[short note: as I’ve mentioned before I have started a new masters course in Public Policy and Management. I will be publishing my essays on this blog, and this is one of these essays.]
In an economy that has achieved Pareto optimality (social efficiency), any additional changes in the economy would benefit some people only by making others worse off. In the real world however, markets fail to achieve this social efficiency and one of the main reasons for this, is the existence of externalities.
An externality occurs when the welfare of individuals and corporate profits are affected not only by the actions of individuals themselves or their companies but also from acts of third parties. Whenever these individuals or their companies are affected beneficially, there are said to be positive externalities, whereas whenever these individuals or their companies are affected adversely, there are said to be negative externalities. A common example of a negative externality is environmental pollution. Pollution will be used for now on, instead of the more general term of “negative externality”.
The existence of externalities prevents the achievement of social efficiency because the one who causes the negative externality (e.g. the polluter) does not equate his or her incremental benefit of generating an extra amount of pollution to the incremental social costs of that externality.
Specifically, the social costs of actions causing negative externalities (e.g. polluting activities) exceed private costs. This can be seen in Figure 1, where demand (D) and supply curves of a good whose production causes a negative externality are presented. If markets were left alone, Marginal Private Cost (MPC) will be the only cost taken into account when the price of the good is set by the market. Thus, the supply curve will be the dark blue one (S). In this case the price of the product would be equal to Pp and the quantity produced will be equal to Qp.
Figure 1. Negative Externality
Since the production of the good causes pollution, the marginal social cost (MSC) is different from the MPC. In fact it is equal to the Marginal Private Cost plus the cost caused by the externality (Marginal External Cost – MEC). The socially optimum quantity is thus smaller than the one produced by the market alone (Qp > Qs) and the socially optimum price is greater than that set by the market (Pp < Ps).
When pollution is ignored by those that cause it, i.e. the polluters, prices fixed by the market do not reflect the full social costs of producing goods and services that cause it and the quantity of the good is larger than the socially optimum. As a result there is too much pollution relative to the Pareto optimum.
Internalizing the externality
Environmental policy aims to reduce negative impacts on the environment through internalising negative environmental externalities. The first such policy was suggested by Arthur C. Pigou (1932) who said that the social cost generated by pollution should be dealt with by the central government. He proposed a tax per unit of pollution equal to the environmental damage created by this unit, when the total pollution is at the socially optimal level. The Pigou tax completely internalises the externality by being equal to the MEC, i.e. by moving the supply curve in Figure 1. from S to MSC, and therefore the market-determined output to Qs.
The second approach was developed by Ronald H. Coase (1960) who, instead of speaking of market failure, looked to markets to find the solution. Where transaction costs are low and property rights for environmental resources are clearly assigned, negotiations take place between those who create the pollution and those who suffer the damage. So it is the market process that leads to a Pareto optimal solution.
Pigou’s approach has the disadvantage that information is costly to assemble, since the information requirement is huge: collection of complicated and rapidly changing information, translating this information into a tax, and imposing the tax on the polluter. An additional problem is that is not always easy to monitor and measure the externality, since sometimes one is not even aware of it.
In contrast, Coasian bargaining leaves the collection of information and the required negotiations to the interested parties. This makes it highly dynamic: a change in the size of the externality will mean that the market will adjust the negotiations by itself. While the Coasian solution takes care of the information problem, it fails when the number of parties is large since this leads to a great increase in transaction costs. This makes bargaining impractical. In addition, the optimal solution assumes that there is full information about the environmental implications of different activities which is unlikely.
Environmental policy instruments
Both of pure Pigou and Coase options are difficult to apply in the real world. For this reason, an extensive toolkit of environmental instruments are now available to the policy makers that can be divided in Command and Control (CC) instruments and Market-Based Instruments (MBIs).
Command and Control policy instruments
If emissions are difficult to measure, then the least that can be done is the enforcement of rules that require the proper installation of the required pollution control equipment (Fullerton, 2001). According to this Command and Control approach, the government agencies impose limits on permissible levels a polluting agent or require the agent to use a particular production method aimed at reducing emissions. The agencies/firms then adjust their output or abatement so that the standard is achieved. If the firms are not complying with these standards, then they are considered lawbreakers and financial penalties or other sanctions are used to bring into compliance.
A disadvantage of CAC instruments is that since abatement costs vary significantly between firms, uniform emissions standards will not minimise the costs of reducing emissions and therefore the costs of compliance may be considerably higher than under MBIs since firms are forced to take on equal shares of the pollution-control burden, regardless of the cost. For the policy to be cost-effective, the environmental regulator would need to define different standards for each pollution source taking into account the abatement costs that each firm faces, information that is generally not readily available and unlikely to be disclosed by firms (Stavins, 2004). Other negative aspects of these instruments are that they do not take into account the remaining pollution associated with each unit of output, just the cost of maintaining the cost of the new technology, and that they do not take into account all the major channels of emission reductions (Goulder and Parry, 2008).
1.1. Performance standards
Performance standards impose requirements on the emissions, i.e. the firms’ output. The regulators measure the observable outcome of the polluter’s behaviour, such as the chemical residues produced. These regulations are usually more cost-effective than design standards described below, since firms are granted flexibility in how they will reach their aim (Goulder and Parry, 2008).
1.2. Design standards
Design standards impose requirements on the production process, i.e. they restrict the technology used by the polluters. For example, such regulations could govern the way farmers produce food and manage their land specifying waste management practices or the level, timing and form of nutrient applications to their crops.
Why are these measures still so popular? It is thought that this is because they are favoured by politicians since they help them gain votes and the public because they think that actions are taken against polluters. They are also favoured by administrators since they require a lot less information than for example environmental taxes. They are also favoured by governments, since it is very difficult to get international agreements on the terms of for example pollution taxes.
2. Market-Based instruments
In the 1970s, policy tools developed from the more regulatory command-and-control measures described above, to more complex Market-Based Instruments (MBIs). Economists are perhaps more likely to favour this ‘market-based’ approach, where the aim is to create economic incentives that will encourage people who are acting in their own self-interest, to simultaneously treat the environment in a way that is in the best interests of society.
2.1. Environmental taxes
There are many definitions and names for environmental taxes but the OECD defines them as “Any compulsory, unrequited payment to general governmental levied on a tax-base deemed to be of particular environmental relevance”. There are various types: taxes on emissions, taxes on products or inputs (when emissions can’t be measured), tax differentiation (for the benefit of activities or products are environmentally friendly), usage fees (payments for environmental services) and tax credit (encouraging activities or products are environmentally friendly). The revenue that comes from these taxes can then be invested by governments in order to tackle pollution in different ways and in R&D of new environmentally friendly technologies.
Even though taxes have been the preferred instrument for pollution reduction, they can have a negative impact if they are not set correctly (for example, they need to be equal to MEC in Figure 1). If they are not set correctly they lead to unfairness (polluters pay more than they emit), distortion of the economy (those industries that succeed will be those that avoid this kind of taxes), reduction of competitiveness of firms of one country compared to firms of other countries and inefficiency.
2.2. Tradable emission permits
Emission permits allow their owner to emit a certain quantity of pollution during a certain period. Those polluters that pollute less than that quantity are able to trade their permits with those that produce more of that quantity. This lead to the creation of permit market where polluters buy or sell permits based on their abatement costs and the price of the permits.
Permits fit in either of two categories: the credit programs and the cap-and-trade systems. Under credit programs, an emissions baseline is set and those that emit less, they get the difference in the form of a credit that they can trade. Under a cap-and-trade system, the overall allowable level of pollution is allocated among firms in the form of permits that they can then be freely exchanged among polluters. In the latter case, there is increased pressure in the EU to change the way these permits are given – from free allocation to auctioning (commission of the European Communities, 2008).
2.3. Subsidies for Pollution Abatement
Subsidies are current unrequited payments from government to producers with the objective of influencing their levels of production, their prices or their remuneration of the factors of production (ESA, 1995). Subsidies provide incentives to introduce environmental friendly technologies or recourse behaviour. They are less cost-effective than taxes and tradable permits (Goulder and Parry, 2008).
2.4. Deposit-refund systems
In a deposit-refund system, consumers pay a surcharge when purchasing a potentially polluting product and receive a refund when they return it to an approved centre for recycling or disposal. For economic efficiency, the size of the deposit should be set equal to the marginal social cost of the product being disposed of illegally minus the costs of the program’s operation. Deposit-refund systems are most likely to be appropriate when the incidence and the consequences of improper disposal are great e.g. with cans of soft-drinks.
2.5. Voluntary agreements
Voluntary Agreements (VAs) have been increasingly used as a new policy tool to achieve energy efficiency measures. In the European Union for example the total number of VAs has been calculated to exceed more than 300.
VAs seemed promising because (Bard, 2002, p.11):
- They provide increased flexibility,
- The industry prefers them instead of new laws and regulations,
- The industry is seeking to avoid new taxes by pushing its own initiatives,
- They are preferred by Non-Governmental Organisations and trade unions, since in this way they can have a bigger influence on environmental policy.
Different types of voluntary approaches have been developed, ranging from the strictest, i.e. contracts negotiated between public authorities and one or more private parties (negotiated agreements) to environmental improvement programmes set up by firms and communicated to their stakeholders (unilateral agreements).
An example of a voluntary agreement is the ACEA (European Automobile Manufacturers Association) agreement with the European Commission. The ACEA agreement aimed to limit the amount of carbon dioxide (CO2) emitted by passenger cars sold in Europe. In 2008, the European Union claimed that the agreement have failed since most companies, except for FIAT, did not reach the target emission level of less than 140g/km.
A number of criticisms have been raised for voluntary agreements such as weak control, transaction costs, free-riding, regulatory capture (where businesses persuade those setting the terms of the agreement to be more lenient) and “business-as-usual scenarios’ (the outcome is equal to that that would been achieved anyway”). Nontheless, given their positive features (flexibility, stakeholder commitment, know-how diffusion), they are likely to work well as complements and/or precursors of other policy instruments, such as all those described above (Bard, 2002, p.12).
A case study
So far the most commonly used instruments for pollution reduction have been reviewed. In this part of the essay, an example will be taken in order to investigate which of these instruments are used in real-case scenario. The example that is chosen is water pollution. Specifically, agriculture-induced nitrate pollution of European water bodies. The current legislation will be analysed in order to detect which of the above instruments have been used.
According to the European Union “Pollution is the introduction of substances or energy into the environment, resulting in deleterious effects of such a nature as to endanger human health, harm living resources and ecosystems, and impair or interfere with amenities and other legitimate uses of the environment.” (European Union website). Water pollution is one type of pollution.
Given that water is important for our quality of life, the things we grow and produce and that it provides natural habitats and eco-systems for Europe’s plant and animal species, the European Union has created a number of Directives that require its Member states to reduce their water pollution levels.
Water quality is influenced by both point (mainly from sewage treatment and industrial discharge) and non-point (diffuse) pollution sources (mainly from farming). The key pollutants of farming are nutrients (e.g. nitrogen, potassium, calcium, sulphur and phosphorus) and pesticides. In this essay we will focus on nitrate pollution from agricultural sources.
Nitrate pollution from agricultural sources
Current agricultural practices often require high levels of fertilisers and manure, hence leading to high nitrate surpluses. These are transferred to water bodies through various diffuse processes and have detrimental effects on the European water bodies by
a) promoting eutrophication
b) disrupting ecosystem processes
c) harming aquatic communities
Even though nitrate’s negative impact on human health has been under debate, a recent study estimated a 3% increase of incidence of colon cancer for 11 EU member states due to nitrate in drinking water exceeding 25 mg/L, being half the legal US and EU limit of 50 mg/L (van Grinsven, Rabl and de Kok, 2010).
In 1991, the European Union released the Nitrates Directive (91/676/EEC) in order to protect water quality in the European Member states, through prevention of nitrate pollution from agricultural sources of ground and surface waters. It also aimed to promote the use of good farming practices.
There are five steps of implementation of the Directive and they will be presented here focusing on what actions were taken in Greece:
1. Identification of polluted or threatened waters (N)
2. Designation of “vulnerable zones” (NVZs) by member states. These are all known areas of land for which:
- surface freshwater contains or could contain more than 50 mg nitrates per litre;
- groundwater contains more than 50 mg/l nitrate;
- natural freshwater lakes, other freshwater bodies, estuaries, coastal waters and marine waters are found to be eutrophic or in the near future may become eutrophic.
In Greece 10 such areas were identified
(5) plain of Thessaloniki
(9) the basin of the Strymon (Serres), with the lake and Kerkini
(10) the plain of Arta – Preveza.
3. Establishment of Code(s) of good agricultural practice, to be implemented by farmers on a voluntary basis.
Greece established a Code of Good Agricultural Practice, whose application is voluntary outside the NVZs but compulsory in their interior. These were applied on three of the 10 NVZs: Thessaly (600,000 acres), Kopais (300,000 acres) and Ilia (30,000 acres). The total program budget for 2000-2006 amounted to 111.9 million euros. It should be noted that in 2005 the European Commission threatened to send Greece to the European Court for breach of the nitrates directive.
4. Establishment Action Programmes, to be implemented by farmers within NVZs on a compulsory basis.
The new Plan for “Agri-environmental payments” under certain action 2.1 of measure 214 of the Rural Development Program 2007-2013 “Alexander Baltatzis” will be launched in the first half of 2011. It will include the following areas:
(1) East and West Thessaly and specific regions of the Magnesia prefecture, Larissa, Karditsa and Trikala Fthiotida.
(2) Kopaida and specific areas of the county of Viotia, Fokida and Fthiotida
(3) Basin Penaeus in Ilia, particular areas of Ilia and Achaia.
(4) Argos in particular regions of the Argolis.
(5) Prefectures of Thessaloniki-Kilkis, Pella, Imathia (Lake Koronia).
(6) Strymon Basin in particular areas of the prefecture of Serres.
(7) Plain of Arta-Preveza.
On the 13th of October 2010, the ministry of rural development and food sent an invitation to farmers in affected areas of lake Koronia and Argolis, to submit their interest to join the 5-year program.
5. National monitoring and reporting every 4 years on Nitrates concentrations, Eutrophication, Assessment of Action Programmes impact and Revision of NVZs and Action Programmes. Three such reports have already been produced:
- 1st action program: 1996-1999 (published in 2002)
- 2nd action program: 2000-2003 (published in 2007)
- 3rd action program: 2004-2007 (published in 2010)
Putting Nitrate Directive into the context of Environmental Policy
Going back to the previously discussed environmental policy instruments, in the case of nitrate pollution, the European Union is using regulatory Command-and-Control performance standards in order to reduce nitrate levels. The government compensates farmers in NVZs to persuade them to use either of two methodologies:
A. Combination of resting and permanent reduction of the applied lubricant units
B. Combining rotation, uncultivated margin and reduction of the applied lubricant units.
Even though the new EU Nitrates fact sheet states that overall, the 2004-2007 report indicated good progress towards cleaner water, the results were not as satisfactory as it was hoped. In fact, Greece has been sent to the European courts for not succeeding to reduce nitrate levels to the required level.
But what about market-based instruments to reduce nitrate pollution? A study by Kraemer, Kampa and Interwies (2004) reviewed cases were tradable permits have been used for water pollution control in the US and Australia. They state these cases benefited from solid scientific understanding of the pollution problems in question, existing monitoring infrastructure and enforcement capacities. Europe has now an extended monitoring network in all of its member states, and those areas that were part of the 3rd plan programme of the Nitrate Directive have developed experience in monitoring nitrate levels. In the following figures (European Union website), the number of monitoring station are shown in parentheses next to each country name:
Figure 2. Concentration of nitrate in lakes and rivers in European countries (2006)
A growing interest exists towards applying environmental taxes on chemical substances. The OECD Environmental outlook study (OECD, 2001) investigated a policy mix that would include taxes on chemical use and showed that the chosen policy mix would deliver significantly reduced nitrogen levels at low economic costs. The European Commission also put forward a report for environmental taxes on cadmium in phosphate fertilisers (CEC, 2002). More recently a study analyzed the economics and politics of taxing chemical compounds and the future potential for increased implementation of such taxation policies in Europe (Soderholm and Christiernsson, 2008). They concluded that the choice of tax scheme is important both to ensure cost-effectiveness but also to reduce any political opposition towards them. Concerning, the implementation of such a scheme in Europe, the authors of the study suggest that taxation should be close to environmental damages in order to be considered as fair and that the reduction of transaction costs should be the priority of the policy.
No environmental policy instrument, whether market-based or regulatory (of the command-and-control approach) is guaranteed to work in every case. Whereas environmental taxes and tradable emissions have had some success in reducing CO2 emissions, it is regulatory Command-and-Control non-point source performance standards that are the instruments of choice in the case of water pollution, despite the arguments against them. This could be a result of the goal-oriented approach that it has been taken due to the imposing threat of climate change. However, this does not mean that the market-based instruments will never be applied. On the contrary, both are very likely to contribute to the reduction of water pollution. In my opinion, the best option will be a policy mix, a combination of market-based and command-and-control measures.
- Coase, R (1960) “The Problem of Social Cost” Journal of Law and Economics 3:1–44.
- Commission of the European Community – CEC (2002) “A possible EU wide charge on cadmium in phosphate fertilizers: economic and environmental implications” Report Number E-00/02, Brussels.
- Commission of the European Community – CEC (2008) “20 20 by 2020: Europe’s climate change opportunity.” Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee, and the Committee of the Regions.
- Don Fullerton (2001) “A Framework to Compare Environmental Policies”Southern Economic Journal 68.2: 224-248.
- Dowd BM, Press D and Los Huertos M (2008) “Agricultural nonpoint source water pollution policy: The case of California’s Central Coast” Agriculture, Ecosystems & Environment 128(3): 151-161.
- European Union website: http://ec.europa.eu/environment/water/water-nitrates/index_en.html
- Goulder LH and Parry WH (2008) “Instrument Choice in Environmental Policy” Review Of Environmental Economics and Policy 2(2):152-174.
- Kraemer RA, Kampa, E and Interwies E (2004) “The role of Tradable Permits in Water Pollution Control” Working paper for the Inter-American Development Bank.
- OECD (2001) “Environmental outlook study” OECD, Paris.
- Pigou, AC (1932) “The Economics of Welfare” 4th edition, London: Macmillan.
- Soderholm P and Christiernsson A (2008) “Policy effectiveness and acceptance in the taxation of environmentally damaging chemical compounds” Environmental Science and Policy 11:240-252.
- Stavins, R.N., 2004. Environmental Economics. Resources for the Future Discussion Paper 04-54, RFF: Washington.
- van Grinsven HJM, Rabl A and de Kok TM (2010) “Estimation of incidence and social cost of colon cancer due to nitrate in drinking water in the EU: a tentative cost-benefit assessment” Environmental Health 9:58.
- Bard, JP (2002) “Voluntary Environmental Agreements: Process Practice and Future Use” Edited by Patrick Ten Brink, Greenleaf Publications, UK.