Lecture #10

Incentive-Based Regulation: Theory

11.0 Introduction

Two schemes were widely discussed. The first was a pollution tax (also known as an effluent or
emission charge or a Pigovian tax). Alternatively, one might achieve a rollback through a cap-
and-trade system (also known as tradable permit or marketable permit systems). Here, permits
would be issued only up to a certain target level of emissions. These permits could then be
bought and sold, again putting a price tag on pollution. These two regulatory approaches—
pollution taxes and cap-and-trade systems—are referred to as incentive-based (IB) regulation,
because they rely on market incentives to both reduce pollution and minimize control costs.
Alternatively, the nation opted for what we have called the command-and-control (CAC)
approach to regulation, requiring uniform emissions across sources and mandating the adoption
of particular pollution-control technologies.

From a theoretical perspective, IB systems offer several advantages over a CAC approach.
First, IB systems will promote more cost-effective regulation in the short run. Secondly, over
the long run, IB systems provide incentives for firms to seek out new technologies to lower
pollution-control costs. Finally, in theory, an IB approach reduces the costly burden of
information gathering for regulatory bureaucrats.

11.1 Different issues with both Approaches

11.1.1. Cost-Effectiveness

One defining aspect of the CAC regulatory approach is its prescription of uniform standards for
all pollution sources. Economists have widely criticized this requirement, as it essentially blocks
any effort to achieve cost-effective pollution control.

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With respect to the IB regulation, the economist continues, “because pollution now has a
‘price,’ every day they pollute the firms will pay for the privilege. This will provide them with a
tremendous long-run incentive to search out new, less polluting ways of doing business.
Moreover, tax revenue for the government will increase.

Summarizing the main points; first, both tax systems and marketable permit systems will achieve
cost-effective pollution control “automatically,”. In either case, government regulators do not
need to know anything about control costs at different sources. In the case of a tax, regulators
merely specify a tax level, observe the market response, and if the induced pollution reduction is
too little (or too great), adjust the tax upward (or downward). In the permit case, the
government merely specifies the number of permits desired and distributes them by either sale or
giveaway.

The discussion also highlights one of the political drawbacks of taxes (and permit sale
systems). Polluters, whether firms or consumers, persistently object to having to pay the
government for the right to pollute up to the legal limit, in addition to the cleanup costs they
face. Such additional costs might in fact drive a firm out of business, and thus, they impose a
bankruptcy constraint on the imposition of tax or permit policies.

In principle, pollution taxes or permit sales can be made revenue neutral by rebating the
revenues to the affected firms or individuals in the form of income tax cuts. Substituting
pollution tax revenues for a tax on labor (the income tax) would enhance labor market
efficiency because in this particular case, people would work harder if they faced lower income
taxes. Accordingly, at least in theory, incentive-based systems achieve short-run cost-
effectiveness.

11.1.2. Technological Progress

Taxes and permits generate important incentives for long-run technological progress in
pollution control. Both systems put a “price” on pollution, so that every unit of pollution emitted
represents a cost to the firm or individual. In the tax case, the cost is direct: less pollution would
mean lower taxes. In the permit case, pollution bears an opportunity cost as less pollution

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would free up permits for sale. In both cases, because pollution is now costly to firms, they are
provided with the motivation to continuously seek out new ways of reducing pollution.

Compare these savings with those achievable under the CAC system. First, the CAC systems
are standard-based. Once the firm has achieved the delegated emission standard P1, it gains
relatively little by improving the pollution-control technology. Also, there is no incentive to
reduce pollution below P1.

By putting a price on every unit of pollution and by reducing specific technology requirements,
IB regulation on paper appears to do a better job of promoting long-run investment in new
pollution-control technologies and waste reduction than does the CAC system.

11.2 Potential Problems with IB Regulation

There are several potential problems with implementing IB regulation. The first two—hot
spots and monitoring and enforcement—apply to both tax and permit systems. Cap-and-trade
systems have their own peculiar problems: the potential for thin markets, market power, and
price volatility. Finally, pollution taxes have the special drawback that they are taxes—and thus
are generally fiercely opposed by industries liable to be regulated.

11.2.1. PROBLEMS WITH IB IN GENERAL

Turning our attention first to potential problems associated with both marketable permits and
pollution taxes, is the hot-spot issue. Hot spots are high local concentrations of pollutants. The
IB system would, indeed, keep total pollution at a certain level, for example at 20 tons per day.
However, residents living near plant A, which would pollute 11 tons per day under either a tax or
a marketable permit scheme, would view the IB system as unacceptable if the higher level of
emissions translated into a higher health risk.

Different pollutants display a different relationship between the sites at which emissions
and damages occur. To illustrate this principle, suppose that certain city was divided into two
air-quality regions: one containing plant A, the other plant B. If gunk were a uniformly mixed
pollutant, 1 ton of emissions from either plant would translated into an even concentration of

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gunk, and its associated health risk, across the two areas. By contrast, if gunk were a
concentrated pollutant, all the damage caused by emissions from plant A would occur in the
area adjacent to A. The more general case is that of a non-uniformly mixed pollutant, where
the bulk of the damage is caused locally, but effects do drift into other areas. IB approaches work
best for uniformly mixed pollutants, those evenly dispersed over fairly broad areas. Two
examples are chlorofluorocarbons (CFCs), which deplete the ozone layer, and carbon dioxide,
which contributes to global warming. An IB approach would clearly not work for a concentrated
pollutant such as nuclear waste, for which uniform safety standards are demanded on equity
grounds.

Beyond hot spots, the next, and potentially quite serious, problem with IB regulation arises in the
area of monitoring and compliance. Unlike the CAC case, however, IB regulation does not
specify particular pollution-control technologies with known abatement impacts. Thus,
regulators must rely even more heavily on (currently inadequate) monitoring of emissions to
ensure compliance with permits or to collect taxes.

11.2.2 PROBLEMS WITH PERMIT SYSTEMS

Both cap-and-trade and pollution tax systems share problems of hot spots and a need for strict
enforcement. A major problem unique to the marketable permits approach is that many proposed
users face thin markets—markets with only a few buyers and sellers. The thin market problem
is essentially this: why go to the trouble of “going to the market” when due to the small number
of traders, there is a low probability of getting a good deal. Is it worth the bother if there is only
one plant in town, which may well not have anything to offer?

A second problem with permits is the potential for the development of market power. Concerns
here typically focus on access to permits as a barrier to entry. What if existing firms refuse to sell
to new entrants in the market as a way to limit competition? This may be a problem when both of
the following circumstances hold: (1) new firms are forced to buy permits from direct
competitors and (2) a single dominant firm faces new entrants with higher pollution-control
costs.

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A third and, in real life, more serious problem with cap-and-trade systems relates to price
volatility. The annual stock of permits is in fixed supply, any changes in demand can lead to
large swings in permit prices

There are two fundamental differences between pollution taxes and cap-and-trade systems.
First, permits are “quantity instruments”: they set a specified level of pollution, and a price
emerges through trading. By contrast, taxes are “price instruments”: they put a price on
pollution, and that price initiates a reduction in the quantity of pollution as firms clean up in
response to the price incentive.