremental damage exceeds incremental control cost. Net benefits of pollution control are maximized at E1.

Command and control approaches generally will not perform as well as incentive-based mechanisms such as pollution taxes, marketable permits, and liability in yielding the efficient level of pollution control. Several factors affect the economic efficiency of different tools for environmental management. As will be shown, market-based instruments offer a number of distinct advantages over traditional command and control approaches. Which instrument performs best, though, depends upon the specific situation. Consequently, a case-by-case approach probably is advisable in selecting the most appropriate instrument from among those potentially available.

In reviewing some of the important characteristics, consider first, the sources of pollution. Are the costs of control known with certainty? If not, how great is the uncertainty? Is the technology of pollution control static, or is it likely to change over time? Can the quantity of pollution from each source be measured (or approximated) easily? How many sources are there for each pollutant? Are incremental control costs similar for different sources, or is there considerable variation?

On the damage side, does a unit of pollution from each source have the same impact on health and the environment, regardless of where it is released? Are the impacts on health and the environment known with certainty? If not, how great is the uncertainty? At which juncture do major uncertainties arise: imprecise knowledge of the effect of pollution on environmental quality, exposures, physical effects, or economic valuation of effects? How many parties are experiencing pollution damage? Is it critical to control pollution within narrow limits to achieve environmental goals, or are damage functions such that there is a continuum of effects from less serious to more serious, with no obvious unacceptable level of pollution?

Depending upon these parameters, some tools of environmental management are likely to perform better than others. Of course, performance can be measured in a number of ways. While economists would place the emphasis on economic efficiency, other criteria such as fairness, political acceptability, stimulus for innovation and technical improvement, enforce- ability and consistency with religious and moral precepts also could be used in place of or in conjunction with efficiency. Cost-effectiveness is a compromise criterion that takes both economics and the political and legal structure into account by finding the least cost means of achieving a stated environmental goal. Alternatively under this criterion, one could identify the pollution control measure that maximized environmental gains within a given cost budget.

Evaluations of incentive systems that have been implemented typically find savings in control costs, improvements in environmental quality, or both relative to a command and control approach. Several of these systems will be described subsequently. Theoretical modeling of pollution control costs consistently demonstrates that incentive systems outperform command-and-control approaches in terms of efficiency.

Economists have long suggested that the traditional approach to environmental pollution control, which is predominantly command-and-control in nature, results in control costs that are higher than necessary to achieve a given level of environmental protection. They have suggested that costs could be substantially reduced if economic incentives were used in place of command-and-control regulations. Costs could be reduced because sources having the lowest costs of additional control would have an economic incentive to control more and those sources having the highest incremental control costs could control less rather than all polluters of a given type controlling to the same extent, as is now usually the case.

Many of the quantitative studies done by these economists are summarized in tables that appear later in this section. The ratio shown for most of the studies in the last column is the ratio of command-and-control costs to the lowest cost of meeting the same objective using economic incentives. A ratio of 1.0 suggests that the command-and-control approach is equal in cost to the economic incentive approach, so that the savings are zero. A ratio greater than 1.0 means that there are positive potential savings from using economic incentives. Since all the ratios shown are greater than 1.0, they support the assertion above that economic incentive approaches are more cost effective than command and control approaches. Some additional studies are listed for which ratios have not been worked out. A review of these studies suggests that they also support the above assertion. No studies reach the opposite conclusion.

Economic theory and common sense argue that incentive mechanisms should enhance the efficiency of pollution control relative to traditional command and control techniques. The reasons for this conclusion are several. First, some incentive-based mechanisms explicitly allow trading of pollution reduction obligations. With trading, sources with high incremental costs of control can have their obligations satisfied by sources with low incremental costs of control. Other incentive-based mechanisms levy a charge or tax on each unit of pollution. Under such an approach sources would control pollution only to the point at which the incremental cost of control equaled the charge or tax. In an idealized world without transactions costs and competitive markets, both permit/credit trading and pollution charge approaches should result in the marginal cost of controlling pollution being the same at each source. At every level of pollution, total control costs should be minimized.

A number of other incentive-based mechanisms, such as information reporting requirements, liability, and voluntary programs, rely on implicit charges for pollution. The efficiency consequences of such mechanisms is more difficult to predict because sources are reducing pollution for reasons that have only an indirect financial consequence. And sometimes that financial link is very tenuous. The motives for participating in voluntary programs are largely one of improving corporate image to customers, to employees, and to regulators, though management concern for the environment certainly could be a factor. While the motives for controlling pollution are very real, the benefit to the firm of reducing emissions is difficult to express in financial terms. Perhaps the best that could be done is to examine what firms actually spend as part of such programs to generate a willingness to pay for pollution reduction. One might find that forms respond in a systematic fashion to various of the indirect incentives. For example across a sample of firms, liability might generate higher willingness to pay for a unit of pollution reduction than does an information reporting requirement, which in turn might exceed the willingness to pay for strictly voluntary activities.

The following tables summarize results of studies that compare incentive mechanisms with command and control approaches for managing the environment. One observes that in every case the command and control approach is more costly than the market-based approach, sometimes much more costly.
QUANTITATIVE STUDIES OF SAVINGS FROM ECONOMIC INCENTIVES
AIR POLLUTION
Pollutant Controlled
Study
Year, Source
Geographic Area
Command and Control Approach
Ratio of CAC to
Market-Based Approach
HydrocarbonsMaloney & Yandle (1984) TDuPont facilities in U.S.Uniform percent reduction 4.15
Nitrogen doxideSeskin at al.
(1983) T
ChicagoProposed RACT regulations 14.4
Nitrogen dioxideKrupnick
(1986) O
BaltimoreProposed RACT regulations 5.9
Particulates (TSP)Atkinson & Lewis (1974) TSt. LouisSIP regulation 6.0
Particulates (TSP)McGartland
(1984) T
BaltimoreSIP regulations 4.18
Particulates (TSP)Spofford
(1984) T
Lower Delaware ValleyUniform percent reduction 22.0
Particulates (TSP)Oates et al.
(1989) O
BaltimoreEqual proportional treatment 4.0 at 90 ug/m3
Reactive organic gases and NO2SCAQMD
(1992) O
Southern CaliforniaBest Available Control Technology 1.5 in 1994
1.3 in 1997
Sulfur dioxideRoach et al.
(1981) T
Four Corners AreaSIP regulation 4.25
Sulfur dioxideAtkinson
(1983) A
Cleveland
Sulfur dioxideSpofford
(1984) T
Lower Delaware ValleyUniform percent reduction 1.78
Sulfur dioxideICF Resources
(1989) O
United StatesUniform emission limit 5.0
SulfatesHahn and Noll
(1982) T
Los AngelesCalifornia emission standards 1.07
Six air pollutantsKohn
(1978) A
St. Louis
BenzeneNichols et al.
(1983) A
United States
Chlorofluoro-carbonsPalmer et al.
(1980); Shapiro and Warhit (1983) T
United StatesProposed emission standards 1.96
All?Toman et al.
(1994) O
PolandEC and German standards 1.1 to 1.2
Sulfur dioxideHaklos
(1994) O
EuropeUniform percent reduction 1.42
OzoneHahn
(1995) O
United StatesVehicle mandate in CA and Northeast 25% CA
50% NE
ParticulatesO’Ryan
(1996) O
Santiago, Chile1. Uniform % reduction; 2. Uniform source concentration standard 6.0 for 60%
reduction
1.9 for 90% reduction
ToxicsMarakovits & Considine
(1996) O
U.S. steel industryUniform % reduction 2.5

In many of these studies, a distinction was not drawn as to the precise nature of the market-based mechanism that would be used. Rather, the assumption was made that pollution taxes as well as marketable permits could yield the least cost outcome identified through linear programming. In practice, however, one finds that few if any of the market-based instruments that have been put in place achieve anywhere near their theoretical potential.

Searching for reasons for the wide gap between the potential and what actually is accomplished, Stavins identifies transactions costs as the primary culprit. With transactions costs as a barrier to trading, sources tend not to venture far from their initial allocation of pollution rights. As transactions costs rise, the prices that sellers receive for pollution rights fall and the prices that buyers must pay rise, making transactions less likely. Transactions costs were especially high in EPS’s early Emissions Trading Program, described later in this report, with the result that fewer than one percent of the emissions potentially available for trading actually were traded (Hahn, 1989). Transactions costs were lower for programs such as lead credit trading, resulting in a far higher proportion of available credits actually being traded.

Transactions costs also feature prominently in the choice between making trades internally within a firm and externally between firms. For all of the trading programs that have been studied, firms exhibit a strong preference for internal trading when that is feasible, even when larger cost savings are available externally. (Burtraw, Kerr). Additionally, markets in rights available for sale tend to be thin (Hahn); it may be difficult to locate potential sellers of rights; and even when rights are readily available, many firms seem to distrust 'paper' credits. One other limitation of trading systems is that pollution credits have a limited life whereas engineering controls may last for the life of a facility.

For tax, charge and fee systems, the principal limitation to achieving the theoretical efficiency gains has been the generally low level of charge relative to what would be required to have a significant impact on pollution. Few jurisdictions have ever experimented with taxes that are large enough to have a significant impact on emissions. Charges typically are set to recover administrative costs for a program, not to impact pollution. The examples where emission taxes of that magnitude have been imposed included a mechanism to redistribute tax revenues to sources so that the mechanism would be (nearly) revenue neutral. Unless tax revenues are redistributed to the affected sources of pollution, emissions taxes impose large costs on sources, costs that probably spell doom for the political acceptability of the approach. With the adverse equity effects of emission taxes resolved through redistributing revenues though, there is reason to believe that a pollution tax approach could achieve greater emissions control than predicted by linear programming models. The reason is the dynamic effect that pollution taxes can have on innovation and technical change. The evidence from Sweden suggests these impacts can be large and unexpected.
QUANTITATIVE STUDIES OF SAVINGS FROM ECONOMIC INCENTIVES
WATER POLLUTION
Substance Controlled
Source
Year, Source
Geographic Area
Command and Control Approach
Ratio of CAC to
Least Cost Approach
Biochemical Oxygen Demand
(BOD)
Johnson
(1967) T
Delaware EstuaryEqual proportional treatment3.13 at 2 mg/l
1.62 at 3 mg/l
1.43 at 4 mg/l
BODO’Neil
(1980) T
Lower Fox River, WIEqual proportional treatment2.29 at 2 mg/l
1.71 at 4 mg/l
1.45 at 6.2 mg/l
BODEheart et al.
(1983) T
Willamette River, OREqual proportional treatment1.12 at 4.8 mg/l
1.19 at 7.5 mg/l
BODEheart, et al.
(1983) T
Delaware EstuaryEqual proportional treatment3.00 at 3 mg/l
2.92 at 3.6 mg/l
BODEheart et al.
(1983) T
Upper Hudson River, NYEqual proportional treatment1.54 at 5.1 mg/l 1.62 at 5.9 mg/l
BOD Eheart et al.
(1983) T
Mohawk River, NYEqual proportional treatment1.22 at 6.8 mg/l
Heavy metalsOpaluch & Kashmanian
(1985) O
Rhode Island jewelry industryTechnology-based standards1.8
PhosphorusDavid et al.
(1977) A
Lake Michigan
SeleniumEDF
(1994) O
Central Valley,
CA
Best management
practices
1.2
HydrocarbonsRaffle and Mitchell
(1993) O
AMOCO Yorktown refineryProposed discharge requirements4.0
QUANTITATIVE STUDIES OF SAVINGS FROM ECONOMIC INCENTIVES
OTHER POLLUTION-RELATED ISSUES
Substance Controlled
Study
Year, Source
Geographic Area
Command and Control Approach
Ratio of CAC to
Least Cost Approach
Municipal solid wastePalmer, et al.
(1995) O
United StatesUniform percent reduction of 10% 2.0
Fuel efficiencyCharles River Associates
(1991) O
United StatesCAFE standards 4.5
Agricultural chemicalsRendleman et al.
(1995) O
United StatesUniform percent reduction 1.1
Traffic congestionHua
(1990) O
Hong KongCar ownership restraint 2.5
Sources: A stands for Anderson et al. (1990); they did not compute the ratio or provide the other information left blank in this table. O stands for original reference. T stands for Tietenberg (1985). See Appendix for all references.

It is important to note that one recent review of retrospective analyses of emission and effluent trading systems concluded that realized cost savings fall well short of these projections. Atkinson & Tietenberg (1991). Trades have been fewer and cost savings smaller, according to this analysis, than indicated by economic modeling. A number of explanations have been offered about why the full savings have not always been realized. [See Atkinson & Tietenberg (1991), Dudek & Palmisano (1988), Hahn (1989), Hahn & Hester (1989), Liroff (1986), and Tietenberg (1985 and 1990)]. Regulatory and legal requirements of the actual programs may limit the trading opportunities to a greater extent than portrayed in the models, especially where the incentive programs is in addition to existing command and control programs. Various models have not fully reflected aspects of real regulatory programs, including the transaction costs, number of buyers and sellers, trading rules, monitoring and reporting requirements, and the administrative burden placed on both emission sources and regulatory agencies. Finally, command and control programs may be more enlightened than is modeled. For instance, the C&C alternative may offer flexibility in terms of meeting deadlines or geographic variation in the extent of control rather than a hard and fast uniform percent reduction.

Even if the cost savings are less than predicted, the actual savings are still impressive. In the appropriate circumstances, the wider use of incentive programs that are feasible in an actual policy setting will result in substantial costs savings while achieving equivalent environmental goals. In other circumstances, the cost differences between an incentive program and a well designed command-and-control program will be less, [Oates (1989)]. although the incentive program will provide a stronger stimulus for innovation and technical change.

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