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Economics of Environmental Policy

Assignment B
Question 3

“Compliance monitoring and policy enforcement


have been for too long the forgotten part of environmental policy design.”
Critically discuss this statement.

Prepared for Module CB9014


“Economics of Environmental Policy”
by
Carlos Ferreira

Submitted on the 5th December, 2008

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Economics of Environmental Policy

1. Introduction – Environmental Policy


There has been extensive debate about the most adequate type of policy to use in
order to face environmental problems. These problems are so diverse in their source,
nature, impact and economic consequences that it has been impossible to agree in one
single type of overarching policy, scheme or instrument. Instead, a general framework has
developed from the debate, in an attempt to determine and promote an optimal level for
each kind of emission, defined as the point where the Marginal Damage resulting from
emissions equals the Marginal Abatement Cost of the same emissions (in Chart 1, this
corresponds to the level of emissions e*, with price P*). This would allow for the
internalization of the damages from the emissions, the reduction of total pollution and
would put a price on the remaining emissions.

Cost

Marginal
Damage

P*

Marginal
Abatement
Cost

e* e1
Emissions
Chart 1

2. The polluter: a cost-minimizer with better information


The debate around an environmental policy begins before the policymakers start
discussing what measures to take. We consider that a polluter company acts as a cost-
minimizer, and will always try to externalise the cost of its emissions as much as possible.
This means the polluter would prefer to work at level e1 in Chart 1: passing on the costs of
damage from its activity to society and having no abatement costs for itself.
In most environmental problems, neither the Marginal Damage not the Marginal

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Abatement Costs are known with absolute certainty (Chart 2).

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).

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Economics of Environmental Policy

3. Moral hazard and the cost of monitoring compliance


One of the consequences of information asymmetry is moral hazard: the polluter acts
illegally, by agreeing to participate in a policy that is costly towards it, accepting the benefits
from that policy (in case there are some), and then not engaging in the needed action, or
acting in a way to minimize the costs to itself. Moral hazard reduces the effectiveness of the
policy (Fraser & Fraser, 2005; Fraser & Fraser, 2006).
Moral hazard can occur with all kinds of policies, whether they force polluters to pay
for their emissions (like taxes and emissions), involve compliance with a standard or give
away subsidies paid against a service by the polluter. As a consequence, monitoring
polluters' compliance is one of the single most important factors contributing to the success
of an environmental policy.
The efficiency of compliance monitoring depends on the technical ability to detect
violations: for instance, for policies targeted at emissions, it is considered that no scheme
can function properly unless this measurement is accurate, continuous and economically
viable (Peterson, 2003).
It is important, however, to remember that monitoring compliance with a policy has
costs – administration costs, and monitoring costs and enforcement costs. The total cost in
monitoring and enforcing a policy is the policy's transaction costs. Transaction costs impact
on society as a whole, so they should be taken in account when calculating the Marginal
Abatement Costs of a policy, or the result of the policy will be sub-optimal, as shown in Chart
3.
In this case, for a given Marginal Damage, a corresponding Marginal Abatement Cost
was estimated, with the consequent optimal level of pollution (e*) and the resulting price
(P*). As the chart shows, failure to account for the transaction costs results in maintaining
emissions at a level above the optimal (e2 instead of e*), with a resulting cost to society (P2)
superior than P*.
Note also that, as the abatement increases, the transaction costs increase as well.
This happens because the greater the abatement cost, the greater the motivation the
polluter has to try and break the law, resulting in a greater cost to keep him from doing so. If
the society tries to enforce an e* level of pollution all the same, the cost will be even higher
(P3).

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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

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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

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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.).

4. Reducing the cost of monitoring: targeting and penalties


We have shown that different polluters might face different incentives to comply.
Offending means there will be a reduction in the Marginal Abatement Cost the polluter faces,
but it also means he might be liable for penalty, if detected. Usually, to reduce the incentive
for cheating, policies include penalties for non-compliance, designed to increase the
opportunity cost of cheating. Of course, there is no absolute certainty of being caught when
not-complying. Indeed, in the eyes of the non-compliant polluter, the opportunity cost
appears as:

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

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equals the Abatement Cost (Fraser & Fraser, 2006).


The fact that different addressees might have different degrees of motivation to fail to
comply with the policy provides a valid case for targeting some of them. This increases the
probability they might be subject to closer monitoring (like more regular in-site inspections).
The targets for this closer monitoring should be the polluters with the higher Marginal
Abatement Costs – as discussed, these have the highest incentive for non-compliance.
Another criteria for targeting is past performance: poor past performers should more
closely watched. This is possible by including the temporal dimension in the monitoring
efforts: the interactions between the polluters and the monitoring authority are repeated in
time, and each polluter can be assessed by its past behaviour. Since the enforcement-
compliance game is played repeatedly, both players will be aware of each other's previous
actions and the resulting outcomes (Heyes, 2000).
The other possibility of increasing the cost of non-compliance is to increase f – the
penalty for non-compliance. This can be achieved by increasing, for instance, the size of
fines. As a practical example, the European Union Emissions Trading Scheme allowed for
fines up to 40€ per tonne of CO2 emitted without a valid permit in the period from 2005 to
2007, and 100€/TCO2 from 2008 on (Pew Center, n.d.). If the enforcing authority decides to
try increasing compliance (or if the price of permits gets so high that it's cheaper to pay the
fine) this value can be increased.
However, there are limits to the effective maximum level of penalty levied at a
polluter. For instance, the penalty might be so large that it effectively bankrupts the offender,
or it might seem overly unfair (Heyes, 2000). It's also important to keep in mind the principle
of marginal deterrence: the level of the penalty impacts the decision about whether or not
to violate the rule, but once this decision has been made, it does not impact the decisions
about the extent of the violation. A penalty too strict, that could bankrupt the polluting
company, effectively means that, if caught, the penalty will be roughly the same whatever
the level of violation.

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

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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.

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References

Becker G (1968) Crime and Punishment: An Economic Approach. Journal of Political


Economy, 76, pp. 169—217.

Blandford, D. (2007) Information Deficiencies in Agricultural Policy Design, Implementation


and Monitoring. OECD Food, Agriculture and Fisheries Working Papers, No. 6, OECD
Publishing.

Diamond, J. (2005) Collapse: How Societies Choose to Fail or Succeed (in Portuguese).
Rio de Janeiro: Editora Record.

Fraser, I. & Fraser, R. (2005) Targeting Monitoring Resources to Enhance the


Effectiveness of the CAP. Eurochoices, 4(3), pp. 22-27.

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

Heyes, A. (2000) Implementing Environmental Regulation: Enforcement and Compliance.


Journal of Regulatory Economics, 17(2), pp. 107-129.

Peterson, S. (2003) Monitoring, Accounting and Enforcement in Emissions Trading


Regimes. Paper presented at the OECD Global Forum On Sustainable Development:
Emissions Trading. OECD Headquarters, Paris, 17-18 March 2003.

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].

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