A Framework to Compare Environmental Policies

1. Introduction To analyze environmental policy proposals, it is important to determine the conditions under which some policies might work better than others. When will a pollution tax work better than the sale of permits or some other alternative? Which is easier to administer or to enforce? Does one policy apply better to some kinds of pollutants than to others? Which policy has a greater chance of getting enacted? This paper provides a framework to compare alternative policies. For each pollutant, in each context, one policy may be more efficient while others better account for competing objectives like administrative efficiency, political feasibility, and fairness. Using this framework, the paper will analyze and compare eight types of policies. Clearly no single policy instrument will work best in all cases. Under some circumstances, command and control (CAC) instruments might be necessary, in either of two forms: (i) emission restrictions, sometimes called "performance standards," or (ii) technology restrictions that might be called "design standards." If emissions are difficult or impossible to measure, for example, then the authorities can at least enforce rules that require the proper installation of the required pollution control equipment such as a flue-gas desulfurization unit (scrubber) on every electric power plant, or a catalytic converter on every automobile. In other cases that are important to identify, these CAC instruments can be replaced by "incentive" instruments such as taxes, subsidies, or permits. As suggested by Pigou (1932), the pollution problem could be addressed by (i) taxes on the pollution, or (ii) subsidies to abatement. A Pigouvian tax applies to the pollutant itself, rather than to output, at a rate equal to the pollutant's marginal environmental damages (MED). The term "incentive instruments" includes both the Pigouvian tax and the subsidy to abatement, and it includes two other policies that involve permits such as those traded by electric utilities under the Clean Air Act Amendments of 1990. Those permits could be (i) "grandfathered," or handed out to existing firms in proportion to past emissions, or (ii) sold at auction by the government. A simple analytical model is used below to demonstrate conditions under which the Pigouvian tax is equivalent to a government sale of permits. Much of the environmental economics literature finds that the use of incentives is more "cost-effective" than CAC restrictions.' With imperfect information, the regulatory authorities may or may not know what is the cheapest form of abatement technology. Thus CAC regulations may require technology that is more expensive than necessary. With a tax or a price per unit of emissions, however, each firm has incentives to find and to undertake any form of abatement that is cheaper than buying a permit. Since only the cheapest forms of abatement are undertaken, these incentive policies can minimize the total cost of achieving any given level of pollution protection. So far, this cost-effectiveness argument does not distinguish between taxes, subsidies, permits that are handed out, or permits sold at auction. Yet the handout of permits does not raise any revenue. Thus a new literature in environmental economics concentrates on a distinction between policies that raise revenue (like a tax on pollution or the sale of permits) as opposed to polices that do not raise revenue (like the handout of permits, or a CAC restriction on emissions).2 The model below will be used to reflect on this distinction as well. So far, I have listed two CAC policies, two Pigouvian solutions, and two versions of a permit policy. Yet in some cases with well-defined property rights, even with pollution, Coase (1960) shows how the private market can still achieve economic efficiency on its own. Government does not need to intervene at all, except perhaps to help enforce property rights through a court system. …