Uncertainty Monitoring Enforcement Using economic models to help inform which instruments are most effective at controlling pollution Motivation Group Project New rules are being promulgated by the Santa Barbara Air Pollution Control District for regulation of VOC emissions from stationary sources They are concerned about the cost of monitoring compliance and want your Bren Group Project to design a cost effective monitoring program Group Project cont Problem How to assure compliance Some possible options Install continuous emission monitors Rely on voluntary self reporting Use self reporting with teeth Random audits Hefty fines for violators Will all do the job Which is likely to be cheapest Today s Menu Uncertainty how does uncertainty influence your choice of regulation Monitoring how do you construct a regulation if monitoring is tough ie cannot observe emissions Enforcement how to construct a cost effective enforcement program Uncertainty Unobserved costs Choice of regulatory instrument tradable permits vs emission fees Case 1 certainty Case 2 uncertainty in costs and benefits Unobserved costs called Adverse Selection Case 1 Observed control costs If MB and MC curves known regulator can choose efficient pollution level MC society 2 equivalent policies 1 Set quota of Q 2 Set tax of t t MB firm Q Electricity Case 2 Unobserved control costs Think of MC as the damage to society of pollution accompanying electricity Think of MB as the savings to the firm from being able to pollute Both MC and MB may be uncertain to regulator Which instrument should be used Price instrument polluter pays t per unit pollution Quantity instrument polluter emits exactly Q Price vs quantity regulation MC If tax t is imposed May get eL e or eH t MBH MBM MBL eL e eH Pollution MB may be high or may be low MBM right in the middle Basic Problem Errors occur in case of either tax or permits Tax MC set equal to the tax can generate big swings in pollution output and thus big deadweight loss Quantities Always know how much pollution but there can be big swings in MC leading to large deadweight loss When MC is steep rel to MB MC Deadweight loss from tax When MB turns out to be H MB Tax Deadweight loss from Permits when MB low Use quantitybased regulation Q Pollution When MC is flat rel to MB Use pricebased regulation MB MC t Deadweight Loss from permits Deadweight loss from taxes Pollution Slopes of MB MC Marginal Benefit of pollution is akin to the cost of abatement to the firm Steep when very few alternatives firm must produce fixed amount of pollution as by product of production Flat when each unit of abatement is equally costly Marginal Cost of pollution is the health environmental cost Steep when threshold effects no cost at low levels then quickly rises to high cost e g water temp on fish Flat when each unit has same environmental cost e g carbon within a range Monitoring Unobserved Actions Suppose we cannot observe something a firm is doing like midnight dumping How do we construct a regulation to deal with problem Unobserved actions called moral hazard Illegal dumping If proper disposal is costly People have an incentive to midnight dump If monitoring free just impose tax on polluters when they are caught If monitoring very expensive could tax sale of the good consumption tax Want a mechanism that taxes polluters but rewards non polluters but we have imperfect enforcement Deposit refund 1 of 2 What happens if we place a tax on dumping equal to marginal environmental damage Illegal dumping occurs if monitoring is not perfect Instead want to reward proper disposal punish illegal disposal Deposit refund 2 of 2 How it works Potential polluter pays X on purchase of waste product eg solvent Receives Y upon return dirty solvent Why is this different than simply taxing illegal dumping or subsidizing clean disposal It s both Deposit refund a clever policy Remember potential polluter effectively pays tax up front Is reimbursed at least upon return A clever disclosure mechanism Refund is paid when potential polluter proves compliance by returning All polluters pay tax X all nonpolluters pay nothing or make money Enforcement Laws worthless if they are not enforced Enforcement can be very costly How to construct low cost enforcement program Enforcement Polluter may be doing something other than what he tells regulator Regulator can audit polluter at a cost Clear interplay between frequency and stringency of audit and fine if caught Probability of detection vs fine E g traffic laws income tax reporting self reporting in RECLAIM etc Auditing an emissions standard e total emissions B e Benfit of emissions S emissions standard f fine per excess emissions if caught prob of detection F e expected fine treated as a cost to firm F e f e S 1 if e S 0 if e S Net expected benefit to firm ex ante NB e B e F e How much will firm pollute NB e B e F e MB e MF e 0 at the optimum MB e MF e Firm pollutes where marginal benefit from polluting equals marginal expected fine MB MB e f f e e0 e Note If firm only cares about f the marginal expected fine can adjust either Should regulator increase fine or If firm only cares about f regulator wants high fine low this makes auditing costs very small But assets of firm may be limited I e bankruptcy Often the case for pollution potentially high damage from cheating May require environmental bond Bottom line costs of cheating must exceed costs of adhering to regulation