People suffering from the effects of environmental pollution may argue that the polluter is infringing their property rights. Usually there will be considerable doubt in law concerning the status of a person's rights; whether they have been violated; what, if any, damage has resulted; and so forth. The government may therefore be asked to clarify the law so as to enable people to protect themselves through legal processes. Suppose for the sake of argument, that the people harmed by the industrial process in Figure 4.1 could be given rights to clean air. The firms would now have to purchase the agreement of all people who might be harmed before they could proceed with production. They would effectively have to buy the right to pollute from the residents of the area. This would obviously ‘internalize’ (i.e. make the firms pay a sum in compensation for) the external costs that were previously incurred. Compared with the initial situation, the externally affected parties would benefit by at least the area oq*bg since compensation for these costs would now be fully paid.
Insisting that firms purchased the agreement of all residents of the area would, however, imply enormous negotiation costs. It would be open to some residents to hold out for compensation far in excess of their real evaluation of the likely damage, and might well inhibit production altogether. Establishing environmental rights which are enforceable by the individual opens the possibility of endless litigation and enormous negotiation costs. This is not the case, however, where rights can be allocated to an individual or small number of individuals in a well-defined resource such as an area of water. Whereas it is difficult to imagine people paying a fee to an ‘air corporation’ to be able to breathe the air in a particular location, it is not so bizarre to think of them paying to fish, sail, swim or drink from a water resource. In this case the new ‘owners’ of a previously open-access resource would have an incentive to maximize its value. If people wished to fish in the water, the owners would charge a licence fee to keep numbers to the levels which maximized their income and prevented resource depletion. Similarly, if people wished to deposit effluent in the water they would have to pay a fee which compensated for any reduction in the value of the water as a fishing or recreational resource.
A policy instrument much favoured in principle by economists is the pollution tax. If the firm faces a tax on the pollution it emits equal to the marginal damage it causes, it will be forced to take full account of the external costs of its activities when it decides on its production plan. Such a tax is called a Pigouvian tax after A. C. Pigou. In terms of Figure 4.1, marginal social costs are shown by curve MSC. If pollution and output vary proportionally, a tax per unit would shift the industry's marginal cost curve upwards (to MIC + tax). Thus a tax of p’ − p” per unit of pollution would induce a reduction of pollution to q’ and marginal social costs would equal marginal private costs at this point. Four interest groups can now be distinguished – firms, consumers, pollutees, and taxpayers. Consumers will pay a higher price p’ for the product, firms will receive a lower after-tax price of p”, taxpayers will gain the revenue p’cep” which can be used for public purposes or for tax reductions elsewhere, and the pollutees continue to benefit by abq*q’.
The pollution tax exemplifies the principle that prices should reflect all costs of production including environmental costs. The OECD has developed an approach which has been interpreted in a similar way called the polluter-pays principle (PPP). Where measures are required to control pollution ‘the cost of these measures should be reflected in the cost of goods and services which cause pollution in production and/or consumption’ (OECD 1975). This principle is compatible with environmental instruments other than the pollution tax, but the tax is specifically designed to confront consumers with the full cost of their decisions.
Charges on the emission of pollution are not common and few are calculated on the basis of economic damage caused. They are found principally in the area of water pollution. In Germany, for example, a charge is imposed on effluent according to its chemical composition and is enforced by the Länder authorities. Constituents such as settling substances with organic content in excess of 10 per cent, similar substances with organic content less than 10 per cent, mercury, cadmium, chromium, nickel, lead, and copper form the base of the charge. It is used in conjunction with a set of standards (see below) and discounts of up to 100 per cent are available if the discharge achieves a high enough quality.
A similar charge system exists in the Netherlands based upon biodegradable matter, suspended solids, toxic substances, and heavy metals. An OECD report (1989) concluded that the effluent charge substantially influenced the abatement levels of firms.
Charges on products rather than on pollutants are not usually considered to result in strong incentives towards reducing pollution unless (as we assumed earlier) there is a close technical link which cannot be loosened between the output of the product and the offending pollution. A tax on electricity, for example, would not give the generating companies an incentive to use ‘cleaner’ sources of fuel by switching from coal to gas. Even a tax on coal would not be appropriate given the possibilities of installing new combustion technology, scrubbing flue gases and so forth. However, product taxes with environmental objectives are observed in certain circumstances.
In Norway, Sweden and Finland non-returnable beverage containers face a special charge. Finland uses the revenue to assist the operation of a deposit-refund system for glass bottles. Charges on car batteries containing mercury and cadmium are also operated in Norway and Sweden.
Germany and France have taxes on lubricant oils which raise revenue to enforce regulations concerning the disposal of waste oil. There is no incentive provided by the tax itself to ensure the proper disposal of waste oil, but the systems are thought to be effective administratively.
In the UK and in some other countries the tax system discriminates between leaded and unleaded petrol. Although the differentiation has not been calculated on the basis of the environmental damage caused by lead, it is a clear economic incentive to use the cleaner fuel.
Instead of taxing the output of pollution, a cleaner environment might be achieved by paying a subsidy for reductions in pollution. Returning once more to Figure 4.1, a payment to the polluting firms equal to the fall in external damage which results from output reductions would initially have precisely the same effects as a Pigouvian tax. The external cost of the firms' operations would be internalized in the sense that output increases would involve the loss of a subsidy rather than the payment of a tax. From the point of view of an individual firm's profit-maximizing decision both systems will imply the same marginal cost curve. However, the tax mechanism differs from the subsidy mechanism in important respects.
The distributional consequences of a tax are clearly very different from a subsidy. In the case of an output reduction subsidy, producers stand to gain a great deal as prices rise. Taxpayers and consumers will lose while pollutees will gain (at least in the short run) the benefits of environmental improvement.
As suggested in the previous sentence, there are doubts about the effectiveness of subsidies in the long run. The problem with paying people not to do something is that it gives them an incentive to do it (or threaten to do it) and then claim the subsidy for abstaining. New firms would have every reason to enter the market attracted by the profits available and would attempt to ‘make up’ the output of the industry to its old level. If these new firms could also claim a subsidy for output reductions below a certain baseline figure, the number of firms in the industry could continue to expand until total output was higher than was the case in the first place. This objection to subsidies is less important where the subsidy is clearly paid for pollution reduction rather than output reduction, and where technology permits large improvements in environmental standards without reducing output.
Subsidies play a relatively minor role in pollution control. One problem is that of reconciling them with the polluter-pays principle which is in essence hostile to subsidies. In practice they take the form of tax-allowances, ‘soft loans’, and grants usually for specific purposes such as investment in abatement technology. In France, funds for subsidies are financed from pollution charges. This is politically important since ‘industry is strongly opposed to new or higher financial burdens, unless revenues return to the sector. Therefore financial aid systems are closely linked to charge systems …’ (OECD 1989).
Political considerations are also evident when environmental taxes or regulations impose costs on firms in areas of high unemployment and create demands for financial assistance to enable firms to cope. Financial aid schemes in Germany are mainly concerned with enabling firms to undertake the investment required to achieve tough regulatory standards.
It might be thought that a straightforward method of influencing environmental quality would be through the imposition of regulatory standards on the industry. The government merely lays down certain minimum standards with which all firms have to comply. It is necessary to distinguish in this context between an environmental quality standard (EQS) and an emission standard (ES). An EQS specifies a standard in quantitative terms for a particular aspect of the environment. An emission standard applies to discharges from a particular source.
The European Community directive on the quality of bathing water sets out certain physical, chemical, and biological standards, In particular it is concerned with the number of coliform bacteria found in samples of bathing water. These provide indications of the presence of sewage, although they are not necessarily closely related to health risk. The relationship of an EQS to ultimate environmental objectives can therefore be contentious. A statement of these environmental quality objectives will usually take a general form such as ‘to ensure that the quality of bathing water poses no risk to health’.
Emissions standards apply to particular sources. For example the EC Directive on emissions from large new combustion plants sets limits for various pollutants including sulphur dioxide, nitrogen dioxide, and dust. For existing plants sulphur dioxide emissions must be reduced by 20 per cent by 1993, 40 per cent by 1998, and 60 per cent by 2003.
A major problem with uniform emissions standards is that the costs of achieving them will vary between plants, firms, or industries and this will create pressure to modify the standards, provide financial assistance, or permit departures from the standards in particular cases. In economic terms the uniform emissions standard has been subject to considerable criticism on the grounds that it is an unnecessarily costly way of achieving a given environmental quality standard. The point is illustrated in Figure 4.2.
Figure 4.2 Cost savings from departing from a uniform emission standard
Consider the example of two firms which face the task of reducing their emissions of pollution. The marginal cost of reducing pollution is given by curve MC’ for Firm 1 and MC” for Firm 2. Suppose a uniform emissions standard of E* is imposed. It is evident that if both firms abate by this amount the marginal cost of further abatement will differ between the two. This will give an incentive for the firms to negotiate between themselves and with the authorities, to allow Firm 1 to reduce its pollution by more than E*, and to permit Firm 2 to abate by less than E*. The best deal that could be struck would be for Firm 2 to abate by E” and Firm 1 by E’. Overall cost savings would arise because cost reductions of area adE*E” (in Firm 2) would more than offset the extra costs of fcE’E* (in Firm 1).
It is worth noting that possible cost savings achieved by allowing low cost abaters to reduce their pollution levels by more than high cost abaters have been important in arguments about the role of pollution taxes relative to standards. A uniform tax on both firms of ot per unit of pollution, for example, would induce Firm 2 to abate by oE” and Firm 1 by oE’, thus achieving the same total level of abatement as with uniform standards but at lower costs. The reader should interpret the horizontal line tt as the ‘marginal revenue’ from pollution abatement. By reducing pollution the firm can avoid paying the tax, and this is therefore a measure of the financial benefit to the firm from abatement.
Whatever the theoretical arguments in favour of taxes rather than standards, we have seen that regulators are likely to be pressured into permitting departures from strict application of emissions standards when cost savings are available.
In the US the Environmental Protection Agency (EPA) has set National Ambient Air Quality Standards (NAAQS). In order to achieve these environmental quality standards the EPA has set emission standards for existing, modified and new sources, based on assumptions about the qualities and costs of abatement technologies available. In areas where the air quality standard had not been achieved, ‘non-attainment areas’, the problem of whether to allow new emissions sources had to be faced. This led to the establishment of offsets whereby a new emissions source could be constructed providing emissions elsewhere were reduced by an equivalent or greater amount. These offsets could be within a single firm or could involve agreements with other firms. For existing sources, firms are permitted to adjust emissions limits providing that total emissions are not increased or, in non-attainment areas, are reduced by 20 per cent. The combined emission from the various existing sources is known as a bubble. Netting is another possibility for the firm and is very similar to the bubble concept. It applies to new or modified sources of emissions. These must meet exacting requirements unless abatement from other sources can be shown to keep net emissions unchanged. All these instruments are ways in which the costs to firms of reaching overall emissions targets can be lowered, either by altering abatement levels at different points within the firm or possibly, in the case of offsets, between firms.
Section 4.4.4 gives rise to the suggestion that markets in ‘ rights to pollute’ might be developed even further. There are, however, several distinct ways of interpreting the pollution rights idea.
Regulators could set environmental quality standards and then sell pollution licences valid for a specified period to the highest bidders up to the total quantity consistent with attaining the standard. In practice, of course, the achievement of any given quality standard will depend upon the distribution of emissions and not just on their total quantity. However, in principle it can be seen that the system would have similar effects to a pollution tax. Instead of the tax being set by the authorities in the hope that it will achieve a suitable level of abatement, they set the total quantity of pollution permitted and let the competitive bidding process determine the price of pollution to the firm. Clearly, low-cost abaters would adopt cleaner processes of production and buy fewer pollution licences than high-cost abaters.
An alternative interpretation is that the existing status quo might be accepted, and rights to current pollution levels would be assigned to the relevant firms and made tradeable. As we saw in Section 4.4.4, this scheme would lead to a redistribution of pollution levels between firms which would save costs, but it would run the risk of validating current total pollution levels for ever as firms added these rights to their portfolio of assets. Clearly, this system will be much more acceptable to business interests than the alternative competitive bidding scheme which implies that environmental rights are collectively held.
In the United States, permitted lead levels in gasoline were reduced from 1.1 grams per gallon in 1982 to 0.1 grams per gallon in 1986. As part of this phase down, refiners achieving higher than the regulatory standards prevailing could sell unused lead credits to those who were unable to achieve the target. It was expected that this would result in the larger refiners selling lead credits to smaller ones. Trading was active during the period, the lead credits were highly divisible, monitoring the lead content of gasoline presented few difficulties, and there were few restrictions on the trading process. Estimated cost savings were several hundred million dollars.
Under the US Clean Air Act 1990, sulphur dioxide emissions were planned to fall from 18.9 million tons per annum to 8.9 million tons by the year 2000. Generating plants received tradeable permits based upon their historical levels of pollution (a system called ‘grandfathering’) and these declined year by year. Cost savings compared with command and control alternatives of over one billion dollars per year have been estimated by some scholars.
Source: Stewart (1992), p. 555.
In these sections we have mainly been concerned with the effects on the major interest groups of the various instruments of policy. We have seen that economic interests will play an important part in determining which instruments are observed in practice. It is, however, impossible to understand the pattern of government intervention simply by looking at the distributional consequences. It is also necessary to consider explicitly the implementation and enforcement problems associated with the various instruments.
