Abstract
This paper addresses the following question: To achieve a fixed aggregate emissions target cost-effectively, should emissions trading programs be designed and implemented to achieve full compliance, or does allowing a certain amount of noncompliance reduce the costs of reaching the emissions target? The total costs of achieving the target consist of aggregate abatement costs, monitoring costs, and the expected costs of collecting penalties from noncompliant firms. Under common assumptions, I show that allowing noncompliance is cost-effective only if violations are enforced with an increasing marginal penalty. However, one can design a policy that induces full compliance with a constant marginal penalty that meets the aggregate emissions target with lower expected costs. This last result does not depend on setting an arbitrarily high constant marginal penalty. In fact, the marginal penalty need not be higher than the equilibrium marginal penalty under the policy with the increasing marginal penalty, and can actually be lower. Finally, tying the marginal penalty directly to the permit price allows the policy objective to be achieved without any knowledge of firms’ abatement costs.
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The policy objective of minimizing the costs of achieving an arbitrary environmental target has always been an important objective for analysts and policy makers alike. Montgomery’s (1972) seminal work on the efficiency of competitive emissions trading takes this approach. The result that competitive emissions trading minimizes the aggregate abatement costs of reaching an aggregate emissions target is perhaps the main justification for proposing and implementing emissions markets. This paper extends the long line of inquiry into the cost-effective design of environmental policies by including the costs of enforcement in the policy objective.
There is no work in the literature that compares the efficiency properties of alternative penalty schedules for emissions trading policies. Keeler (1991) provides a positive comparison of emissions trading to emissions standards under exogenous enforcement strategies that involve increasing, constant, and decreasing marginal penalties. In contrast, this paper is concerned with deriving endogenous enforcement strategies and the determination of whether marginal penalties should be increasing or constant. Decreasing marginal penalties are not considered in this paper.
Analysts and policymakers alike stress the importance of making sure that marginal penalties exceed the price of permits (US EPA 2003a). For example, noncompliance in the SO2 Allowance trading program is penalized with a constant marginal penalty that has always been many times higher than going allowance prices. The penalty was set at $2,000 per ton of emissions in excess of allowances in 1990 dollars, while allowance prices have rarely risen above $200 (US EPA 2004a).
See Boemare and Quirion (2002) for examples of penalties in emissions trading programs. There is quite a lot of variation in how actual constant marginal penalties are set. The SO2 Allowance program employs a fixed (in real terms) financial penalty. Most papers in the literature on enforcing emissions treading programs, including this one, model sanctions as financial penalties. Another variation of a financial penalty is found in the EPA’s recent Clear Skies proposal, which called for a unit penalty that is three times the clearing price in the most recent auction of permits (US EPA 2003b). I demonstrate in Sect. 5 of this paper that tying penalties to going permit prices can help maintain compliance when firms’ abatement costs are unknown. Many policies employ an offset penalty whereby a firm’s excess emissions in one period are deducted from its allocation of permits in the next period. The SO2 and Clear Skies programs include a one-to-one offset to complement the financial penalties of these programs. The US EPA’s Ozone Transport Commission NO x Budget Program employs a 3-to-1 offset as its primary penalty for noncompliance. Modeling offset penalties requires a dynamic analysis that is beyond the scope of this paper. See Stranlund et al. (2005) for an analysis of the use of offset penalties to maintain compliance in a dynamic emissions trading program with banking provisions.
It is important to note that the model of this paper can easily be applied to other tradable property rights programs. Recent papers by Hatcher (2005) and Chavez and Salgado (2005) are direct applications of the literature on compliance and enforcement of emissions trading to individual transferable fishing quotas. Thus, the results of this paper apply in this context as well.
Stranlund et al. (2005) examine dynamic enforcement of emissions trading programs that allow various forms of permit banking and borrowing. They do not address the regulatory choice of noncompliance, choosing instead to focus on designing enforcement strategies that guarantee full compliance.
If e i < l i , then the firm could reduce its abatement costs by allowing its emissions to increase to l i without incurring any costs.
The lemma will not hold in the presence of market power or transaction costs. See van Egteren and Weber (1996), Malik (2002), and Chavez and Stranlund (2003) for analyses of compliance and enforcement of emissions trading programs in the presence of market power. Chavez and Stranlund (2004) analyze compliance and enforcement in the presence of transaction costs.
Substituting (2) into (3) and allowing for the possibility that firm i holds no permits yields \({\mathcal{L}_l =p-{c}^{\prime}_i (e_i)\geq 0.}\)
Stranlund and Dhanda (1999) were the first to demonstrate this result. They show that a parametric increase in a firm’s marginal abatement cost function leads it to increase its emissions. However, this change also induces the firm to demand the equivalent number of additional permits, leaving the firm’s violation unchanged. Thus, a firm’s violation choice is independent of its abatement cost function.
This conclusion does not hold if firms face fixed emissions standards, because the marginal productivity of increased enforcement in reducing violations tends to be higher for firms that have higher marginal abatement costs or who face lower emissions standards (Garvie and Keeler 1994). Murphy and Stranlund (2006) use emissions trading laboratory experiments to test and confirm the hypothesis that firms’ violations choices are independent of their abatement costs.
However, see Polinsky and Shavell (1992) for an analysis of how sanctioning costs affect optimal law enforcement. I model the expected costs of collecting penalties in the same way as Polinksy and Shavell.
This is similar to a result obtained by Arguedas and Hamoudi (2004). They show that the optimal emissions standard for a single firm is zero when violations to this standard are punished with an increasing marginal penalty and sanctions are costless.
Simple forms for monitoring costs and the expected costs of sanctioning firms are used to ease the analysis and to highlight the essential aspects of the regulator’s choice of noncompliance. These cost functions can be generalized substantially without affecting the main results of this paper. All that is required is that monitoring costs are decreasing and expected sanctioning costs are increasing in individual violations, the sum of the two costs are strictly convex, and if any two firms have the same violation, then their marginal monitoring costs are equal as are their marginal expected sanctioning costs.
The possibility that the marginal costs of monitoring may differ among firms is related to the idea that the government may be able to detect the violations of some individuals more easily than others. Bebchuk and Kaplow (1993) were the first to examine heterogeneous probabilities of apprehension in the determination of optimal law enforcement. A recent paper by Macho-Stadler and Perez-Castrillo (2005) assume heterogeneous probabilities of apprehension in their study of enforcing emissions taxes.
This is in line with how penalties were to be determined in the EPA’s proposed (but not enacted) Clear Skies Initiative, which called for a unit penalty that is three times the clearing price in the most recent auction of permits (US EPA 2003b).
Since this implies D′(E) > −C′(E), the efficient level of emissions is greater than the first-best level. Less control than first best is efficient, because the optimal choice of aggregate emissions internalizes the enforcement costs of maintaining this level of emissions.
See Jacoby and Ellerman (2004) for an informative account of the evolution of the safety-valve concept in the context of controlling greenhouse gas emissions, including using noncompliance penalties in this role. With a simulation study of greenhouse gas control, Pizer (2002) provides a welfare analysis of greenhouse gas quantity limits, greenhouse gas taxes and hybrid approaches that use taxes as a safety valve. Among several interesting results, he demonstrates that even sub-optimal hybrid policies produce large efficiency gains over pure quantity controls.
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Acknowledgements
Primary funding for this research was provided by the U. S. EPA – Science to Achieve Results (STAR) Program grant #R829608. Additional support was provided by the Cooperative State Research Extension, Education Service, U. S. Department of Agriculture, Massachusetts Agricultural Experiment Station, and the Department of Resource Economics under Project No. MAS00871. I thank Carlos Chavez, James Murphy and Charles Mason for helpful comments on earlier drafts of this work.
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Stranlund, J.K. The regulatory choice of noncompliance in emissions trading programs. Environ Resource Econ 38, 99–117 (2007). https://doi.org/10.1007/s10640-006-9058-3
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DOI: https://doi.org/10.1007/s10640-006-9058-3